New burst of energy augurs well for future of US dollar

AFTER years of being a currency no-hoper, the US dollar may become the big surprise for the vast majority of foreign exchange forecasters. Greenback cynicism is not surprising considering that since the beginning of floating exchange rates in the early 1970s, the dollar’s index against other currencies has slumped by 33 per cent. During those long four decades, however, there have been periods of dollar strength.

The intriguing question now is whether the currency is on the cusp of recovery. A fundamental change in the outlook for both the US economy and its currency is the rapid shift of the country towards energy independence. An explosion in US natural gas and oil production and exploration is expected to turn America from an importer to an exporter of energy.

Iran and the law of unintended consequences

Iran is yet another page in the law of unintended consequences as it has concentrated the minds of both Democrats and Republicans. They are now side-stepping environmental concerns in election campaigns and are encouraging energy producers. According to the US Energy Information Administration (EIA), the US has surpassed Russia as the world’s biggest producer of natural gas. Moreover, prices are much lower than levels in Europe and Asia.

American companies are building more plants to produce frozen, liquefied natural gas (LNG) that can be sold in Asia and elsewhere. Meanwhile, growing numbers of trucks are converting from diesel to natural gas and cars are expected to follow.

High prices and worries about future supplies from Iran, Iraq and other Opec nations are also stimulating exploration and development of oil reserves. In 2006, the US Department of the Interior estimated that recoverable US oil reserves were 134 billion barrels. New horizontal drilling methods have raised the estimate to 1.5 trillion barrels of recoverable oil in shale deposits. There are environmental concerns as the hydraulic fracturing drilling methods can pollute water supplies.

Surging US oil and gas production will eventually cut trade deficit

But the oil and gas companies are homing in on new techniques to counter this risk. So, natural gas and oil production are rising rapidly and the implications for the balance of payments and the US economy are huge. Such is the frantic activity in the energy resource sector that it is helping to lift overall US domestic investment and the balance of payments current account could well swing from deficit to surplus in the medium and long term.

To be sure, the current account deficit has already fallen from its 2006 high and continual improvement could well change the foreign exchange throng’s mindset from US dollar scepticism to cautious belief.

Currency forecasting at the best of times is a frustrating business and the armies of currency analysts and strategists will vouch for that. Indeed, US Federal Reserve chairman Ben Bernanke is the latest policymaker who has been wrong-footed. One of the key aims of Mr Bernanke’s strategy of monetary easing and negligible interest rates is dollar devaluation to spur US exports.

US dollar holds above lows

Renewed monetary ease failing to devalue dollar further

Instead, recent bouts of so-called quantitative easing (QE) and monetary flood have failed to bring about further currency depreciation. The US Federal Reserve chief was initially successful in his devaluation policy when, in 2002, he encouraged the then Fed chairman, Alan Greenspan, to pursue QE.

The greenback headed south and the dollar index slumped by almost 40 per cent from 120 points to around 72 points in 2008. The nadir was significant as it occurred during the real estate, stock market and commodity bubble that QE and dollar depreciation had created.

Surprise, surprise, there was an almighty crash which precipitated the Great Recession. The flight to safety caused the greenback index to recover by 23 per cent to 90 points, but two further bouts of QE caused the currency to fall back to 72 points in September last year.

Dollar is cheap  in terms of relative national prices 

Significantly, however, the dollar did not fall below its 2008 bear market low. Moreover, the index has since recovered by about 10 per cent. For the moment, the overwhelming market mood is that any dollar rally will prove to be short-lived because of America’s massive budget and balance of payments deficits.

Dollar doubters believe that its current recovery is a counterpoint to weakness of the euro, the yen and other currencies and is the least awful choice. Following a decade of devaluation, however, the dollar is now cheap. On a purchasing power parity basis, ie relative trade, the euro-dollar rate should be 1.15, yen-dollar rate 122 and dollar-sterling 1.43.

And, further ahead, monitor America’s energy production and trade. That is a game changer!

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