New trading year, new 2009 low for the dollar

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The dollar slid to a yearly low versus the euro and British pound Tuesday, as the new trading year began as institutional investors returned from summer vacations. Even so, the compelling question for foreign currency traders remains unresolved: will the dollar's slide continue?

The dollar weakened about one cent to $1.4487 and $1.6525 against the euro and British pound, respectively, on sentiment that a global recovery will lead to a move out of the dollar and into higher-returning emerging market investments. The dollar also fell about one yen to 92.99 Japanese yen, and about about 1.5 cents to $1.0431 versus the Swiss franc.

Dollar bears argue that more dollar doldrums are ahead. They say demand for capital abroad, the prospect for only modest capital gains in the U.S., and the U.S.'s large budget deficit will place more pressure on the greenback in the months and quarters ahead.
Are you ready to jump in to the currency market and start shorting the dollar? Not so fast. Dollar bulls argue that the dollar's recent fall against the world's other, major currencies may prove to be short-lived. The problem, the bears argue, is the amount of asset destruction that occurred during the global financial crisis and the lack of demand needed to sustain adequate GDP growth in the United States.

In a nutshell, demand is basically consumer spending, housing, business investment, and exports. When it's present, the gears of the economy are in motion, and goods are being purchased and used. That translates to rising corporate revenue and earnings -- and, ultimately, rising U.S. stock markets. For demand to result in sustained, adequate GDP growth, it must be broad-based.

What's a good example of broad-based demand? The 1990s U.S. economic expansion, the 'Roaring 90s.' A tax increase that ended the U.S. budget deficit lowered interest rates; combined with technological advances and earned income tax programs that lifted millions out of poverty, an enormous, broad, diverse pool of producers and consumers was created -- broad-based demand. That demand triggered widespread production increases by manufacturers and other firms, resulting in continual jobs gains of 300,000 jobs per month, double-digit corporate revenue and earnings increases, business formation, and of course, rising U.S. stock markets.

If the dollar bulls are right, deflation, not inflation, is up ahead, the U.S. recovery will be weak (or its economy will fall into a double-dip recession), and the global economic recovery will be less strong than expected -- conditions that are ripe for low inflation, if not outright deflation, and in the process dispel the dollar bears' thesis.

Moreover, whereas the dollar bears argue inflation is avoidable in the quarters and years ahead -- too many dollars chasing not enough goods -- the dollar bears argue deflation is the major concern: there won't be nearly enough consumers to purchase the flood of goods that's entered the global economy as a result of globalization, and just as important, as a result of high unemployment in the United States, and in other countries.

Dollar Analysis: And to think both camps occupy the same space in the world's currency markets! Well, that's part of what makes a market. Which camp has the stronger argument? At this juncture, the evidence is tipped in favor of the dollar bulls. The apparent, nascent U.S. economic recovery is too young to argue that GDP growth in the U.S. will approach initial growth rates registered in previous recoveries. Unemployment is too high, real wages are flat-to-declining, and hiring tendencies are light-to-sporadic at best -- which points to inadequate demand, and hence less pressure on the dollar.
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