A Look at History Reinforces the Idea That Dollar Is Due for a Rebound

I believe that the dollar could be due for a comeback from the slump it has suffered since March. Sure, there are plenty of reasons why the dollar has been and may continue to be weak.

First, interest rates in most major foreign countries are higher than in the United States, especially short-term rates. This difference, of course, tends to attract money out of the dollar and into currencies with higher yields. Until foreign rates decline, or U.S. rates rise, the pressure on the dollar will continue.

Second, the U.S. economy is continuing the stop-go pattern that has persisted since the second quarter of 1989. A retreating U.S. economy is one that discourages U.S. investments and the related purchases of dollars by foreigners, and encourages Americans to move funds abroad.

Third, until late July, the Administration tried to talk down the dollar, believing that a weaker dollar would pump up the domestic economy by making imports more expensive and stimulating exports, which become cheaper in foreign currencies. This hasn’t worked in the past, but the Administration is desperate, facing a weak economy and a huge deficit as the election approaches, and has few options.

But Washington has apparently decided that the dollar weakness was overdone. Rather than raise short-term interest rates--a no-no in an election year--officials opted for coordinated central bank action to support the U.S. currency, starting late last month. Central bank intervention in currency markets never succeeds if it bucks the tide, but this time the tide is probably changing in the dollar’s favor.

In spite of the many good reasons for continuing dollar weakness, the collapse since March seems extreme, especially since the many problems of the world--such as the escalating troubles in Yugoslavia--should benefit the dollar as the traditional safe haven for scared international money. I rather suspect that the extreme weakness in the greenback has been caused by something quite different.

A look at history will demonstrate what I’m getting at. The dollar declined in the late 1970s. No wonder, with all the inflation and other problems at the time. But then it turned around and took off like the proverbial scalded dog in July, 1980.

Why? In part because the Federal Reserve wasn’t persuaded that the 1980 recession, then ending, would bring inflation under control, so the monetary authority raised interest rates to make sure the job was completed. (In the process, of course, the Fed precipitated the 1981-82 recession that followed after only one year of recovery.) Higher interest rates attracted funds to the U.S. despite the weak economy.

Nevertheless, the skyrocketing of the dollar suggests that something else was also at work in the summer of 1980. I believe that it was the realization by foreigners and others involved in setting the dollar’s value that a vast political change was about to occur in the United States. This was not clear, however, to most Americans at the time.

Polls showed presidential candidates Jimmy Carter and Ronald Reagan in a close race, and many questioned whether Reagan would win. Voters were disenchanted with both candidates, citing the recession, Abscam, the Iran hostage crisis and a sense of disgust with Washington on the whole. Despite this disillusionment, pollsters predicted only small gains in Congress for the Republicans: four or five seats in the Senate, with Democrats retaining control, and 10 to 12 seats in the House.

In fact, the dollar’s strength was foreshadowing a political watershed which paved the way for a decade of strong, ultimately exuberant, growth and a climate in Washington that would be extremely favorable to American business--and therefore the dollar. Reagan, of course, won in a landslide that November, and the Republicans gained 12 seats and control of the Senate as well as 33 seats in the House.

Maybe the same thing happened this year, but in reverse. Maybe foreigners and other currency market participants sensed earlier this year, to a far greater degree than domestic investors and business people, that American voters had lost confidence in politicians and wanted a real change.

This negative voter attitude was certainly aided and abetted by the continuing stop-go economy, fear of layoffs and the huge consumer debt loads. Foreigners, in effect, may have been worrying about a genuine challenge to the political structure in the form of “Washington outsider” candidate Ross Perot, with his protectionist leanings, and about the possibility of the presidential choice being thrown into the House of Representatives with uncertain results.

Now, however, Perot is gone from the race, and although the election result is still unknown, it will be decided in November. Consequently, a great deal of uncertainty has been removed and, as a result, the dollar may well bounce back.

As noted, continuing military problems abroad should also help the dollar. So too should continuing economic slippage in Europe and the unfolding serious recession in Japan.

The U.S. economy may be weak, but it may well prove to be the best of a bad lot. The safe haven aspect of the dollar may again be significant since, in the kingdom of the blind, the one-eyed man is king. Furthermore, economic slowdowns abroad will, sooner or later, induce foreign central banks to reduce their own interest rates, thereby removing the depressing effect on the dollar of higher foreign interest rates.

A stronger dollar will squeeze revenues of domestic firms that compete with imports as well as U.S. exporters, but only in a limited way, since the effects of currency changes on trade are offset in considerable part by price changes. U.S. tourists abroad will benefit as their greenbacks buy more foreign goods and services. And foreign investment in the United States will be encouraged.

There are many reasons for the weakness in the dollar since March, but one of them, the threat of severe disruption in the presidential election process, has now been removed by Perot’s withdrawal from the race. As a result, the dollar may rebound--at least, that’s what I believe. In portfolios we manage, we have covered our short positions in the dollar and are going long.