With sentiment turning decidedly bearish against the dollar, concerns about a rapid meltdown have intensified.
But analysts say any precipitous declines are likely to be halted by foreign central banks, and that a steady, orderly selloff is more likely.
In recent days, the dollar has fallen to a record low against the euro, as worries about huge trade and budget deficits have grown after the re-election of President Bush.
While Bush and Sen. John Kerry both had plans that would have increased the deficit over the next 10 years, analysts said Kerry's proposals would have faced challenges in a mostly Republican Congress.
Bush, on the other hand, has broad support for making his tax cuts permanent and partially privatizing Social Security. Both of these plans would add trillions of dollars to the budget deficit. In addition, analysts say, the Bush administration has pressured the greenback over the past year by adopting a policy of "benign neglect."
"It's very striking that the consensus is so unanimously negative for the dollar," said Ashraf Laidi, chief currency analyst at MG Financial. "That could evoke very rapid declines by the hedge funds."
Bets by hedge funds and other large speculators on the dollar to fall against the euro rose to a record by Nov. 2, according to
On Monday, former U.S. Treasury Secretary Robert Rubin warned that the dollar's decline could become more serious and that interest rates could rise sharply if steps aren't taken soon to narrow the deficit.
Still, Laidi said, European and Asian central banks are likely to buy dollars and sell their own currencies, or at least hint that intervention is coming, if the depreciation in the dollar gets materially worse over the coming days and weeks.
Indeed, Jean-Claude Trichet, president of the European Central Bank, said Monday that "recent moves, which tend to be brutal on the exchange markets between the euro and U.S. dollar, are not welcome from the standpoint of the ECB." And on Tuesday, ECB council member Guy Quaden said, "It would be undesirable if the euro's appreciation continues and even less so should it accelerate."
The European economy is not considered strong enough right now to tolerate a rising euro, which hurts exports. Retail sales in the eurozone declined for a third straight month in October. Meanwhile, business confidence in Japan fell for a third month in October, and economists worry that the nascent recovery there is starting to falter.
In addition, while rumors have swirled that China has been selling dollars recently and is ready to switch to a flexible exchange rate, some say that isn't the case. China's renminbi is pegged to the dollar.
"My sources in Beijing were unanimous in underscoring that nothing has changed," said Stephen Roach, chief global economist at Morgan Stanley. "While Chinese officials may now be preparing the way for a regime change that may come sooner rather than later, nothing imminent appears to be in the cards."
Meg Brown, senior currency strategist at Brown Brothers Harriman, expects the dollar to strengthen over the near term, citing technical factors, but she believes the longer-term trend remains firmly in place.
A year from now, she projects that the euro will be worth between $1.35 and $1.40, up from $1.29 today. The dollar will probably be worth less than 100 yen, from 105 today.
The fall in the dollar has come as a surprise to some analysts, particularly in the wake of a much stronger-than-expected employment report last week, which raised the odds for a fifth interest rate hike in December. The
is widely expected to raise rates a fourth time on Wednesday.
Tighter monetary policy is often considered to be positive for the dollar, because higher rates make U.S. bonds more attractive to overseas investors. In order to buy these bonds, foreigners have to buy dollars and sell their own currency.
Still, the U.S. dollar index has fallen more than 5% since the central bank started hiking rates in late June, as investors have failed to shake off fears about the huge trade and budget deficits. The index is down about 9% from its highs in May.
"Some think deficits don't matter," said Richard Berner, chief U.S. economist at Morgan Stanley. "History indicates that what matters is committing to fiscal restraint, which is hard to find in Washington."
If government tax cuts are extended, the budget deficit could reach $4.5 trillion over the next 10 years, according to the Congressional Budget Office. And analysts estimate that the U.S. trade deficit hit $54 billion in September, the second-highest level in history.
While foreigners have been willing to finance these deficits so far, there are signs that they are becoming more reluctant to do so. In August, net purchases of Treasuries fell 34% to an 11-month low of $14.7 billion. Meanwhile, foreigners sold stocks to the tune of $2 billion after purchasing $9.8 billion in equities the month before.
When overseas investors buy fewer stocks and bonds, they also buy fewer dollars. This can prompt the Fed to hike interest rates to attract foreign capital.
"I think the most likely scenario is for a continued decline in the dollar," Laidi said. "But
foreign central banks are going to have to draw the line somewhere and will either talk down
their currencies or threaten to do so."