Thinking Through the Smaller Dollar - TheStreet

Major averages were struggling at midday, having failed to sustain a midmorning flurry. Not coincidentally, the stock market's struggles were accompanied by more weakness in the dollar.

As of 2 p.m. EDT, the

Dow Jones Industrial Average

was down 0.6% to 9860.20 after having traded as high as 9943.52. Similarly, the

S&P 500

was down 0.8% to 1059.50 vs. its early best of 1069.50, while the

Nasdaq Composite

was down 0.3% to 1619.66 after having traded as high as 1637.65.

In early currency trading, the dollar traded at a six-month low of 122.82 yen and a 15-month low of 94.02 cents per euro. Confronted by the greenback's latest bout of weakness, the U.S. Treasury Department felt compelled to issue a statement that its dollar policy is unchanged; i.e., it still supports a strong dollar. That helped give the greenback a lift, but only temporarily. As of 2 p.m. EDT, the dollar was trading at fresh session lows.

Like the equity markets, some believe the dollar is oversold and due for a rally. Market participants, however, no longer are able to ignore the currency's recent weakness and the implications thereof.

On Tuesday, PIMCO issued the results of the asset management firm's annual "Secular Economic Forum," which included the following prediction: "The dollar will decline by more than 10%

in the coming years, a result of the large and growing U.S. account deficit and global disillusionment about U.S. corporate profitability. This is another factor pointing in the direction of a modest rise in inflation." (The full release is available at

Pimco's Web site.)

Today, William Dudley, director of U.S. economic research at Goldman Sachs, issued a more detailed and somewhat draconian report. Dudley discussed how a sharp decline in the dollar poses risks to the "consensus view of a sustained, non-inflationary recovery," as it would hurt U.S. growth prospects, cause the trade deficit to widen, and raise U.S. inflation. (Certainly, this is something bears have been saying for some time, so Dudley's view may not be revelatory.)

Furthermore, the risk of precipitous decline "is significant because the dollar is already significantly overvalued," he wrote, adding there would be "no easy remedy" for policymakers if the greenback tumbled precipitously.

Federal Reserve

tightening "could be viewed as damaging to U.S. growth prospects" and currency intervention "probably would be ineffective," the economist contended.

Perhaps most troubling, Dudley suggested "the notion of dollar weakness is intuitively appealing," because although the U.S. investment bubble has popped, the dollar has not. Noting the Fed's trade-weighted dollar index is still up more than 30% since 1995, he forecast: "Thus, the next stage is deflation of the dollar bubble."

Some say the dollar's long-term strength is a reason to pooh-pooh its recent weakness, and Dudley agreed the recent downturn is "trivial relative to the earlier rise." But "the important point to remember is that trends that are unsustainable -- such as widening current account imbalances and persistent currency strength -- must inevitably end, even if it is impossible to be confident about the precise timing," he wrote.

Forecasting that the current account deficit will reach 4.5% of GDP by the fourth quarter and approach 5% by the end of 2003, Dudley wrote that such "imbalances are not a problem," as long as foreigners want to increase holdings of dollar-denominated assets.

Discussion of

foreign buying of U.S.-based assets is quite in fashion these days. Dudley concluded "it does not seem reasonable to anticipate" foreigners' demand will continue at the same pace as in past years.

The most troubling aspect of a weakening dollar is that it can quickly become what Dudley dubbed a "downward cycle." A weaker dollar hurts U.S. growth prospects and lifts inflation, increasing the "risk premia" on dollar-denominated assets and lessening their appeal to foreigners, which causes the trade deficit to widen further, resulting in additional weakness in the dollar. And so on.

Ultimately, a weaker dollar would "stimulate U.S. economic activity by improving U.S. competitiveness" in overseas markets. This is one reason some are getting bullish on U.S. multinationals in the wake of the dollar's recent decline. However, the 25 S&P 500 components with the highest percentage of foreign sales, as cited by

Barron's

on May 20, were mostly down at midday and haven't benefited much of late from the greenback's weakness. They were paced by

Applied Materials

(AMAT) - Get Report

, down 4.8% (to below $22 and on heavy volume for those following the Trader X saga).

It could be that foreign owners of big U.S.-based multinationals are now selling in the face of the greenback's slide, among other concerns. Or it could be that it will "probably take a year or more" for weakness in the dollar "to have a significant positive influence" on the U.S. economy, as Dudley wrote.

The Goldman economist even compared the current environment with the 1985-87 experience. After peaking in 1985, the dollar didn't sharply decline until two years later, resulting in a sharp steepening of the Treasury yield curve in the fall of 1987. Bond yields rose very sharply in the days leading up to the Oct. 19 stock market crash, he recalled, calling the dollar's decline the "proximate cause" of that harrowing episode.

"A sharp dollar slide appears almost inevitable," although the timing is "highly uncertain," Dudley concluded. "But we believe it makes sense for investors to stress test their portfolios to see how they would hold up if the dollar were to slide significantly."

Investors unwilling or unable to do their own "stress testing" might have it thrust upon them -- today's midday action being a sample.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.