Wall Street's Dollar Worries Fade

The burgeoning current-account deficit was the big concern a month ago, but as the dollar has found some stability, fears have waned.
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While the U.S. markets have by no means been having a very happy time of it lately, it's worth noting that the

big worry besetting the market little more than a month ago has come to naught.

Remember how it went? The current-account deficit -- the share of U.S. wealth held by foreign countries -- was (and remains) at its highest levels since 1987. Such imbalances are not perpetually sustainable, and the fear was that strength in the yen and the euro against the dollar -- beneficiaries of the renewed growth in their respective homelands -- would prompt a return to the mean in the current account that was just a little too quick. Foreign investors, jittery over exchange-rate losses, would withdraw assets from the U.S. That would force the dollar lower still, prompting a vicious cycle of capital flight familiar to anyone who's lived through the past couple of crises to roil capital markets.

Through the summer, as the greenback slid against the euro and, to an even greater extent, against the yen, you began to hear people grumbling about the current account and floating the idea that it posed a serious hazard to U.S. markets. But it was really, at that point, one of the many things that are out there to get bearish about: Earnings yields are too low relative to bond yields. Market breadth is narrow. The universe is expanding.

'The current-account issues are still real,' says Paribas' Bob Lynch, 'but keep in mind the adjustment that's already occurred in the exchange rate. What you've seen in terms of dollar/yen, in particular, is a move from the 120s to 106. That is not insignificant.'

But in September, the problem blossomed in the popular investor consciousness -- particularly in the second week of the month, when the dollar fell a sickening 6.5% against the yen. Idle (and, one might add, ridiculous) chatter of how

Treasury

Secretary

Larry Summers

was abandoning the strong-dollar policy championed by

Robert Rubin

even surfaced (as if he were

Lloyd Bentsen

, or something). Peak to trough, the

S&P 500

dropped 6.5% in September. The flight of capital out of the U.S. had begun.

But not really.

Really what happened was that investors paid an inordinate amount of attention to what was going on in the yen -- to the exclusion of the euro, where things weren't nearly as bad. And while an obvious part of the yen's strength was the resurgence of the Japanese economy and a desire to put money to work there, the pace of its appreciation had a lot to do with the regular fiscal-half-year repatriation of funds by Japanese companies, and with some bizarre goings on between Japan's

Ministry of Finance

and the

Bank of Japan

.

Since that

mensis horribilis

, the dollar has recovered into a range of 104 to 107 yen, and talk of how the burgeoning current-account deficit is on the verge of laying the U.S. low has subsided.

Which isn't to say that there aren't some people continuing to grumble about it. Particularly beyond U.S. shores.

"The contrast between the view from abroad and the view from home is dramatic," says Steve Roach, chief economist for

Morgan Stanley Dean Witter

. "This is a worrisome problem, and domestic investors are in denial. You go overseas, they'll say, 'Look, this is a crisis in the making.'"

By Roach's reckoning, the foreigners are right to worry. He sees the current-account deficit growing to 4.1% of gross domestic product next year -- which translates into roughly a billion dollars a day to fund the current account balance. Foreign investors may not be willing to finance that deficit at the same price that they have in the past.

"For the last few years, foreigners have been very, very willing to fund the current-account deficit at existing asset prices," says Josh Feinman, chief economist at

Deutsche Asset Management Americas

. "More recently, though, the global situation has started to pick up. That means you get better opportunities abroad. Not better than the U.S., per se, but better than what they were a couple of years ago. As the rest of the world continues to do better, on a relative basis, the U.S. may appear less rosy." In short, that means that investors may be less willing to place as high a premium on U.S. assets.

Tracking the Greenback
Dollar strength vs. the major currencies

Source: Baseline

These need not mean there is a crisis brewing, however. Feinman considers the rebalancing in global growth, all else being equal, to be a slight negative for U.S. assets. The all-else-being-equal part is important -- there may be other factors that will contribute to an outperformance of U.S. assets. And it's also important to remember that we're talking relative performance here. All else being equal, foreign assets should outperform U.S. ones. A hard landing is certainly a possibility, but most market observers think that so long as the U.S. doesn't see a significant economic downturn (while the rest of the world continues to grow, mind you), a soft one is more likely. "Unless the story in the U.S. gets significantly worse, you probably have gradual dollar weakness," says Jim McCormick, currency strategist at

J.P. Morgan

.

It's also important to recognize that the dollar has already seen a significant decline off its highs of the year, notes

Paribas

currency strategist Bob Lynch. "The current-account issues are still real," he says, "but keep in mind the adjustment that's already occurred in the exchange rate. What you've seen in terms of dollar/yen, in particular, is a move from the 120s to 106. That is not insignificant."

Lynch thinks the thing that could really induce capital flight out of the U.S. is a sharp drop in the U.S. stock market. "With asset prices correcting, and not collapsing," he says, "the fear of capital flight seems overdone."

Moreover, while foreign investors may spend a lot of time grousing about the current-account deficit, the idea that their stock markets can go up while the U.S.' goes down seems anathema to them. Tokyo's

Nikkei

, London's

FTSE

, Frankfurt's

Xetra Dax

-- all have followed along the furrow cut for them by the major U.S. indices, rising when U.S. stocks rise, falling when they fall. In effect, that tendency may act as a governor against a hard drop in the U.S. If worries about the dollar and the current account spark a fall in U.S. assets, those assets' overseas counterparts, too, may fall. In such times of trouble, investors start looking for a safe place to put their cash. And traditionally that place has been -- you guessed it -- the U.S. of A.