On the one hand, we believe there will be more US interest rate cuts than the market is pricing in (the market’s anticipating about two 0.25% rate cuts by this time next year, and no more thereafter). We’ve posted a number of comments explaining why there is a very real risk of the US entering recession (for example see US house prices experience record fall, or will this financial crisis send the US economy into recession). If there is a sharp slowdown or recession, expect the Fed to react very aggressively.
From the technical side, the effects of globalisation have weakened the world’s reliance on the US economy. As I commented in Top dollar no more in November last year, the development of Asian countries’ economies and financial markets will reduce Asian investors’ reliance on US dollar assets. Asian demand has been a fundamental support for the US dollar over the past decade, and a weakening of this pillar will have big consequences.
US investors have reacted to the steady weakening of the US dollar by putting more money in overseas equities than ever before. The US trade deficit stood at -5.5% of US GDP in Q2, which is an improvement on the low of -6.8% at the end of 2005, but in light of the above it looks like the dollar will continue to weaken for the foreseeable future.