A U.S. recession could ironically boost the dollar against the euro and high-yielding currencies as worried investors avoid risk, but much would depend on the depth of the downturn and its impact elsewhere.
This was the view of participants at this week's Reuters Investment Outlook 2008 Summit in New York, who also noted that dollar weakness next year would be mostly versus Asian and some emerging market currencies. These economies, they say, would be forced to allow their currencies to strengthen to beat inflation caused by higher import prices.
A U.S. recession coupled with evidence of global stress could lead to flight-to-quality flows into the dollar.
If the U.S. goes into recession and it looks like it's going to have a knock-on in other major economies, the dollar may actually outperform in a recessionary environment, said Robert Kowit, an international bond fund manager with Federated Investors.
Analysts reckon that, despite increasing talk of economic de-coupling, the export reliant euro-zone economy would be unable to withstand a recession in the United States and that would put the brakes on the euro, which surged to a record high against the dollar this year.
The euro's rise of over 9 percent against the greenback so far in 2007 already has started to hurt European exports, prompting a growing chorus of complaints from the leaders of France, Germany and Italy.
It is important to realize that Europe cannot stand much more appreciation in the euro. If we went into recession, Europe would not be far behind, and that would act as a corrective in the currency theme, said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co.
A sharp housing market downturn in the world's largest economy, triggered by loans to homeowners with poor credit histories, has raised the odds of a U.S. recession.
RECESSION ODDS UP
On Monday, investment bank Morgan Stanley warned the U.S. was likely headed to a recession, citing the tightening conditions in the credit markets that have made it difficult for both consumers and businesses to access credit.
Morgan Stanley currency strategist Stephen Jen also shares the view of a stronger dollar under a recession environment.
An outright recession of any severity will materially alter the mindset of investors. Specifically, global risky asset prices are likely to come under further downward pressures as risk aversion intensifies, Jen wrote in a note.
In a normal environment where greed dominates investment decisions, yield differentials determine currency trading, giving currencies with high interest rates a boost, he said.
However, this is different in situations of uncertainty where fear takes over and causes investors to seek low yielding currencies such as the yen and Swiss franc because the low rates reflect the capital surplus positions of these nations.
The United States does not have a capital surplus, as pension funds and life insurance companies have been aggressive diversifiers since 2003, according to Morgan Stanley.
Even though the U.S. is not a capital-surplus country ... it could be in a similar position as Japan as potential repatriation flows, fueled by fear, could lead to a rally in the dollar similar to repatriation rallies in the yen, Jen said.
Recession or no recession, next year analysts expect the dollar to rally against the euro and Morgan Stanley has forecast the European currency would decline to $1.32 by the end of 2008 from around $1.4432 currently.
I think the dollar has had its run to the downside against the euro and the pound, said Bill Gross, chief investment officer at Pacific Investment Management Company.
The weaker dollar will be an Asian, emerging market and Middle Eastern phenomenon as opposed to a European or Canadian phenomenon.