The dollar has enjoyed a rally this year. There are two reasons why. The first is the Fed's policy of raising interest rates. US rates are now some of the highest in the developed world. This makes US assets - typically bonds - more attractive to foreign investors because higher interest rates mean higher overall returns. Secondly, the US economy is growing faster than Japan and European economies. This adds to the dollars allure.
The twin deficits - the federal and trade deficit, have been notably absent from forex reports this year. While traders are aware of their existence, they have not placed any trades based on this. Combine last years balance of payments deficit was 5.5% of GDP, this year's balance probably being worse and Bernanke's global savings glut theory and the possibility of a bear market in the dollar becomes a real possibility.
First, why is the balance of payments deficit economically bad? Let me illustrate with a more down-to-earth illustration. Suppose you and your neighbor trade goods and services on a regular basis. For a long continuous time, you buy more from him then you sell. So, over this time, you give more money to your neighbor than you get from him in trade. Where does this money you give to your neighbor as a result of trade with him come from? (Remember, despite actively trading with your neighbor on a regular basis, your purchases exceed your sales.) First you draw down your savings. But eventually that runs out. Now you have to either increase your revenue from other sources to pay for this money going to your neighbor or you can borrow the money. Eventually, you can no longer afford to buy all of the goods and services you use to get from your neighbor because you have either over-extended your credit, or can no longer boost revenue from other sources to make-up for this capital outflow.
The general consensus among economists is when the balance of payments reaches 5% of GDP, the country's currency should start to decrease in value. This has two positive benefits to the balance of trade benefits: it makes your goods more competitive in other countries and foreign goods more expensive in your country. This overall net affect reduces the trade imbalance over time.
While higher GDP growth and interest rates are reasons for the dollar's strength this year, there is another reason: Greenspan. Love him or hate him, Greenspan had credibility with market participants. Earlier this year, he made a public statement that eased concerns about the trade deficit.
Bernanke replaces Greenspan at the end of January. Assuming this happens, Bernanke will bring two large liabilities into office: being the new kid on the block and the global savings glut theory. This theory essentially states the US is the beneficiary of too much savings in the world. A primary result of this theory is the belief the essential problem with the trade imbalance is external to the US, not internal. The Bush administration has attempted to translate this theory into policy. For the last year, Treasury Secretary Snow has been attempting to persuade other countries to change their internal policies from a savings oriented society to a consumption oriented society. There have been no domestic initiatives addressing the low level of US savings. As a result, it may appear to other countries the US is doing nothing to address it's trade imbalance.
Bernanke will may face a perception problem with the inherent passivity of his theory. By essentially arguing the US is at the mercy of international forces, Bernanke's lack of domestic action may demonstrate to the forex markets that he is doing nothing to address the payments imbalance. As a result, forex traders will sell the dollar. Adding to this temptation to sell dollars is Bernanke's inexperience. Although Greenspan did little to actually alter the trade deficit, his public comments always soothed the market. He has a great deal of personal credibility with traders. Bernanke does not. He is new. Although he has an impressive resume, he has not run the Fed. His statements will not carry the same degree of weight as Greenspan's.
Bernanke can start to head this problem off by publicly dealing with the trade and balance of payments issues directly. If he states the problems exist and policymakers should start to actually deal with the problems, the markets will be more likely to give him and the US dollar some breathing room.