Is the recent upward movement in the dollar a signal that it has bottomed out, and will now move back to a higher level? Or is it just a bull trap for those who are long the dollar?

Despite reports of cheaper prices for international travelers to the States due to the depreciated dollar, it would be wrong to safely conclude that U.S. goods are now so cheap at the existing exchange rate that the dollar must appreciate from its current level. Overall the price of American products is still too high to ease the massive trade imbalance between the U.S. and the rest of the world.

The falling dollar over the past few years has made American products more competitive and has caused the real value of U.S. exports to rise sharply. Nevertheless, the 2007 trade deficit still remains at $700 billion or 5% of GDP. The other side of the coin is that foreign investors must have added approximately $700 billion of U.S. securities to their portfolios. It is their unwillingness to do so in the current U.S. dollar trend that causes the dollar to continue to depreciate relative to other major currencies. It is unthinkable that the global economic system will continue to allow the U.S. to import more goods and services than it exports indefinitely. At some point, the enormous trade deficit will need to be balanced out.

An important factor in determining the dollar's longer term view will be the future price of oil and the extent of U.S. dependence on oil imports. In each of the past four years, the U.S. imported 3.6 billion barrels of oil. At the current price of more than $120 a barrel, that implies an import cost of more than $432 billion. The higher the cost of oil, the lower the dollar has to go to balance the trade deficit. So a rising oil price as measured in euros or yen implies a greater depreciation of the U.S. dollar, and therefore an even higher oil price in dollar terms.

There is one further important consideration for the future trend of U.S. dollar: the relative rates of inflation in the U.S. and abroad. If the U.S. experiences higher inflation than the trading partners, the dollar's nominal value must fall even further just to maintain the same real value.

The inflation differential between the dollar and the euro is now relatively small - only about one percentage point a year - but is greater relative to the yen and lower relative to the Renminbi and other high-inflation currencies. Over the longer term, however, inflation differentials could be a more significant force in determining the dollar's path. In the meantime, a pull back in oil price from $140 to $120 creates a temporary consolidation range for the U.S. dollar.

David Cai is the International Markets Analyst for Goldmau.com. Formerly with HSBC, David monitors global financial markets and trends as the editor of Goldmau.com’s Pre-Market Daily. David can be reached at david@maucapital.com. To sign up for the FREE Pre-Market Daily, visit us at http://new.goldmau.com/subscribe.php.

Disclosure: At the moment we have no holding in any of the securities mentioned in this article.

Goldmau.com editor and analyst Rory Johnston contributed to this report.

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