It is clear that the US economy is looking more vulnerable given past excesses. However going forward the question is that will the US economy strengthen? The economy has to exhibit robust growth for many years to bring down its deficits. The Fed cannot expand its balance sheet continuously. US has a vibrant corporate sector and if the corporate sector can pick up pace there is a good probability that the US economy can come out of the woods.
The USD in the meanwhile is unlikely to decline much further from current levels given the problems faced by other major countries, but for it to strengthen fundamentally on its own, it requires the economy to strengthen.
US policies have led to USD decline
The US Dollar Index (DXY) has been on a steady decline since the beginning of the 2000 decade. The USD has declined by over 30% over the last ten years against other major currencies. What is the reason for the decline?
The policies adopted by the US government and the US Federal Reserve has resulted in a broad USD weakness. The fall in the USD has been accompanied by deterioration in the health of the US economy. The following charts show the extent of deterioration.
Deficits
The US trade deficit as a percentage of GDP has deteriorated sharply over the last twelve years. A widening trade deficit if not fully funded leads to a rising current account deficit. The US current account deficit as a percentage of GDP has gone up over the last ten years and this has been funded by foreign investments.
The US has been consistently running up more debt over the last decade and this debt is being funded by countries such as China and Japan that have large foreign exchange reserves.