The US dollar has taken quite a beating over the past three months causing many traders to wonder when this sharp verticalization will be over.  In the last 30 days, the dollar has fallen over 700 pips against the Euro, 800 pips against the Japanese Yen and 1200 pips against the British pound.  Just when we start to think that this move has to come to an end because it has become far too extended, do we realize that if we reach back into history, we can see that the dollar has much more room to fall.  Although the US dollar has been gradually weakening since the end of 2005, the latest push lower has been triggered by the G7 comments last April.

The Power of the G7 -- 2003 Revisited

By now, everyone should realize the power that the G7 meetings have on the markets.  At the most recent meeting, the G7 toughened its stance onChina, calling for exchange rate flexibility specifically from the Asian giant. This is eerily reminiscent of the 2003 G7 meeting in Dubai.  If you recall, back in 2003, the G7 finance ministers called for â�,��"more flexibility in exchange rates.â�,�  At that time, the change to the statement was the first significant move by the committee in 3 years.  Over the next four months, we saw the dollar slide 13 percent against the Euro, 7 percent against the Japanese Yen and 14 percent against the British pound.  To put this into perspective, we compare how much each currency has moved over the past three weeks since the most recent G7 meeting to how much it moved in the four months after the 2003 meeting.  We can see that the EUR/USD, GBP/USD and AUD/USD have far more room to rally while USD/JPY has already sold off by approximately the same amount.  The table also tells us that the long-term impact was far more substantial than the marketâ�,��"�s knee jerk reaction, which is the risk that the market faces today.   However, there are two very important differences between the last meeting and the one in 2003.  First, the tone was far harsher and the charges were more direct at the April meeting indicating their increased significance.  Secondly, the US dollar already sold off going into the 2003 G7 meeting while it did not ahead of the most recent meeting.

If we add on the dollar's sell-off fives days before the 2003 meeting, the comparison of the move are far more substantial:

USD/JPY sold off 3 percent more which is the equivalent of 350 pips while the EUR/USD rallied 220 more pips and the GBP/USD rallied 515 more pips.  Therefore do not underestimate the power that the G7 has on the market and the potential move that can occur in the currency market, especially since this time around, aside from the G7, there are a number of other pressures on the dollar that can exacerbate its slide.  Old problems are resurfacing and each is more worrisome than the last.    

Geopolitical Risks

One of the biggest risks facing the US dollar at the moment is geopolitical.  Tensions with Iran are boiling, causing commodity prices to skyrocket.  Oil prices are hovering near its all time highs above $70 a barrel while gold prices are at 25 year highs.  The world fears that the problems with Iran could escalate into a global war with the US combating Iran while China and Russia defend it.  Iran has recently claimed that it has â�,��"joined the club of nuclear countriesâ�,� and has threatened to attack Israel.  Should this conflict ignite, the dollar could suffer not only because of the imminent risk, but also because another war would only exacerbate the rise in oil prices and the already burgeoning budget deficit. US consumers will not be able to stomach $5 gallon gasoline, which may be a reality if there is not a peaceful solution to the Iran crisis soon.  

Fed at End of Tightening Cycle

The Federal Reserve is also nearing the very end of its tightening cycle.  The FOMC statement has been gradually toned down with the appearance of a new word in the latest May statement.  If you read the report carefully, the Fed is showing hesitation by saying that "some further policy firming may yet be needed."  The word â�,��"yetâ�,� is what the world is focusing on especially since Fed Chairman Ben Bernanke recently mentioned that the market should not rule out a â�,��"pauseâ�,� in the tightening cycle.  With sixteen consecutive rate hikes, the economy is finally feeling its weight.  Job growth has been slowing with non-farm payrolls increasing by far less than expected in the month of April while retail sales growth is also slowing.  The following chart is something we published in 2005 indicating how the dollar responds to changes in the Fed cycle.  Whenever the Fed changes from one bias to another (either tightening to neutral or tightening to easing), there is a sharp reaction in the dollar.   Now we are facing a similar scenario.  The dollar has already begun to sell off in anticipation of a shift, but weakness has been limited because it is not clear exactly when the Fed will be done, only that it will come soon.  Once it does happen however, the dollar could fall even further.

Reserve Diversification

Slowly, but surely, reserve diversification continues to benefit the Euro. Last year, we heard a lot of talk about reserve diversification by countries like Russia, South Korea and India. This year, the United Arab Emirates joined the group by shifting 10 percent of their own reserves from dollars to euros while Qatarâ�,��"�s central bank has said that up to 40 percent of its reserves could be moved to Euros.  Sweden has also announced that they have increased the Euro share of their reserves from 37 percent to 50 percent while Russia announced that they would allow their $61 billion oil fund to invest in bonds issued not only by the US and Britain, but also by Eurozone countries.  Of course, compared to many other countries, the UAE, Qatar and Sweden only have a small portfolio of reserves, but with talk of China still looking beyond US Treasuries, the Euro should find itself as one of the primary beneficiaries, even if it simply means that China will stop accumulating  US dollar reserves. East Asian countries own two thirds of the worldâ�,��"�s US$4 trillion of forex reserves, so their activity is particularly important. China has already been looking beyond the dollar as an investment over the past few months as they assume exposure to more tangible assets such as oil fields or gold.  If they are forced to revalue their currency even further, their need for US dollars would be even less. 

Impacts on Other Markets

If the dollar continues to weaken, the impact on other markets could be profound.  Although the stock market is holding on strong, its strength may begin to waver as foreign investors shy away from dollar denominated investments.  Both bond and stock markets could suffer as investors and central banks realize that their returns are being eroded by the weaker dollar as they lose out when they convert their dollar denominated investments back to their local currencies.  For specific stocks, importers will face the biggest decline since their purchasing power is reduced while exporters will see the biggest benefit.  Ultimately however, no market will avoid being impacted by the fluctuations in US dollar.

Kathy Lien is the Chief Currency Strategist at FXCM.