The resiliency of the U.S. economy continues to astound market commentators, many of whom are relentlessly focusing on what is going wrong in the economy and ignoring what is doing well. Real GDP expanded at a 3.9 percent pace in the third quarter and is up 2.6 percent over the past year. To be honest, it certainly does not feel like the economy is growing this fast. We do not question the validity of the GDP numbers, however. The reason the economy does not feel this strong is that there is a growing divergence between domestic demand and real GDP.

We have repeatedly noted the emergence of the split between gross domestic demand and real GDP in our monthly outlooks. Housing and consumer spending, two areas that most households readily identify with, are clearly slowing, while exports are surging. This best illustration of this point is that exports have more than made up for the decline in residential construction since homebuilding began to slide at the tail-end of 2005. The trade deficit is shrinking. The improvement in net exports added 1.3 percentage points to second quarter growth and a full percentage point to growth in the third quarter.

We are looking for continued improvement in the trade deficit but expect the quarterly improvement to be much less than what we have seen in the past two quarters. The improvement in trade will help offset the continued slump in homebuilding, which will remain a significant drag on GDP growth through at least the middle of 2008.

The dollar continues to trend lower, which reflects the interplay between the current account deficit and the long-term capital inflows that help to finance it. Although the current account deficit is getting smaller, the greenback faces a number of headwinds.

First, recent dislocations in credit markets have significantly diminished new issuance in structured fixed income product markets, which gives foreign investors fewer U.S. securities to purchase. Second, interest rate differentials are not helping the dollar at present. The Fed has been cutting rates, but other major central banks are either on hold or about to tighten further. Finally, the trend decline in the value of the dollar, which has been in place for nearly six years, gives foreign investors little reason to expect a turnaround anytime soon. Why buy an asset if you think its price will decline further? In our view, these headwinds likely will continue to buffet the dollar for the foreseeable future.

The bottom line is that the trend decline in the value of the dollar likely has further to run. Although a short-term correction is bound to happen sooner or later, we project that the greenback will trend lower until the end of next year. We are usually reluctant to project future turning points in exchange rates. However, our forecast calls for the Fed to tighten policy anew in 2009 as U.S. economic growth strengthens. Under that scenario, the dollar should appreciate versus most major currencies in 2009.