Despite a narrowing U.S. trade deficit, reported today, the economists at BMO Nesbitt Burns say the strength of the American dollar is hurting the U.S. recovery.

U.S. exports and imports fell sharply in April, although imports fell a little harder. BMO Nesbitt Burns says this result is “fully consistent with the weakening manufacturing sector. More up-to-date production and employment figures from factories suggest that the trade gap remained under intense pressure through May.”

But, say BMO economists, “The overvalued dollar is crushing prospects for U.S.-based producers and causing substantial erosion of pricing power. Earnings are also being squeezed by the dollar’s high value.”

The overvalued dollar and its effect on the trade gap, “are very important headwinds blocking the effects of Fed easing steps to date”. BMO NB notes that U.S. manufacturing associations have begun lobbying for a weaker dollar, but so far the Bush administration remains unmoved.

“The best guess is that the dollar will stay strong near-term and U.S. manufacturing will pay a severe price. The clear investment theme is to rotate out of equity positions in U.S. basic industries into holdings in similar industries that are located in competitor countries with substantial cost advantages due to the dollar’s incredible strength,” it concludes..