Table of Contents:
Weak US Dollar
one of the major underlying trends that are shaping our world today
see also: rising inflation worries 2008 , High Oil Prices , commodities bubble in 2008
Measuring the strength /weakness of the dollar:
vs. a "basket" of currencies: .DXY (see link here)
Recent strengthening...will this trend reverse?
While the long term trend still appears to be for a relatively weak US dollar, there has started to be some movement toward strengthening. Is this the beginning of a reversal? Or, a minor blip on the radar screen?
09/2008: "The dollar continued to rise against a range of currencies, boosted in part by an OECD report that raised the estimate of America's 2008 GDP growth rate to 1.8% (from the 1.2% published in June). The same report lowered the predictions for economic growth in the euro area to 1.3% and in Japan to 1.2%. Britain was forecast to fall into a technical recession in the second half of 2008; the pound dropped to a record low against the euro."
Freddie / Fannie nationalizations...what effect on the dollar?
Markets around the globe rallied on the news of the US nationalization / bailout of Fannie Mae and Freddie Mac. But while it may be good to increase confidence in the US financial markets, and to reassure investors of their solvency, the bailout does raise some interesting questions...
The government is adding $5.4 trillion dollars in liabilities, or about 40% of GDP to its balance sheets. Ouch. What is the effect of these nationalizations will have on the long-term balance sheet of the US government, and on the future for the US dollar.
Key questions:
1. Effect on inflation: Ive read that inflation may result from this action...why? Are we printing more money to nationalize these entities? Why does Jim Rogers predict "inflationary" pressures from these nationalizations?
2. Effect on US dollar: If they are nationalized, will foreign countries continue to purchase their bonds? If not, how will this effect the US dollar?
3. Effect on national debt: How will the nationalization of Freddie/Fannie effect the balance sheets of the US national accounts? Will this dramatically increase the debt? Can we afford to bail out these two companies?
4. Effect on bond yields: Will the increased debt scare off foreign investors? Will they require a bigger return in exchange for the increase risk of national default? If so, then will the cost of borrowing increase for government bonds? How will this effect money supply/ credit markets in the USA?
Some answers:
1. As far as the effect on the national debt: it doesnt really change anything because the two institutions previously had an implicit guarantee from the government, that most investors believed was solid. Now that the guarantee is explicit, the amount of debt that the government has taken on has not really changed, even though it has now been officially transferred to the balance sheets. Most professional investors previously had factored that debt into the numbers, so as far as they are concerned, not much has changed. This is reflected in the fact that the yield on US treasuries have barely moved since the bail out, showing that investors already had the debt factored into the big picture.
2. As far as the effect on the US dollar, there is the possiblity that temporarily there will be fewer foreigners purchasing new debt offered by Freddie/Fannie. We saw recently that new bonds were issued, at a lower premium that before, but that fewer foreigner purchased the bonds. This could be the beginning of a new trend, or just a momentary change reflected in a one time event....time will tell.
Long term problems:
USA Government gross debt increased from 55% in 2000 to 63% in 2007.
According to the CBO (Congressional Budget Office), the budget deficit in 2008 will be about $407 billion, with expectations to grow to $530 billion by 2009.
While it does make sense to expand deficit spending in times of recession...it also is important to watch out for structural deficits, which are expected to be around 5.2% in 2008.
USA increased federal spending expected:
1. More war spending
2. Health care (potential of universal health care plan if Obama is elected).
Why does the Dollar weaken?
Loss of confidence
Due to factors such as the subprime lending crisis, and the ensuing credit crisis of 2007, many foreign investors have lost faith in the stability of the US financial system, and that has led investors to sell. Confidence and psychology are key to a successful "strong dollar" policy.
What is causing the weak dollar?
Robert Lynch (HSBC, in an article in Wall Street Journal) wasn't far off the mark: the dollar's weakness fundamentally reflects the collapse in demand for securitized US credit. By far, the US 's biggest export in recent years has been the financial innovations such as SIV's, collatoralized debt, and asset backed securities. European banks have been great customers. But, since the housing crisis of 2007, and the ensuing credit crunch, the foreign banks are no longer hungry buyers of US financial innovations. Rather, they are staying away... this lack of demand is driving down the demand for US dollars.
Many analysts have compared the US dollar to the Microsoft operating system: its the most used, and hard to live without...but no one really seems to like using it ! For this reason, many foreigners are happy to have a way in which to avoid using the US dollar. If they are offered an opportunity to conduct business in Euros, for example, many foreigners are happy to do so. This incentive plays right into their natural "anti-Americanism" which is trendy around the world.
Negative impacts of a weak dollar:
As the US dollar has weakened against the Euro and other major currencies, it has made importing into the US that much more expensive. As imported products (such as oil, commodities, and manufactured goods) all become more expensive, there is a risk of inflation. As goods all become more expensive as a result of a weakened US dollar, there is hightened risk that the Fed will have to raise interest rates to combat that inflation, which will have the negative effect of making borrowed money more expensive, which can slow down the US economy. A mixture of low growth and inflation is called "stagflation", and is the dreaded condition that the US faced in the 1970's.
Why doesnt a High Oil Price cause the US dollar to appreciate?
why the US dollar is not appreciating as the world is demanding more and more expensive oil (purchased in Dollars)?
Background info: As you know, the value of the dollar (and any Currency) is determined by supply and demand, in an exchange between buyers and sellers. As you point out, since oil is more expensive, there should be more demand for US dollars, which should drive up the price of dollars (US dollar should appreciate). This is happening, but....
But, there are other trades that are stronger, and are happening at the same time, which is driving down the value of the dollar (in spite of what is happening with the oil market).
What are these forces? The “simple” answer:
#1. There used to be a massive demand for US financial innovations (such as securitized mortgages, asset backed securities, SIV’s, etc). Robert Lynch (HSBC, in an article in Wall Street Journal) hit the nail right on the head when he noted that these financial innovations were by far the biggest US export in recent years. That market is now gone. With the credit crisis (caused by the subprime meltdown), the demand for US financial innovations has ground to a stand still. No longer are European Banks buying all of the asset-backed securities, nor securitized mortgages from the USA. This lack of demand, and all of the missing buyers of US dollars is the major driving force that is putting downward pressure on the US dollar.
#2. Lack of confidence. In any trading system; buyers want to buy assets that they think will appreciate in value. But, as traders have lost their confidence in the ability of the US dollar to hold its value, they have become sellers. Don’t underestimate the role that confidence and psychology plays in traders decisions! Traders buy currencies that they expect to appreciate in value, and they sell ones that they think will depreciate.
#3 Final comment: In the past, China was a massive purchaser of US dollars. They were very active in purchasing dollars in an effort to keep their own currency undervalued (to spur export growth). But, over time, they amassed a huge pile of foreign currency, perhaps too much. Recently, their policy of actively purchasing USD has been halted (or severely slowed down), and have shifted their focus away from US treasuries, and are now looking for higher returns through a Sovereign Wealth Fund. It’s a bit technical, I know….but the point is that they are no longer pumping liquidity into the US banking system, nor are they large purchasers of US dollars. This is one HUGE buyer of US dollars that is now sitting on the sidelines (perhaps looking at the Euro).
These three forces combines are very powerful, and offset any upward pressure that might be placed on the US dollar as a result of higher oil prices.
There is a much more interesting answer to your question, but it’s a bit more difficult to explain (unless you understand economics). It has to do with the “balance of payments” of a country. The basic theory is that if a country has a “current account” deficit (like the USA does), then it must also have a “capital account” surplus. In total, the total balance sheet for the country must balance. If it does not, then the currency must depreciate. In the past, the USA has maintained a current account deficit by also maintaining a capital account surplus. This surplus was possible only because foreigners had a very high level of confidence (see discussion above). But, as that confidence has been eroded by (a) excess spending on the Iraq war, and (b) the Credit crisis of 2007…we see a predictable downward pressure on the value of the US dollar. According to theory, the US dollar must depreciate.
Effect of Interest rate changes on currency valuations:
Final comment: although most analysts accredit appreciation or depreciation with changes in interest rates from the Federal Reserve, I believe that this factor is secondary. Why? Because historically we see that a raise in interest rates will only cause a temporary (short term) appreciation of the currency value, but over the longer term, the higher interest rates may in fact lead to depreciation. This is a bit counter intuitive, but as an example…consider the case of the US in the early 2000’s. The US had very low interest rates, but a very strong currency. On the other hand, some developing countries such as Brazil had a very high interest rate (highest in the world), but the currency depreciated to nearly 4:1 on the dollar.
While many analysts like to over-simplify the situation by stating that a rise in interest rates causes an appreciation of the currency, this is not necessarily true in the longer term.
Links:
Positive impacts of higher Oil Prices
On the other hand, a weakened dollar has some potential positive impacts, such as:
1. US exporters benefit from a weakened dollar; such as Boeing
2. Foreigners can purchase US real estate for "cheap", which helps limit the downside of the US housing bubble bust. (see subprime lending and credit crisis discussions). Markets such as Miami have seen waves of Europeans coming in and buying up "cheap" Miami condos, which has helped limit the downside of the real estate bust. Also, they say that "traded goods" are three times the size of the housing market in the US, so conceivably the boost of exports could help the US to weather the US housing troubles
3. US trade deficit should shrink which should help overt potential balance of payments pressure on the dollar.... If the dollar remains weak against the euro and other European currencies, there is good reason to think the US bilateral balance with Europe will swing into surplus. An important adjustment is clearly underway. But, in Asia...The recent stabilization in the balance with Asia – by contrast – seems cyclical. It reflects a slowdown in the US relative to Asia. The broader adjustment required over time to bring the US-Asian economic relationship into better balance – and by that I mean that the US should export more, save more and rely less on Asian central banks and sovereign funds for financing – hasn’t really begun.
The hard slog of real adjustment hasn’t begun – not v. Asia, and not v. the oil world
Since 2002
The dollar has depreciated significantly against the Canadian dollar, the euro, the pound and most European currencies. It has depreciated modestly against some emerging Asian currencies (notably the won and baht). And it moved by much less against the RMB and yen. The RMB’s roughly 13% appreciation against the dollar from 2002 through the end of 2007 (and a bit more since then -- the total appreciation is now 15%) remains small compared to the moves in the euro and won – especially given the rapid growth in Chinese productivity.
Crisis risk?
Because the US runs such a massive trade deficit (and a budget deficit), there are often talks about a potential meltdown of the US economy, as we have seen in crisis after crisis in the emerging economies. If it could happen in Asia in 1997, could it happen to the US in the future?
Fears
One of the more worrying trends is discussion in Asia of central banks potentially switching to Euros rather than dollars as their way in which they spend their foreign currency reserves. The US relies heavily on foreigners to continue to purchase our debt in order to finance our massive trade deficit. If the foreigners were to loose taste for purchasing US debt, then the US would be forced to raise interest rates on a massive scale, which could crush the US economy. A weakening dollar is worrisome if foreigners loose confidence in the ability of the US dollar to maintain its value against other currencies. If that happens, then foreigners stop investing in the US.
One of the main causes of the weaker dollar is due to a massive trade deficit, and excessive spending (and very little savings in America) due to the Iraq war. Note that the last time the US went to war with Vietnam, the excessive spending during war time led to a collapse of the monetary system back then (the Gold Standard), and it led to a decade of inflation in the 1970's as the US recovered from the excess spending which led to a massive weakening of the USD dollar (and an inability to stay pegged with gold).
But, the US is unique (so maybe a crisis cant happen here)
The US has benefited enormously from its capacity to borrow in its own currency, and thus to pass the risk of dollar depreciation onto its creditors. Central banks willingness to add to their dollar reserves has helped to provide the financing that allows the US adopt counter-cyclical rather than pro-cyclical macroeconomic policies despite running large deficits. No emerging market had a similar luxury.
Balance of Payments issue on the US dollar:
With the US running record deficits, many analysts question whether or not the US could face a "Balance of Payments crisis". The answer is "no", its not possible as long as the US dollar is a floating exchange rate, which it has had ever since the collapse of Breton Woods in 1973. Before a crisis would occur, the dollar would depreciate.
How does this work?
In order to explain this topic, it is first important to note that the USA has a massive current account deficit (importing more than exporting), but makes up for the balance by having a massive Capital Account surplus (more foreigners are investing in the US, so more money is coming in than is going out). This capital account surplus is achieved by having massive amount of T-bills purchased by foreign central banks (such as China, etc) that are doing so in order to keep their currencies at low levels. Note that China has over $1 trillion investment in the USA. They pay for these investments with the money that they earn from trade.
From Chinas perspective: since their overall Balance of Payments must also balance (just as with every country), and since they have a massive current account surplus (exporting more than importing), then they must also have a massive Capital account deficit (sending more money overseas than is coming in). That means that the Chinese must invest overseas. In the past, most of that money has come to the USA in the form of US treasuries purchases.
The USA model for the past 30 years has been = keep a current account deficit, and finance the gap with foreign investments.
This has worked well for the US over the past 30 years. Should countries such as Brazil do the same thing? Is this a model for success for others to follow? Not necessarily. This "business model" only works as long as foreigners have a very high level of confidence in your currency. If they loose confidence in your stability, or growth, then they will no longer demand your investments, and the model breaks down.
So, if you undersand this model...you will understand the warning to the USA: don't do things to destroy foreign confidence in your country. If you loose confidence, then foreigners will no longer demand your Treasuries. If you loose the capital account surplus, then you must also loose your ability to run a current account deficit (because the BOP must balance!). If that were to happen, then the US would need to severly cut back on imports. The currency would depreciate (lose value in international markets) until exports become more competitive, and imports seem less attractive. This would lead to higher prices for consumer goods (inflation, anyone?). This is highly undesireable, and explains why the US government has persued a "strong dollar" policy for decades.
But, can the USA continue running such a large current account deficit?
How sustainable is this model? There is a lot of debate in this area, but the US has shown an unbelievable abilility to do so for more than 30 years.
The key is "confidence". As long as the world continues to show confidence in the US, then it will continue to be desirable for foreign investment. Foreigners will want to purchase US treasury bonds because they are seen as "risk free investments".
Where will future money come from?
In the future, as China and India continue to open up their economies (and reduce controls on foreign investment), they will need to meet the pent-up demand of their citizens to invest money out of the countries. Much of this investment will likely go to the USA (as long as confidence remains high). With this happening, it is possible that the US could run a current account deficit for the next 30+ years (as they have done for the past 30 years) without much problem. As it currently stands, Indian and Chinese consumers have very limited ability to invest overseas. Some economists predict that as their economies open up, that we should see increased demand for US investments.
In summary:
As long as the US is able to run a capital account surplus, then they should have no trouble maintaining the current account deficit. This balance should be fed by India / China for many years to come.
China and Japan supporting our debt
Japan($349B) and China($643B) are two of the largest purchasers of US debt. China in particular has exbited a voracious appetite for US debt. Its rapidly growing economy is heavily dependent on exports, and the US is one of its largest trading partners. In any given year, the US imports much more from China than it exports to China. As a result there is a net flow of dollars to China. Normally, one might expect China to sell these dollars on the global market, causing the dollar to weaken. Instead China reinvests its dollars in US debt. In doing so, China stregthens the US dollar and limits the appreciation of its own currency. Chinese exports remain cheap to American consumers.
The IMF gets concerned:
06-2008
Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system.
For seven years, US President George W. Bush refused to allow the IMF to conduct its assessment. Even now, he has only given the IMF board his consent under one important condition. The review can begin in Bush's last year in office, but it may not be completed until he has left the White House. This is bad news for the Fed chairman.
As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests — worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.
A Brief History of US dollar policy:
The gold standard was the way in which the international monetary system maintained parities until the 1930’s (with a notable interruption during WWI and the years that followed it). Later, at the end of WWII, more than 40 countries signed on to the Bretton Woods agreement, which established a fixed exchange rate system between most of the major world economies.
The accord stipulated that the undersigned fixed the value of their currencies in relation to the US Dollar (USD), and that the dollar would be convertible to gold at the fixed price of U$35/ozt. The Bretton Woods lasted until 1971, when President Richard Nixon suspended the USD convertibility to gold and unilaterally changed the USD parity with other international currencies. From 1973 to 1999, the USD, the Japanese Yen and the European currencies operated a “dirty float” exchange system, that is to say the currencies were allowed to move in accordance with market forces but the central bank of each country would intervene to move the exchange rate in one or another direction. In general, exchange rates between the European currencies stayed inside a tight band from 1973. For example the German Mark and the French Franc freely floated with respect to the USD, though they stayed within a tight band between each other most of the time by virtue of an agreement known as the European Monetary System.
In January 1999, eleven countries adopted the same currency, the Euro, issued and administered by the European Central Bank (ECB), which floats against the dollar in the same way as the various European currencies did up to 1999. Today, thirteen countries have adopted the Euro, with two more due to join in 2008. After Bretton Woods fell apart, the USD remained the focus of the international monetary system, and evidence to support that abounds. In 2000, more than 70% of international reserves were in USD. However, that proportion has fallen every year, reaching a bit under 65% in 2007. It is the Euro which has gained from the reduction of dollar holdings: Euro assets have gone from a little over 18% of world reserves to nearly 26% in 2007. The British Pound has also gained, to 4.7% of total reserves in 2007.
Considering the announcements that various countries (including China) have made about diversifying their reserves to lower the proportion held in USD, the question we should consider is whether we are (or not) at an inflexion point in the international monetary system. Could the USD lose its role as the world’s reserve currency? Which currency would replace it? The Euro? The USD could effectively lose its protagonist’s role in the international monetary system. And the probability of that happening has certainly increased with signs of weakness in the US economic scenario, with a current account deficit of around 6% of GDP and with several years of deficits of similar magnitudes already behind it. Also, added to this is an inactive government that cannot make the needed reforms due to its low popularity, the lame duck syndrome and its concentration in the Iraq war. The challenge of the new US administration is no small one. It must bring strength back to the USD, putting it back to the position it has held.
http://www.rgemonitor.com/latam-monitor/252505/the-future-of-the-dollar/
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