Hubert Marleau is President and Chief Investment Officer, Palos Management Inc.
Now, that the US is established as the first Western economy to emerge from recession, the dollar is set to behave in line with interest rate expectations. However, there are fiscal and monetary pessimists who argue that the US dollar is more likely to resume its relationship with
risk sentiment.
Recent history shows that the US dollar has undergone a full cycle. First, it experienced a period of relative strength during the acute stages of the financial crisis from July 2008 to March 2009. During that period the
dollar rally was divorced from hawkish views and, in turn, was driven by three risk-aversion factors:1) an unprecedented global margin call on every asset class,
2) an unprecedented foreign demand for US treasury bills, as they were considered as the safest asset in the world and
3) an unprecedented scramble for dollar liquidity for transactional purposes as US banks pared back their credit lines.Second, since the end of March 2009, risk appetite returned to the world financial markets as the monetary system mended and global economies recovered. The relative value of the dollar started down again on a more or less steady path of decline driven by two risk-tolerant
factors:1) US banks re-opening their line of credit on favorable terms to the international banking system and
2) investors actively sought returns that were well above the cost of money.Consequently, The US dollar gradually replaced the yen as a funding currency for all manner of carry and risk trades. The trick is simple and profitable for players who borrow at low interest rates in a depreciating currency. In the mind of speculators, this is a situation that may last
for as long as spare capacity in product and labour markets stays above historical norms. Recent data demonstrates that international capital flows have changed direction and volume since March of 2009. Yet, short term determinants are not conclusive that the US dollar should collapse. In fact, reports and data of speculative bets and expected interest-rate differentials between major currencies are not indicative of extreme
market pressure. It looks as if it’s managed somehow.The drop in the value of the US dollar has more or less retraced the safe-haven rally. On a twelve month basis the dollar is flat against most currencies and the real broad index is modestly below its historic average.
However, there are threats against the US dollar that are primarily generated by gold bugs and fiscal and monetary hawks who, in turn, are momentum traders. The incessant palavering that the US dollar is ‘in for it’ and will eventually loose its primary role as a reserve currency and global monetary standard is based on the notion that the issuance of dollars is not fully backed by the FED. They suggest that the creation of dollars is discretionary and too dependent on the ability and willingness of the FED.
Should the monetary authorities lose its independence, the much needed nominal anchor to regulate the money creation would be gone. Hawks believe that the stock of US dollars, being fiat money, will not be able to grow at a pace that would be consistent with potential economic
growth without inflation. There are, indeed, a number of concerns that make it unclear as to how the US authorities can anchor the US dollar supply.The "transfer risk": It is apparent that private businesses have transferred a large part of their risk to the public sector via subsidies of credit, quantitative easing, government spending increases, low cost of money and government insurance schemes.
The "intervention risk": Other than frightening traders about the burning possibility of speculation, foreign exchange interventions are useless for they are usually sterilized in that what is destroyed in the foreign exchange markets is recreated in the domestic markets. There is no underlying change in the relative supply.
The "mortgage risk": The huge fiscal stimulus has significantly increased the ratio of public debt to national income and for it the US has mortgage it’s future forcing the economy, once the initial recovery phase is over, to grow slower than in the past.
The "conspiracy risk": A leaked report (see The Demise of the Dollar) stated that Arab Gulf Oil producers including China, Russia, Brazil and Japan have a secret project to end the 65 year old iron rule of selling oil only in US dollars and replace it with a basket of currencies reflecting producer-consumer trade relations backed by gold.
It is arguable and correct that these risks could leave no other choice but for the FED to finance quantitatively for lack of any options leading to a renewed bout of inflation that would resemble the 1970’s. We are of the opinion that the aforementioned risks are overblown for the following reasons:
1) Does anyone really want to give China or Russia extraordinary power over the global financial system and many economies?
2) One should be aware that the USA is a WOUNDED TIGER with a very powerful military. Things may not be as they appear. Who knows what is going on diplomatically and politically behind the scenes.
3) What we may be witnessing is a managed devaluation of the US dollar at the expense of others for a lower currency is most beneficial
for multinational businesses.
4) It is also very strange that the strongest and most resilient economy in the worldwide recession has the weakest currency.
5) As long as the Yuan is pegged to the dollar, the odds of a full-blown dollar crash is very slim. That’s the US/China deal "Peg for Dollars".
6) An acknowledgement that the US needs higher taxes and spending cuts with an overt commitment to deficit reduction as a dollar stabilization program is coming.Indeed, I’m not sure that what we see for sure is really sure. What is going on geopolitically is always an unknown, uncertainty or hidden. Things are often exaggerated by the media. There is one aspect of what is going on internationally that is neglected but very important and interesting. Wolgang Munchau and Martin Wolf of the FT did touch on the point that the massive global imbalances that are a main reason for dollar depreciation are clearly and presently disappearing for three reasons.
1) A weak dollar is helping an export-led recovery in the US.
2) A rise in the US personal savings rate is helping to reduce US demand for foreign goods and services.
3) A relative growth advantage of emerging markets is fueling demand for US goods and services.The sum of international imbalances in dollar terms are huge and any change here could affect exchange rates for the price of currencies are determined at margin like all other commodities. At their 2008 peak, the global imbalances amounted to 2.5% of world gross national product.
The hawks may have not noticed that total imbalances are estimated by the IMF to be slashed even more in 2009 to 1.5% of world gross domestic product. Given the recent changes in exchange rates and the continuation of de-leveraging in the US, it is very possible that total imbalances may be only 1% in 2010. There may be, according to several think tanks, an understanding or tacit arrangement among the G-20 that
as soon as things are assuredly stabilized the world could ultimately adopt maximum targets for current account imbalances. The imbalances create t
oo much uncertainties as an IMF study shows.In conclusion, the dollar correction may be just natural and profitable and about to stop. This is not a time for experimentation. On the contrary, in a more balanced world the dollar will have its position.
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