Why the Dollar Has Rallied During Current Crisis 13 comments
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Welcome to part two of a four part series covering the current conditions of the foreign exchange market. This series of articles is focused on the dollar’s moves in relation to other currencies. The first part of this series is focused on the relationships between the Dollar and the Euro, commodities, and inflation and their role in the forex market. This part of the series will explain some of the reasons regarding why the Dollar has rallied recently in light of the financial crisis.
The moves in the currency market over the past couple of months have been extremely volatile and violent. Many currencies such as the Euro, Pound, and the Australian Dollar have depreciated against the Dollar at historic rates. Since reaching its high of $1.60 EUR/USD in May, the Euro has plunged over 21% to 1.25. The Euro has rapidly declined since August of this year due to many concerns including a flight to safety in U.S. Treasuries, a possible worldwide recession, the European Banking system and the U.S.’s TARP plan.
Flight to Safety
As many of the equity markets around the world have gotten slammed this year, many investors are seeking the safety of U.S. Treasuries to protect their money. U.S. Treasuries are believed to have zero default risk because the default of the U.S. government, the most powerful nation in the world, is almost impossible. Because of the low default risk on this fixed income security, it is one of the most liquid securities in the world. Considering the S&P 500 (SPY) is having one of its worst years in history, down over 45%, many general investors are re-evaluating their risk tolerance in equities and moving into less risky fixed income assets like treasuries. Markets abroad, such as London’s FTSE 100 index and Tokyo’s Nikkei 300 index are down as much as 40% and 45% respectively, which has only added to the rush to U.S. Treasuries. With the increased demand of this extremely safe asset, those who do not have Dollars must purchase Dollars in order to buy treasuries. This demand for Dollars has helped strengthen the Dollar against other currencies. The treasury has also been willing to supply these treasuries, as the demand has not only outstripped the supply, but they need to raise money to bail the U.S. financial institutions out to prevent another large failure.
Possible Worldwide Recession
Many economists believe that the U.S. government has helped steer the U.S. away from a deep depression, like the one that was experienced in the 1930’s, but a long recession isn’t out of the picture. Personally, I believe that this crisis will continue well into 2009, and we will be picking up the pieces from the U.S. financial services sector for a very long time. The Yen and Euro have fallen considerably following announcements that these countries are in fact in a recession. Although the U.S. hasn’t officially admitted that it is in a recession, many independent polls have found that over 75% of Americans do believe we are in a recession. If you add this to the consumer confidence index number of 38.0, the lowest ever recorded, I believe it is safe to say we are in one, and have been in one since at least January. Global economies, especially emerging markets, are extremely dependent on the strength of the U.S. economy and their consumers. The U.S. economy is in a slump, a slump that has and will continue to spread to the rest of the world.
U.S. and European Banking Industry
The banking industries, not only in the U.S. but also abroad, have had their credibility attacked regarding whether or not they have adequate capital to survive this credit crisis. Large financial institutions have failed, such as Wachovia (WB), Washington Mutual (WAMUQ.PK), Lehman Brothers (LEHMQ.PK), Bear Stearns, National City (NCC), etc. as a result of this crisis. Even the “Big 4” U.S. banking institutions have lost a considerable amount of equity in the past 12-18 months.
These events have pushed investors away from not only investing their money in these financial giants, but many have also pulled their deposits and other monies out in fear. Major reform has taken place such as these governments choose to either force or allow the banks to choose whether or not they receive direct equity investments from their respective governments. Although this has helped, the underlying problem of falling home values have not been solved. Many top banks still have tens of billions of dollars of risky assets sitting on their books just waiting to be written down.
Since the summer, home prices have only lost more value, home foreclosures have increased, housing supplies have increased, and more people are now unemployed. This combination poses a perfect storm for these financial institutions to weather. If you add this onto the concerns of what regulation will arise from the new President-elect Barack Obama, and how quickly action will be taken only adds to the fear and uncertainty of investors.
Wrap-Up
Although the U.S. dollar has appreciated to other currencies mainly due to a flight to quality and the uncertainty of the equity markets, it may be short lived. The treasury is pumping out billions and billions of dollars at these low rates to fund their debt and to save the U.S. and world financial system. This massive issuance of debt is likely going to be the downfall of the Dollar’s strength as inflation will take over in the coming years.
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This article has 13 comments:
Exactly....and then what currency shall we be holding??
Disclosure: Long gold
Furthermore, I am confident Bernanke understands how we got us into this crisis. And part of that reason concerns the Fed's lost control over the money supply generated by the lucrative derivative market. I am hopeful the Fed will fight to regain control, and I for one will hold congress to it's constitutional mandate to regulate the price of money. Now, if everyone else will join me...I cannot do it alone. :)
Now, I do not dare to believe we will eliminate those weapons of mass destruction: derivatives. They are just too necessary, in many ways, in our current financial system to be relegated to history. But, I'd bet they will be heavily regulated and monitored.
We must have learned a lesson of easy credit. I suspect after we begin to recover, and we will recover to dominate as the world's premier economy, credit will be a little tighter for many years. We will come out of this crisis a different animal than we went in as.
Furthermore, Obama states on his own web site he is a fair trader and a strong dollar advocate. There will be some pressure to revalue the dollar after all this is said and done. So, I do not believe all is lost for the dollar, even in the long term.
One could argue, and I have, part of the rise in the dollar is confidence. The US Fed, despite the hate mongering, has been acting to correct this down turn since (at least) October last year when Bernanke asked congress to shore up the GSE's and act to prevent foreclosures.
One could also argue the Fed is not acting in our best interest by printing money at it's current rate. I've argued, but no one seems to agree, this is actually in our national interest. We have to act, and we did act. We took steps to pull back the reigns of recession before anyone else. We're building confidence in ourselves and, by extention, our fiat currency.
Our current crisis is a liquidity crisis. The Fed is trying to boost liquidity.
I know some have put forth the idea we're in a solvency crisis. And others have argued we're in a "transparency" crisis. Both have some merit. But, those are arguments for another day.
What's scary is, all fiat currencies have failed. It's gonna be a matter of timing and pure moxy to maintain confidence in the dollar. But, we're pretty well equipped for the task.
By the time the average Joe has taken his losses and has gone all cash (what little is left), THEN inflation will rear its ugly head and devalue that cash.
The Fed can't undue what fix they've put in already, and everyday is just more debt and more printing going on. The impact of this 'new' money will be MASSIVE inflation. 1979 has nothing on what we're about to experience.
All those suckers who overpaid and overleveredged themselves on real estate would have had another chance to get out at high prices. Just give it a couple more years... But instead the vulture funds and smart investors will be racking in the profits - as usual.
I think there is a step they are missing. The money isn't 'created' until the Fed buys US Treasury bonds with money it 'prints.'
So far, there has been plenty of buyers around the world buying US Treasury Bonds: So much so that the the dollar has rallied 20% and up against most other currencies because you need US$ to buy US Treasury Bonds.
If you think this can't continue on much longer, I agree. Somewhere down the line, the demand for US Treasurys will stop, yet the Treasury will have to keep issuing them to finance the huge deficits and bailouts. That leaves the FED to buy the bonds with newly printed money.
Talk about a bubble: Inflation goes up, the dollar falls, and the Foreigners who hold our Treasurys see their value heading South both due to the inflation and the exchange rate changes. As they try to head for the exits, the prices of this debt falls farther and interest rates rise farther.
When does all this start? Not until the Fed starts buying US Treasurys. So far they don't have to. Financial panic around the globe is just fueling the biggest bubble of all.
The nearly dead carry trade is the primary source of the yen's current strength. Realizing, also, the yen carry is responsible for nearly 10% of global liquidity, such a rise is not surprising. And it underscores the depth of this crisis brought on by (what should have been) a simple US housing market down turn.
The dollar is certainly benefiting from risk aversion. No doubt. But, it should, I say...should...benefit from a drop in MZM globally. I argue this crisis is a liquidity crisis. Much of it (in dollars) is disappearing faster than the Fed can print dollars. So, there appears to be some other forces supporting the dollar in the longer term.
Credit appears to be severely down, so less trade puts fewer dollars into the forex and eventually into the PBoC coffers. Blah, blah, blah...I'm repeating myself.
As for inflation eating away at investors treasuries, the basis of a fiat currency is confidence the Federal government will not act to change the value of it's currency markedly. The Fed will have to get control. If not, we're sunk. I assert, the reason the dollar has been so devalued in the past few years is the immense addition to the money supply brought on through the housing market derivatives.
People call the Fed inept. No wonder. They have no control over the enormous amount of money out there...75% of global liquidity, of which MBSs make up some portion. I just don't think the Fed or congress will let that happen again. Once bitten, you know...
why?? is it the power?
what are we gonna do when all those buyers of U.S. Treasuries want to cash them in?
1-print money
2-nuke em
3-sell em New Jersey
4-default
Pick one. None are very pretty.
I also understand, and want to share with other readers, a broader dollar outlook.
First, we will come out of this crisis a different financial animal than we went in. One would bet the drivative market will be tightly regulated and will have some transparency. And, sure, no one will be buying into home mortgages anytime soon. So, I assert, the money supply will be at a lower level than previously.
Second, if Obama is to entice China into continuing to fund our debt, bail outs, and stimulus, he will have to restore confidence in our finjancial markets and economy, period. The dollar, being a fiat currency, benefits from this confidence.
Now, sure enough, inflation will rear it's ugly head at some time in the future. I hope later rather than sooner, as I believe we all do. So, the Fed will agressively fend off inflation through it's normal means: intersst rate hikes, higher reserve rates, etc. However, the timing will be very critical, we'll have to be showing sure signs of a recovery, I guess.
So, beyond the risk aversion, there are forces acting (or will be acting) in favor of the dollar during the coming year. And despite the return to risk appetite due to the Obama appointments and Citi bail out.
The dollar might slump a little before thing get better in the longer run. But, I am hopeful they wlll get better, and before the EuroZone can apply full power, pull the nose up, retract gear and ease up the flaps on it's economy.
Regards