Will the Dollar Rally Survive?

The U.S. dollar has been holding up quite nicely during this credit crisis. In fact, it rallied significantly from deeply oversold levels against the euro and British pound (remember dollar-euro at 1.60 and dollar-pound at 2.10?). However, America has a number of structural problems which will inhibit further appreciation. Moreover, former buyers of U.S. Treasuries in the Middle East and Asia are going to have domestic economic worries of their own very shortly and will not be supporting U.S. assets. This means that the dollar will be a weak currency in the not too distant future.

Let’s address the structural weaknesses of the United States. The first issue is savings. As the Anglo-Saxon countries of Australia, Canada, New Zealand, the U.K. and the U.S. prospered in the 1990s and earlier this decade, their savings rates dropped precipitously. In the U.S., we saw a drop from 7% at the beginning of the 1990s to near zero before the credit crunch hit in earnest.

As a result, the U.S. has run a massive current account deficit, borrowing money from abroad in order to maintain adequate levels of investment at home. In essence, Americans were selling off pieces of the country to finance their spending. This is akin to an addict selling furniture to fuel his habit. In 2005 and 2006, this deficit was as high as 7.5% of GDP.

In the meantime, all of this deficit spending was financed by debt. Debt to GDP levels have reached unprecedented levels: 341% Total U.S. Debt to GDP, 98% Household Debt to GDP, 133% Household Debt to Annual Disposable Personal Income, 115% Financial Sector Debt to GDP — all as of Q2 2008.

While debt levels could continue to rise during good times, the present financial crisis has caused massive credit writedowns at U.S. financial institutions, restricting their capital and ability to lend. Debt levels will contract.

Now, the U.S. could try to shift the burden of borrowing onto the federal government to cushion the downturn this deleveraging will cause. And it will do so in part as Federal Government deficits are expected to reach into the trillions in the coming years. However, the U.S. will be greatly constrained by events in the Middle East and China in particular — major U.S. creditors. Both China and Middle Eastern countries will have large domestic economic concerns with which to contend. I anticipate they will pull back on their purchases of U.S. assets, as a result.

In the Middle East, the economy boomed as oil rose from $10 a barrel to $147. However, oil has recently come crashing down to $50 a barrel. This is happening in the midst of an enormous property crash in places like Dubai (see source articles below). Most oil-exporting Middle Eastern nations have experienced a population explosion of late and this puts enormous pressure on government to create jobs and economic growth. With oil prices and property prices falling, there will be a hard landing in these countries. They will not spend their money buying U.S. Treasuries or agency paper in such a predicament.

Then, you have China, America’s largest creditor. China is seeing its manufacturing sector implode and a very serious stock market and housing crash. The situation there is much worse than we are led to believe as the Chinese have recently lowered interest rates considerably, have started large domestic stimulus packages and have even tried to depreciate their currency. Again, one should anticipate a much lower appetite for U.S. assets going forward.

Where does that leave the U.S.? To my mind, it leaves the U.S. in a situation where inflation will be the preferred mechanism to reduce the real burden of its mountain-like debt load. This is dollar bearish. Moreover, even if the U.S. cannot or does not inflate, the structural problems I have already run down will inhibit growth over the medium-term in the U.S. This too is dollar bearish.

The U.S. dollar is riding high right now in part due to weakness abroad. However, as recessionary events start to play out, it will become more evident that the U.S. is structurally weak and that is when the dollar will lose favor.

Other Charts

Sources

• Dubai: Has the bubble burst? - The Economist
• Dubai shares hit despite promises - BBC News
• Heavily in Debt, Dubai Calls in the Bankers - Deal Book
• Could China be depreciating? - FT Alphaville
• Economic nationalism and the USD - FT Alphaville
• China factory output down sharply - BBC News
• China’s $586bn boost for own economy may have done the whole world a favour - Independent Ireland
• China tops US govt foreign creditor list - Sydney Morning Herald
• China Property Slump Threatens Global Economy as Growth Slows - Bloomberg
• Flow of Funds Data - Federal Reserve Board

Comments

[1worldcurrency:]

I agree with all of this. If I were making a long term contract of any kind, including negotiating wages, leases, setting up a factory, (in fact any creditor) I would demand an adjustment for inflation built in. I would not trust the US Government inflation numbers either, but would demand a weighted index based on a basket of currencies, commodities, and metals. National currencies are effectively obsolete.

2008 Dec 04 02:18 AM

[Income Tax:]

I agree with most of it. Inflation is inevitable. And this deflation and inflation cycle is going to be bigger and more volatile than any historic precedence. The thing is that if the government (Treasury, FED) can smartly control it when they see the deflation cycle turns.

2008 Dec 04 02:33 AM

[DollarTalkNet:]

This is a very well written and presented argument. I would only want to add that I believe the recent strengthening of the dollar has been due to China's decrease in spending since the Olympics ended. This only adds to the argument that this strength may be temporary, since our national debt is going to sky rocket over the next two years at a minimum, and all China has to do is start spending US dollars again in the international marketplace.

2008 Dec 04 03:13 AM

[J-Bird:]

Great article! Thanks Mr. Harrison. Your research is very helpful and your conclusion, I believe, will be accurate. Your comment on the adict selling the furniture is a great analogy. My comment on the banks credit bailout was "they are like crack addicts sceaming for a fix and giving away the keys to their house for it". With the absence of foreign credit we will certainly have a difficult rehab ahead.

I have been researching this information for investment reasons. I have correctly predicted the EURO decline vs. US Dollar and see this continuing until the EU runs out of room to drop rates. The US Dollar currently at 1% Fed Funds is basically done. The US will print money to fill the credit vacuum will kill the US Dollar.

So Mr. Harrison and readers, if you agree the dollar will soon be thrashed ( I think we will have a US Dollar Crisis ), where do you put your wealth?

Gold, Land, commodities, other currency??? HELP!

2008 Dec 04 09:20 AM

[Larry House:]

Good presentation of what is coming. We will be forced to reduce debt and live within our (family budgets and governemnt) means if we don't have the will to change our lifestyles on our own.

2008 Dec 04 10:20 AM

[carey_jim:]

The concept of nation state only exists for the bottom 99% of humanity whose only control of the financial system is through democratically elected government activity.

The wealthy elites (who are usually bilingual: Chinese/English, Spanish/English, European language/English) don't care where they live and move freely from one country to another but obviously, English has become the linguua franca.

To be part of the wealthy elite, families must be worth at LEAST 100 million dollars. However, 100 million dollars only allows them to own a small private jet and keep up appearances. They need closer to a quarter billion dollars to qualify for respectable membership in the wealthy elite which is truly a supra national class.

While "the rich" certainly do not "rule the world" they have more power over the financial system than any other group and they fear the only power that can tell them what to do: the governments of the world.

Since they own most of the media outlets, they can trumpet their fear of government over the rooftops and they do. But this fear is greatly exaggerated.

For the rest of us, nationalism matters, just as language and culture matter: we can't afford to move to the south of France either financially or culturally.

They can and do, regularly.

For us, cultural identity matters and that includes the value of our national currencies and the quality of life in the countries we live in.

But, as F. Scott Fitzgerald observed almost a hundred years ago: "The very rich are different from you and me."

2008 Dec 04 12:53 PM

[ozcutty2:]

Agree except that other nations are no better off than the US. In other words, sure the US is weak, but where else do i put my money? Uk? Swiss francs? Japan?
The US should recover before these other countries, which surely favours the US dollar.
Also, if US inflates, so will everyone else!!!

2008 Dec 04 11:15 PM

[1worldcurrency:]

I value my nation for its Constitution, which does not contain the word dollar. In fact the value of the dollar is being abused by my government.

The French and Germans associated their cultures with Francs and Deutschmarks for much longer than the US has existed. They adopted the Euro in no time, because common currency reduces transaction cost.
In other words, let free markets determine the value of an item, not a government treasury. Some think free markets are part of American cultural identity. We'll see.

2008 Dec 05 05:42 AM

[Asbytec:]

It is a good article and a lot of good comments. I believe as Salary does, the cycle will be severe. When inflation hits the Fed will act aggressively. They'd better, and congress had better see to it they do. As 1 World Currency points out, our constitution means something. It gives congress the responsibility to set the price of money...yes, even though it's been delegated to the Fed.

I am not sure what DollarTalk means by China spending dollars in the international marketplace. Repatriating our dollar in the form of fair trade? Ain't gonna happen. So, by what mechanism will their spending dollars improve it's value?

While I am on China, they have a vested interest in helping their largest importer survive. Their survival depends on it. Decoupling is a myth. Besides, they will not release trillions of dollars into the market and buy up euros. s long as they run a trade surplus, they will fund our debt and devalue their yuan.

Larry is exactly right. We will have to live within our means. I spent the last 4 of the last 6 years becoming debt free and doing just that...not by any market timing, nust dumb luck. And it's funny how things change when one is debt free. I love deflation. It makes my dollar go further and me feel a bit rich (though not rich enough to fly in my private jet to my beach home is the south of France, Carey...LOL) But, those in debt love inflation. Makes their home values soar so they can feel rich and mortgage to buy that Hummer.

And oz makes another point. Who is better off? As of this writing, apparently, many feel the Euro Zone is. Well, the appreciating euro will undergo the same export pricing strains as the US dollar did. The EU must fight (the threat of) deflation and stimulate lending, too. Fortunately, easing attacks both of those concerns. I suspect they will ease along with the rest of the world.

So, my favorite saying..."all fiat currencies fail, and all currencies are fiat." So, which one will remain on top after the collapse? The dollar, most likely. The euro just does not have the demographics nor economic might to take on the role as reserve currency and associated trade deficits.

Besides, china should have bought at $1.26. Maybe they're waiting for $1.21. Sometime after Christmas the ECB will ease. And, oh yea, they're in debt, too.

2008 Dec 14 11:44 AM