Greenback's Slumped on the Canvas

On Tuesday, Bernanke & Co. signaled to the financial markets that they were hell-bent on pursuing an “inflate or die” approach to rescuing the ailing U.S. economy and fending off the forces of deflation. The Fed is now inflating at a level possibly not seen before by a developed nation since Weimar Germany.

Since the credit crisis started intensifying in July, the dollar benefited from a global flight to safety in U.S. Treasuries and a scramble for dollars to repay USD-denominated debt. The deleveraging process effectively created a short position in the greenback.

But more recently, U.S.-specific worries concerned with public debt expansion and the potential inflationary implications of quantitative easing dawned upon battle-weary investors, causing the dollar to reverse the uptrend that had commenced in July.

The U.S. Dollar Index (i.e. a trade-weighted basket) has not only breached its 50-day moving average convincingly, but seems to be forming a top of at least medium-term significance (see chart below). The fall from grace was brutal with the Index recording its largest six-day decline (from December 10 to 17) ever, setting up an assault on the key 200-day line (often seen as a crude indicator of the primary trend).

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The U.S. dollar also suffered its biggest one-day slide against the euro on Tuesday, and plunged to a 13-year low against the Japanese yen. (Also, see my weekly “Words from the Wise” review for comments on currency movements.)

The table below shows the performance of the U.S. Dollar Index, as well as a number of major and emerging-market currencies against the US currency. Gains against the US dollar (green) / losses (red) are given for (1) the period since the dollar’s high of November 20, (2) the period from the dollar’s July 21 low until the November high, and (3) the year to date.

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The devaluation of the U.S. dollar de facto exports deflation and depression, raising the question of how long it will take before other countries retaliate and embark on “beggar thy neighbor” currency debasement. China is already in the process of “managing” the renminbi lower, Russia’s central bank has signaled it would step up devaluation, and the Bank of Japan and others might also consider intervention.

Stephanie Pomboy (MacroMavens) said:

Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the US is, the former choice is not an option. So a weaker dollar is the natural valve.

U.S. creditors - such as China - with large hoards of dollars are growing increasingly nervous, and the dollar is likely to come under additional pressure if foreigners stop finding dollar assets an attractive proposition. The only way the U.S. can attract foreign capital is by offering a higher interest rate or making its assets cheaper through a weaker currency.

Jim Rogers commented as follows in a Bloomberg interview:

… the dollar is a terribly flawed currency. I hate to say it, but my goodness, they’ve messed up the dollar badly. So, I don’t like to do it, but I’m going to sell all the rest of my dollars sometime in the next few days, weeks, or months … Again, I don’t like saying it, but I’m afraid the dollar is going to go the way the pound sterling went.

The speed of the dollar’s decline has been such that it is quite likely to see a relief rally before the downtrend resumes. Arguing for a temporary hiatus from a fundamental viewpoint, Stephanie Pomboy said:

… right now, we are enjoying some real competition in the ugly contest from the currencies of the European Union and the United Kingdom, and that will probably persist for a while because they are in pretty bad shape, and they are a little bit behind the curve relative to us.

Lastly, a sustained break in uptrends of the U.S. dollar and the Japanese yen – low-yielding currencies previously used for funding risky investments – should indicate that forced selling due to deleveraging is starting to subside. As this situation plays itself out, we should see a return of confidence and a calmer period for stock markets in general, and also see some support for precious metals and commodities. The dollar may be down for the count, but could herald a sense of normalcy in broader markets.

Comments

[Chris B:]

The article's comparison of the Weimer republic to our current deflationary environment was my first warning. Thanks for putting that at the beginning.

2008 Dec 19 08:35 AM

[NotinMarket:]

Greenspan = no credibility; helped start this entire mess with his low then high interest rate. Do you think he has a solution using his fraudulent statistics ? Probably was friends with Madoff and AIG. Statistics are only useful if the data comes from reliable sources.

Weimar Republic = True; print money, trash the country you are in, move all assets to Swiss Banks. However, this scheme is now getting risky. Can't even trust your tribe anymore.

2008 Dec 19 09:04 AM

[wpdragon:]

"Lastly, a sustained break in uptrends of the U.S. dollar and the Japanese yen – low-yielding currencies previously used for funding risky investments – should indicate that forced selling due to deleveraging is starting to subside. As this situation plays itself out, we should see a return of confidence and a calmer period for stock markets in general, and also see some support for precious metals and commodities."

I think we're starting to see that now with many good bases setting up on many of the commodity and cyclical stocks/indices, and the rapid breakdown in the VIX and VXN we have seen in the past two weeks.

They're hopeful signs, at least.

2008 Dec 20 09:50 AM

[Asbytec:]

The "beggar they neighbor" has begun. Has the eventual collapse of all (most) fiat currencies begun as well? "All fiat currencies fail, and all currencies are fiat."

It's like having that root canal, it'll hurt but not after it's over. And when it's over, my bet is the dollar will be on the top of the heap. I think most central banks believe that, too. I suspect that's why none bought into the euro in mass while it was $1.26. Sure, there is some diversification...but not a wholesale flight from the dollar some have speculated.

Scary times. The greenback is certainly on the canvas with the euro moving in for the choke hold. But, the euro just does not have the demographics or might to supplant the dollar. The EU could never support huge trade imbalances with China.

2008 Dec 20 09:32 PM

[auto44:]

Jim Rodgers also said that the 19 century belonged to England, The 20th to U.S. and the 21st will belong to China. He also says that natrual resourses are the key to wealth in this century. I always keep this in mind when looking foward.

2008 Dec 20 10:55 PM

[Asbytec:]

Hmmm...the 19th century belonged to England because of it's economic and military empire. The sun never sat until the 20th century. The US, same economic and military empire in the 20th century. Will china have some global military reach this century?

I imagine China's resources are largely untapped and it has massive human resources. It's production is unequaled today. But, one problem is China has not a sufficient middle class, yet. And is still, best I can tell, a command economy (with a free market interface.)

Interesting thought, though...

2008 Dec 21 05:05 AM

[johnbee:]

when England ruled the world it had no middle class. the masses did as they were bid and were rewarded. It was a command economy. just like China today.

2008 Dec 24 07:58 AM

[Tim W:]

In one sense - it is a complete free for all - But looking rationally at where we are: One can reasonably assume that the tipping point will be the day that the Congress allows Americans to hold Foreign bank accounts in the US.
That currently is not allowed. This is unlikely in the near term - If it didn't happen in the Clinton term - it is unlikely to happen soon.
Secondly - The current situation is truly a blessing in disguise - The financial manipulators are out - Value is in - Value in work - in productive efforts-
The Wall Street boys are mostly all shown for what they are leaches on the productive person's efforts - Cynically claiming that they create capital - Capital is ultimately created by a group's ideas, education, character and work effort.
Natural resources play a part - but look at Japan - No Natural resources -
So - my sense is that the dollar is going to bounce around - but it ain't going nowhere fast - Jim Rodgers has been largely right and I wouldn't want to bet a against him - But like most commodity traders - He just wants to make a buck on his observations of the current trend - not work to change the underlying foundation of what is causing a trend. (although in fairness to Jim - his books make the case that change is necessary)

Right now we have an unprecedented (in our lifetimes) occurrence where millions of Americans are going to look at what has happened and they are going to make a lot of judgments over the next few years - The election of 2010 is going to be the interesting one - cause all the dirt will be on the table - The clean up folks are going to be rolling up their sleeves - good behavior - and savings are going to be the new rule - savings most everywhere - Government- homes, businesses etc.
Prudence will be the new watchword -
It will be pervasive as we take steps to undo all the stupid thinking of the past 30 years - (which is not say there wasn't tons of good thinking - there was.
Think about all the underlying principles of "green" and "frugal". These are the moral values that will underpin the next years.

So what does this mean for the dollar? Strength if we are prudent - weakness if we don't raise rates at the right moment. And when is the right moment ?
Well off the cuff - I would say sometime about the moment that average house prices reach the 2.7% annual increase mean price (over the past 40 years) based on 1992-4 price levels. So just ask Professor Shiller. He knows approximately what that figure should be.

My calculation from 1987 when the CS HOMEprice index was at 62.82 indicates that at 2.7% annual increase the index should now in Q1 - 2009 be at 112.89 - and it is currently at (as Sept 08) 173.25.
The good news is that that is down from 226.09 in June of 06. (down 53 with just 61 to go) Encouraging isn't it -

But here's the caveat - What is the real inflation rate value of the money being printed today - IE: does the 2.7% mean hold or should it be higher.
I figure when Case Shiller is about 145- we will be near the bottom close enough. In other words - we are actually pretty close.

2008 Dec 28 03:03 PM