The unloved dollar has proven among the best performing assets over the past 12 months as the dollar index gained 26%, with 'safe haven' gold pretty much flat, having peaked 10% above current levels last April. The irony is that just about every goldbug was also a convinced dollar bear a year ago, and their emotionally charged analysis has proved utterly misconceived in a deleveraging global economy.
On July 27th last year, I wrote:
The Euro, Yen and Sterling all risk major fundamental downside over coming months as evidence mounts that their respective economies are sliding into recession; decoupling is dead. Meanwhile the US trade deficit is in rapid decline... the prospects of a sharp dollar rally in the next few months are high.
Currency analysis isn't that complicated; ultimately, it comes down to whether foreign demand for US assets exceeds US demand for foreign ones. Not only did it seen obvious that the world economy would 'recouple', but also that a bursting commodity bubble would prove dollar positive.
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But beyond these supportive factors, it became clear in the Autumn market panic that the world was structurally short of dollars, from professional speculators to emerging market corporates and foreign commercial banks. Indeed, the huge natural short position built up in European bank loan books is detailed in a new BIS report available here.
Many observers forgot that the low-yielding dollar was a 'carry trade' funding currency for foreign investors almost as much as was the Yen in the boom years. Another factor was the fact that Americans were selling foreign financial assets faster than foreigners were selling American ones through 2008, as can be seen in the chart below. Additionally, there was a huge surge in safe haven buying of T-Bills in late 2008 by overseas investors. So where to now for the newly virile dollar? While capital flows globally are still contracting, the way in which they are doing so is still proving dollar positive. I think the impact of rising US savings (to maybe 8-10% by year-end) and its impact on funding both the trade and fiscal deficits, is key to the outlook.
Structural dollar bears always assumed that foreign buyers of US debt and other obligations would eventually become sated, and dump US assets triggering a crisis. That analysis missed the extent to which those same countries were dependent on the US consumer for their employment and GDP growth prospects in an unsustainable perpetual motion machine of capital flows. Ultimately, it was the collapse of the asset side of US consumer balance sheets, as real estate and then equities slumped, that forced a rapid deleveraging and a US savings ratio hitting a current 5% heading to 8% plus.
Consumption as a share of US GDP is set to tumble to below the long-term average to maybe 62-64%, leaving foreign merchandise exporters trapped in a round of competitive devaluation to maintain their share of a shrinking pool of demand. While a smaller US current account deficit is probably net dollar positive, it does hugely reduce the surplus dollar volume exporters like China have available to recycle into US Treasuries (China and Japan accounted for 65% of foreign buying of Treasuries in 2008). With a 12% of GDP US fiscal deficit forecast this year, even if all the new US private sector savings were directed into bonds would leave foreign official buyers to pick up at least $500-700bn just as their trade surpluses slump. That's a big ask.
Funding the deficit at anything like current yields will be the litmus test of the dollar's new strength. However, as the US economy is in fundamentally in far better shape that the hugely overleveraged and export dependent economies of the Eurozone and Asia who with the demise of the US consumer simply don't have a Plan B, I'd expect the dollar to remain the tallest pygmy among major currencies for the foreseeable future, but ultimately devalue against real assets as incipient inflationary pressures rise over the next 2-3years.