Questions About the Dollar

In the near-term, the stars are aligned against the US dollar. Sentiment is decidedly negative. If the news stream is good, we are told investors are less risk averse and do not need the dollar’s security. If the news stream is poor, we are told the US is in horrific shape and the budget deficit and Fed’s balance sheet will swell even more.

It is difficult to see what will break this psychology in the coming weeks. The euro could rise toward $1.4600-$1.4800, with sterling headed toward the mid-$1.60s. The dollar also looks poised to fall into the low JPY90 or high JPY80s.

Yet despite the likelihood of these near-term dollar losses, we are reluctant to substantially alter our more constructive medium term outlook. It may be helpful to put our views in the context of questions often asked.

How can you offer a constructive view of the dollar when the US government is acting like it has an unlimited checking account and the Federal Reserve is abetting them by rapidly expanding its balance sheet?

The aggressiveness of the US policy response needs to be understood within the current financial and economic crisis, which is of historic proportions. A strong policy response is important and it can make a difference in the magnitude and duration of a crisis. The strong policy response from government officials and the dramatic liquidation of inventories should help the US economy find steadier footing in the coming quarters. The sooner the US economy begins to expand; the sooner the government and Federal Reserve can withdraw or otherwise unwind some of their emergency measures.

But the cost of that policy course will be inflation and won’t that debase the dollar?

Inflation could be a problem in the future, but the immediate risk is just the opposite. Policy makers and many economists believe that undesirably low inflation or outright deflation pose a greater risk as the de-leveraging process continues.

The Fed is creating reserves (money) and the government is spending hundreds of billions of dollars. Why won’t that fuel inflation?

The answer lies in how you understand inflation and in some way pits the monetarists against the Keynesians. To the extent that quantitative easing expands the Fed’s balance sheet and high power money, some monetarists will worry about inflation. The Keynesians, on the other hand, are not as worried about inflation because of the low levels of capacity utilization and rising levels of unemployment.

Then isn’t stagflation possible as in the economy remains in the doldrums and we have a dramatic increase in inflation?

US core inflation has been remarkably steady. Over the past 120 months, the prices of core personal consumption expenditures have increased at a year-over-year average rate of 1.8% and over the past 24 months, it has averaged 1.81%. This measure of inflation, often cited as the Fed’s preferred, though not sole, gauge, has averaged 1.9% over the past year, and 1.78% over the past six months. The most recent data in March stood at 1.8%. If anything there has been some easing of core inflation pressures. The average monthly increase in the first quarter of this year was the lowest since the third quarter of 2007.

This is not simply backward looking. The point here is that there is no compelling sign that price pressures ought to be the main concern of policy makers. One can also look at inflation expectations, for which there are many different measures. The Fed and the ECB both cite the 5-year/5-year forward, which looks at market based instruments to uncover expectations for inflation not in the next five years, but for the five years after that, to offer a cleaner view of inflation expectations. The US measure stands around 2.45%. However, in Europe this measure picks up greater inflation expectations, with France, the proxy for the euro zone, standing at almost 3.10%, and the UK just below 4%.

What then do you make of Bill Gross’s point that the dollar and US assets suffer amid concerns that the US sovereign debt rating could be downgraded in the future?

With all due respect to the famed investor, this assertion seems an unlikely narrative to explain the recent price action. Consider that recently a former Comptroller of the Currency wrote an op-ed piece which threatened that the US could eventually lose its triple-A rating if it did not quickly get its fiscal house in order. Since that op-ed appeared, Japan’s foreign currency debt rating was cut and the outlook for Great Britain’s debt was cut to negative from stable. According to IMF figures, the US government’s debt-to-GDP was just above 60% going into this year. When S&P expressed its concern over the UK’s debt outlook, it indicated that one of its considerations was that the UK’s debt was approaching 100% of GDP. Roughly speaking, the US budget deficit for both this year and next will be little more than 20% of GDP, bringing the debt-to-GDP ratio to around 80%.

The point is not that this is good, but rather that many other countries are in worse situations. According to IMF data, last year Japan’s debt-to-GDP was almost 200%, while Italy’s was 104%. Germany entered this year with a debt-to-GDP ratio of 76.4% and France was at 65%. Moreover, Gross’s claim seems incongruous with the fact that in the face of an actual change in the outlook for UK debt, sterling fully recovered from the initial sell-off and managed to make new highs against the dollar; and we are to believe this was on the distant prospect of a US downgrade.

One would not know by the rhetoric, but the risk of default by the United States, judged by the cost of a 5-year credit default swap, has fallen by nearly 40-50% this year. Even as the budget, bailout, and Fed’s bond purchases expanded, default risk remains lower than for almost every other country. However, there have been some unusual anomalies, like the time recently when the cost of insurance for one or a few individual companies was lower than for the US government.

Surely you have to agree that with numerous central banks diversifying their reserves, the official supply of dollars will undermine it?

The demise of the dollar as the numeraire for the world economy is greatly exaggerated. The most authoritative data from the IMF suggests that until the last part of 2008, central banks as a whole were accumulating reserves. For two-thirds of the world’s reserves for which the composition is reported, central banks held more dollars than ever before. In the last quarter of 2008, the IMF data shows an overall reduction of reserves, which appeared to be a function of valuation and, ironically, intervention to slow the dollar’s rise. Federal Reserve custody holdings for foreign central banks rose roughly $94 billion in the final quarter of 2008, almost $80 billion in the first quarter of 2009, and have risen by more than $100 billion thus far in the second quarter.

US Treasury data is unequivocal: China increased its Treasury holdings by more than a third in the second half of 2008, has continued to increase holdings this year, and currently holds more Treasuries than ever before. No country has a monopoly on politicians whose declaratory and operational policies differ. Most recently, both Saudi Arabia and Bahrain reaffirmed a commitment to their dollar-peg currency regimes. South Korean and Russian officials have stated that they have no intentions to sell Treasuries. Ten years into the great experiment of our time, monetary union without political union in Europe, and the single currency is roughly the size of its constituent parts (ECU, the German mark and French franc), as a reserve currency.

By the ECB’s own figures a little more than 50% of the euro-zone’s exports are invoiced in euros. Likely the smaller half is mostly dollars, with a little sterling and yen thrown in the mix. The yen, backed by the world’s second largest economy, has a small and, in recent years, diminishing share of world reserves. Only about a quarter of its imports and a little more than a third of its exports are invoiced in yen. The recent buzz about China and Brazil using their own currencies for bilateral trade was largely a market/media generated story with little official encouragement and of course, no action.

Don’t US policy makers really want a weaker dollar as a stealth form of default and to boost exports?

In testimony on May 21st, US Treasury Secretary Geithner specifically said he is committed to policies that sustain confidence in a strong dollar and US economy. Compare that with the Swiss National Bank, which has committed itself to preventing the appreciation of the Swiss franc to resist deflationary forces. Yet thus far in the second quarter the Swiss franc has appreciated by more than 4% against the US dollar. Since Geithner’s confirmation hearings, where he quoted campaign rhetoric about the Chinese currency, there simply is no evidence that the Obama Administration is seeking a weaker US dollar overtly or covertly. Of all the challenges the US economy faces, the dollar’s exchange rate is not one of them.

Comments

[Prudent Man...:]

If other major countries were not printing money as fast as we are, the dollar would have crashed months ago. "Relatively" is one thing, absolute is another. China has been putting most of its excess reserves into oil and other industrial commodities. Take them out of the demand variable for Treasuries and what do you have?

If Geithner and the BHO Administration want a weak dollar they better be careful what they wish for. As neither have any "real" experience and are theorists they don't know the reality of when no one wants the dollar interest rates explode they will also.

The hostile takeover of business by the Federal Government is another factor for weaker business climate. Will the entrepreneurial class wake up before it is too late? We will definitely see.

Many are talking inflation. You don't need inflation to weaken the dollar and increase rates. Supply and demand for dollars are just as debilitating as they are destroying saving for a political agenda. Of course, the BHO Administration doesn't believe the bourgeois should have savings except for themselves.

May 28 09:24 AM

[Prudent Man...:]

It is my understanding that China's treasury holding have moved down the maturity scale and have increased dramatically into Treasury Bills rather than later maturities. Being so liquid they can move out of the Treasury market painlessly.

May 28 09:26 AM

[ding:]

We only "think" China is in a dollar trap. The reality is much different.

May 28 09:48 AM

[Jimbo:]

I cannot share the author's sanguine attitude about current rates of inflation. In my area, state and local taxes, as well as "fees" are increasing. The local power company secured a 25% increase in rates.(I can hardly wait until "cap and trade" hits the utilities). Fees charged for services from haircuts to tax return preparation are going up. Food containers in the grocery are being downsized. The citizen consumer is being devoured. I submit that economic statistics are being "cooked" by the Federales. The best description of this situation where we have "overcapacity" and underemployment with rising costs of many aspects of the living standard: Stagflation. Welcome to JIMMY CARTER< PART TWO.

May 28 10:44 AM

[ozzy43:]

Great example of GIGO. Any analysis that relies upon the fraudulent government-generated numbers like CPI and GDP is bound to wind up issuing fundamentally misguided conclusions. Furthermore, the assertion of Keynesian principles as though this model had not been disproven conclusively in the 70s in a period of rising unemployment AND rising inflation (something the Keynesian model said was flat out impossible) perpetuates the fantasy-based underpinnings of the logic here. And the nail on the coffin is the way in which the author presume that 'strong policy response' will result in the expansion of the economy. Hello - unemployment continues to soar and the gargantuan private debt overhang will need to be paid down, painfully, by people with fewer jobs. Meanwhile, the strong policy response by the government consists of wresting capital resources from the more efficient private sector, leaving that sector - which is the ENGINE of growth - with fewer resources to actually build capital and contribute to a REAL expansion of economic activity (this does not include digging holes and then filling them in again).

The cherry on top is where the author cites Geithner with an apparent total lack of skepticism as to whether that Wall St banker might not actually be 100% honest.

This article is an exercise in pure fantasy on virtually every level.

May 28 11:32 AM

[topshelf:]

Just this consideration I've thought to comment on in many Seekingalpha articles. As the USD Drops it has the by-product effect of causing the Market to go Up, all other things being equal.
In fact the Orchestrated Rally we all witnessed, that began around March 9, included the last rally in the USD of about 10%.

If we woke up in the morning and the USD had dropped 10% Overnight, each Unit/Dollar of the DOW, S&P, any equity, would have a value of $0.90 compared to the $1.00 of the day before, so if the DOW was at 8,300 the day before it would take 830 DOW points to equal the $8,300 @$1.00 of the day before, actually a bit more, a 9230 DOW made up of 90 cent Dollars would equal the 8,300 DOW of a full 100 cent Dollar.
I hope you get my point----a bit hard to explain, maybe if you also think of Hyper Inflated Currency <<< a weakened currency, it might help grasp my point.

May 28 01:28 PM

[Ray Winter:]

Prudent Man has a very good point. The Chinese, having expressed their Treasuries concerns to the U.S. are now hell bent on amassing stockpiles of minerals as their alternative 'currency', hence the reason that the price of copper and aluminium continues to rise in a falling market for manufactured goods. In addition, their desire to buy into the west's major mining companies and to forge close working agreements with African governments are other indications of their desire to hedge against their dollar exposure.

May 28 02:11 PM

[topshelf:]

let me correct and display, you'll note the rally in the USD Topped exactly on the same day the orchestrated Index rally began. the USD shed over 10% in the same time the Indexes gained 30%+. the 10% "loss" in the USD was thus part of the gain in the Indexes. of course they had to change the accounting rules on the banks, make it retro, fudging the Q1 earnings, and most all the big 5 gained from double to 5-fold, and then issued 'new' stock....quite an orchestration...the 2x & 3x Financial ETF's brought bag fulls of Loot via Optionization.....incr...

www.fxstreet.com/rates.../


On May 28 01:28 PM topshelf wrote:

> Just this consideration I've thought to comment on in many Seekingalpha
> articles. As the USD Drops it has the by-product effect of causing
> the Market to go Up, all other things being equal.
> In fact the Orchestrated Rally we all witnessed, that began around
> March 9, included the last rally in the USD of about 10%.
>
> If we woke up in the morning and the USD had dropped 10% Overnight,
> each Unit/Dollar of the DOW, S&amp;P, any equity, would have a value
> of $0.90 compared to the $1.00 of the day before, so if the DOW was
> at 8,300 the day before it would take 830 DOW points to equal the
> $8,300 @$1.00 of the day before, actually a bit more, a 9230 DOW
> made up of 90 cent Dollars would equal the 8,300 DOW of a full 100
> cent Dollar.
> I hope you get my point----a bit hard to explain, maybe if you also
> think of Hyper Inflated Currency <<< a weakened currency, it might
> help grasp my point.

May 28 03:44 PM

[realold:]

Excellent response. CPI and other government "facts" are at the core of the manipulation that is taking place. If one thinks otherwise, load up on TIPs and be safe. Or, collect on any CPI indexed income vehicle. It is all nonsense, or at the very least, living in the distant past.


On May 28 11:32 AM ozzy43 wrote:

> Great example of GIGO. Any analysis that relies upon the fraudulent
> government-generated numbers like CPI and GDP is bound to wind up
> issuing fundamentally misguided conclusions. Furthermore, the assertion
> of Keynesian principles as though this model had not been disproven
> conclusively in the 70s in a period of rising unemployment AND rising
> inflation (something the Keynesian model said was flat out impossible)
> perpetuates the fantasy-based underpinnings of the logic here. And
> the nail on the coffin is the way in which the author presume that
> 'strong policy response' will result in the expansion of the economy.
> Hello - unemployment continues to soar and the gargantuan private
> debt overhang will need to be paid down, painfully, by people with
> fewer jobs. Meanwhile, the strong policy response by the government
> consists of wresting capital resources from the more efficient private
> sector, leaving that sector - which is the ENGINE of growth - with
> fewer resources to actually build capital and contribute to a REAL
> expansion of economic activity (this does not include digging holes
> and then filling them in again).
>
> The cherry on top is where the author cites Geithner with an apparent
> total lack of skepticism as to whether that Wall St banker might
> not actually be 100% honest.
>
> This article is an exercise in pure fantasy on virtually every level.

May 29 12:00 AM

[morry:]

Who really knows,

Without all the formulas and theories, anyone with half a brain and a little common sense, has to know that sdthis guy has crapped on a nation, and the dummies love him for it. I suspect they will begin to wake up when taxes on everything from sugar to toiletpaper begin to hit. Not to mention a VAT (Value Added Tax) has some tril balloons out. The consumer gets to pay all that too.

I like many others I am sure, are torn between gold, maybe a backyard full of copper, aluminum, brass etc. Something of important value that will increase in value as the Dollar poops out.

I have been around for 78 years and I have yet to see anything a Democrat touches turn to anything but s - - -!

I am so fearful that the true agenda of our new President is too totally break our financial backs, take away guns then announce that we are now living in a Dictatorship and there is nothing we can do about it!

Pray that I am wrong.

May 30 12:13 PM