Dollar Declines Set to Continue

A nation’s exchange rate is the single most important price in its economy. --Paul Volcker

The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.

The reason given for the current decline? The U.S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking loose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.

Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.

Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.

This is a tremendous cloud hanging over the financial markets!

We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U.S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.

But, now with the strengthening of the U.S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.

And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.

This is not a financial mix that participants in international financial markets like.

Let’s take a look at the historical record. We start during the Nixon administration, because until August 1971 the value of the dollar was fixed in value relative to other currencies. But once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.

In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.

The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.

Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23%! (Through one stretch, the value of the dollar actually declined by more than 40%.)

With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%.

I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.

In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.

Comments

[LKofEnglish:]

BIG difference between Bush 43 and Obama. After 9/11 we were gearing up for a war that we can and did win. That ended the recession. This time we're throwing "good soldiers after bad" in a war Obama and Democrats continue only because "'we're powerful and your weak." That was AFTER they were "against this war." Not only will this NOT end the recession it's could very well result in a Dien Bien Phu DEEP in Central Asia and a hyperinflation here at home. America today looks very much like France in the 60's, unfortunately we have no Charles DeGaulle who "saved his country twice" but instead people who wish to ruin it AGAIN AND AGAIN.

Sep 17 03:22 PM

[market ace:]

It is becoming clear that the dollar is dead. Massive deficits and printing dollars to buy our own debt is a kiss of death in itself. More importantly we have lost all faith and trust from the rest of the world.

The dollar is now the currency of choice for the carry trade, because of the FED's stupid zero interest rates, and that is about all that is propping up the dollar now. When you see countries like Canada issuing bonds in US currency it is not because they think it will be increasing in value in the future.

The perceived increase in market values and commodities is mostly caused by a falling dollar. US stocks again look cheap to foreign investors and international compaies can report good earnings so everything looks womderful on the surface, but when the dollar is losing purchasing power at its current rate the citizens of this country will eventually be crushed.

When you see the change in attitude in China just in the past 30 days it is startling. They now laugh at your AMEX card and taking US currency, that they were glad to take last month, is not happening any longer. That alone is a very scary sign.

I'm not sure what economy Mr. Bernanke thinks is out of a recession when 1 in 8 mortgages are delinquent or in foreclosure and the number is headed for 1 in 5. Hopefully he will issue a playbook so we will be able to recognize the recovery from the recession over the next ten years or so.

The value of a currency is nothing but trust and perception of the country issuing it and we have screwed the rest of the world with our crooked banking and ridiculous mortgages for way too long. They have learned a valuable lesson and we will now pay the price as our curreny loses value every day..

Sep 17 03:46 PM

[paulsjj:]

A declining $ is inflation.

Sep 17 03:51 PM

[Dave Wrixon:]

Yes, I find the use of the term "deflation" in this context confusing. The dollar is devaluing. Deflation means you get more goods for your money. Logically, Dollar Deflation means you get more goods for your Dollars. Not quite what the author appears to be trying to say, although obviously I agree with the sentiment.

On Sep 17 03:51 PM paulsjj wrote:

> A declining $ is inflation.

Sep 17 04:26 PM

[tws:]

Thanks for the comments regarding inflation/deflation. I agree, and the original headline has been changed from "Dollar Deflation Set to Continue" to "Dollar Declines Set to Continue."

Sep 17 04:32 PM

[chap08:]

Just to confuse you some more Dave, if you look around SA, you will see some people saying "the dollar is going to zero" and the same people saying "we can't avoid deflation". Perhaps consistency is over rated.


On Sep 17 04:26 PM Dave Wrixon wrote:

> Yes, I find the use of the term "deflation" in this context confusing.
> The dollar is devaluing. Deflation means you get more goods for your
> money. Logically, Dollar Deflation means you get more goods for your
> Dollars. Not quite what the author appears to be trying to say, although
> obviously I agree with the sentiment.
>
> On Sep 17 03:51 PM paulsjj wrote:

Sep 17 05:58 PM

[John Ryskamp:]

Fear not. The rest of the world's economies will collapse even more rapidly than ours, and our currency will then strengthen as the last currency standing. But it will be the depths of a depression. Sure, a dollar will buy a lot. But who will have a dollar?

As for inflation, don't underestimate collapse in demand. That will always be ahead of inflation, from now on. Prices will sink to NOTHING.

Sep 17 06:29 PM

[Mad Hedge F...:]

idim It’s all about the dollar, which I have hated all year (click here for my call ). The assured onslaught of federal debt issuance headed our way will be the overriding investment consideration for traders and portfolio managers for the next decade. That will knock the stuffing out of the greenback against every currency except the Zimbabwean dollar, and even that will rally when you get a regime change. There was once an argument that foreigners piled into these currencies to capture a huge yield pickup, but even that advantage is now gone. The soggy buck also explains a lot of what is going on in our stock market, with companies earning most of their from increasingly wealthy foreigners, like those in technology, energy, and commodities. As I write this, I am looking at new one year highs for my favorite picks of the former British crown colony currencies of the Canadian (up 14% YTD), Australian (up 26% YTD), and New Zealand (up 23% YTD) dollars (for my C$report click here ). There bounteous resources, Anglo-Saxon contract law, an almost common language, and vibrant ports make them the safe bet of choice. It’s just a matter of time before the loony hits parity, to be followed by the Aussie dollar, and then the kiwi.

Sep 17 11:32 PM

[Dave Wrixon:]

And I thought most of you were getting past Denial and getting stuck into Anger.


On Sep 17 06:29 PM John Ryskamp wrote:

> Fear not. The rest of the world's economies will collapse even more
> rapidly than ours, and our currency will then strengthen as the last
> currency standing. But it will be the depths of a depression. Sure,
> a dollar will buy a lot. But who will have a dollar?
>
> As for inflation, don't underestimate collapse in demand. That will
> always be ahead of inflation, from now on. Prices will sink to NOTHING.

Sep 18 12:40 AM

[flow5:]

Interest rate differentials don't determine the exchange value of the dollar. Federal Budget deficits don't determine the exchange value of the dollar. The trade deficit determines the exchange value of the dollar. And the US will never correct this acute problem, thus the dollar will continue to decline along with our standard of living. We will have relatively high rates of inflation coupled with declining output. This spells stagflation and it is going to ruin this country

Sep 18 02:36 PM

[thiazole:]

And when will inventories get rebuilt? If there are no inventories, how can the $ have so much value?

Economics is just a shell game. The idea that money will just go "poof" and disappear seems pretty ludicrous to me.


On Sep 17 06:29 PM John Ryskamp wrote:

> Fear not. The rest of the world's economies will collapse even more
> rapidly than ours, and our currency will then strengthen as the last
> currency standing. But it will be the depths of a depression. Sure,
> a dollar will buy a lot. But who will have a dollar?
>
> As for inflation, don't underestimate collapse in demand. That will
> always be ahead of inflation, from now on. Prices will sink to NOTHING.

Sep 18 03:43 PM