The U.S. Dollar: A New Accord

by: David Andrew Taylor

"Whatever man can conceive and believe, he can achieve...." -Napoleon Hill

It was 1985 when world finance ministers from the G5 (then just France, Germany, Japan, the United Kingdom and the United States) led a coordinated effort to devalue the U.S. dollar.  It was known as the "Plaza Accord" because it was signed and agreed upon at the Plaza Hotel in New York City.  The idea was to lower the value of the USD vs. its trading partners to reduce the United States' trade deficit, and to pull the economy out of a deep recession.  The Accord was a planned and systematic approach to revaluing the dollar in order to make American exports more competitive. 

Some 20 years later, it appears the world's finance ministers have converged to change the value of the USD à la the Plaza Accord all over again.  

Structurally, the USD has become the "monkey in the middle" from all of the cross transactions in FX markets as money moves from one money center to the other in search of higher yield.  Since interest rates favor most other countries over the United States, the USD is left chasing the ball around.  After several years of running around chasing, the Monkey in the middle is looking a bit weak and tired.  The popular, and consistently profitable "carry trade", whereby a currency in a lower yielding country (read: Japanese yen) is sold short vs. a currency that yields a higher interest rate, has eroded the value of the USD pushing it to the brink of historical levels, and in some cases beyond because of the structural imbalance.  

Take a look at one of the higher yielding currencies to give an example.  Let's look at Australia.  

As Australia's monetary conditions were attractive to the carry traders, money flowed into Australia at almost breakneck speed coming out of Japan where monetary policy has been sitting on the basement floor for what feels like an eternity.  As these funds flooded into Australia, economic growth continually pushed higher, pushing the hand of the RBA to raise rates.  That, of course, drew more and more money into the healthier interest rate environment Down Under, which of course forced the hand of the RBA to continue to push rates higher and higher.  It was a continually vicious cycle as the allure of higher interest rates drew more and more flows into such a high yielding economy.  

All FX transactions flow through the USD in order to promote liquidity.  If you want to buy AUD/JPY you must sell JPY vs. USD and then sell USD vs. AUD.  AUDJPY is nothing more than a mathematical calculation of the the two currencies vs. USD from the resulting transaction.  So, the Monkey in the middle named the USD was getting drained of its power, and the world's economies were becoming more and more imbalanced.  

On Monday evening here in the U.S., there will be an announcement from the Reserve Bank of Australia about interest rates.  I'm predicting at the very least that there will be an extremely dovish tone, to at most a surprise lowering of the rate (Just like their neighbors did, the Reserve Bank of New Zealand).  There are plenty of reasons to lower interest rates at this point, and the minutes from the last meeting certainly suggest the Bank is ready.  If that's the case, then the AUD will get pounded.  If you've been following the FX market as of late, that's nothing new from the past two weeks' trading - the AUD has lost almost 6% in a straight line down with expectations of such.  The economic outlook in Australia hasn't looked worse since the last recession, so an easing is absolutely in the cards.  

On Tuesday, the Federal Reserve meets to decide interest rates as well.  The likely outcome?  Hawkish at the very minimum to perhaps extremely hawkish at the maximum.  I'm expecting the wording to say something to the effect that the risks to inflation outweigh risks to growth.  Boom.  The USD just took off like a rocket.  The interest rate differential is now beginning to narrow between the U.S. and its trading partners and the carry traders are now starting to move with deft speed out of AUD and NZD, the former highest yielding currencies, and into USD.  

Next up this week is both the Bank of England and the European Central Bank on Thursday.  

First to hit is the BoE.  The Bank has some work to do as the economic data coming out of England is steep enough to make even the most seasoned cliff diver queasy.  I can argue six ways to Sunday as to why the Bank will lower rates, and the economic data all points to them doing so sooner rather than later.  We may very well get a move out of the Bank considering the most recent data and the continued decline in oil's price.  If we don't get the decrease on Thursday, then when we see the minutes later in the month, the story will spell dovishness based on abysmal growth coupled with a medium-term inflation outlook that is within expectations (derived from lower demand and oil prices rapidly receding).  Boom.  That's how you drop a currency by 2.5% in about a minute as GBP gets offered on every terminal across the globe.  

And the ECB?  Even Trichet knows that he painted himself into a corner when he took such a hawkish stance prior to the last meeting, raising rates, and virtually perpetuating the problem (squeezing the dollar and pushing oil higher).  His comments after raising rates last month weren't exactly firm with conviction that the Bank was poised to continue their direction.  But, despite not wanting to lower rates until he actually sees the whites of inflation's contained eyes, Trichet is likely to mention medium-term inflation outlook is in line with expectations, and contained with the current price of oil falling as it has.  Boom.  Another currency loses another 2% in value.

The stage is getting set for a major move in the FX markets, and currency traders around the world are starting to smell blood in the streets.  Lots of blood.

If you have all the major industrial central banks in the world lowering interest rates, while simultaneously the Fed is hawkishly about to raise rates, that in itself will perpetuate the flow of money.  Funds will flow into the U.S. and out of the rest of the world.  That forces the central banks around the world to continue to lower interest rates, chasing the flow down.  And the Fed is poised to continue to raise rates as more and more funds chase the higher yield.  

The vicious cycle breaks and actually reverses.  

The wheels of change are upon us.  We have four banks meeting this week alone.  Another bank has already lowered interest rates just two weeks ago, the Reserve Bank of New Zealand.   That was the highest yielding industrialized nation out there, and according to the accompanying statement, will go lower and lower.  If the other banks follow suit and take at the very least a dovish tone, while the same time the Federal Reserve takes a more hawkish tone, then the new trajectory for the USD will have been firmly established.  And the course of the world's economies will be on a brand new path.  All of this in one coordinated move.  

What's most interesting is that this is all occurring after the latest G7 Finance Meeting.  

The April meeting had this to say regarding exchange rates:

We reaffirm our shared interest in a strong and stable international financial system. Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange markets closely, and cooperate as appropriate.

A shot across the bow.  The line in the communique was all but ignored, and the USD was continually sold off.  However, that line is tantamount to a Plaza like accord. 

Just ask the French Finance Minister in a follow-up interview. Her take: The markets missed it.

There's an estimated $1.5 trillion USD in the carry trade.  If the USD becomes more attractive vs. its counterparties as the differential narrows, then over the course of the next few weeks/months/years, the USD will see a significant increase in demand as that money finds a new home with yields that are growing more and more attractive.

The first victim of a higher USD?  The price of oil.  Oil prices will collapse in the face of a stronger USD and an outlook of higher interest rates, much like what we've seen the past couple of weeks since the Fed and some of its governors have come out touting higher interest rates to combat rampant inflation.  The fall in the price of oil actually takes this scenario even further, and pushes the value of the USD higher vs. its counterparties.  That, of course gives other central banks room to lower rates, which of course pushes the value of the USD higher and higher as its competitive advantage improves.

Think further beyond about the ramifications of the potential of $1.5 trillion USD flowing into the U.S. banking sector.  Wouldn't that be attractive to banks' balance sheets at the very moment that the world's #1 financial sector needs capital at all cost?  If the world's biggest financial sector were to be propped up by a continual flow of funds into their banks, then the U.S. will be poised to move forward out of its current economic malaise flush with capital coming in from abroad.  And beyond that, the world's largest economy will then pull any other country out of recession.  

The best aspect of this is that any future recovery will be different this time.  During the recovery from the recession of 2001, money was flowing out of the United States favoring an interest rate environment that was more attractive abroad.  As capital left the shores of the U.S., growth rates were lower than what they should have been.  Now, however, as capital flows back into the U.S., our recovery from this economic downturn has the potential to surpass expectations.  And with that, growth rates in the rest of the world should follow with the same upbeat tone.

Is it coincidence that we may see such a different outlook with regards to interest rates so quickly around the world?  Is it that the economic wheels of change are spinning in a new direction, and the timing is unique?  Or was it a coordinated hand shake deal at the April G7 meeting?  History will only tell us that.  But, if you listen to Treasury Secretary Paulson, you have reason to believe that "benign neglect" is no longer the standing policy for the USD and that there is some kind of coordinated effort on the parts of the world's financial ministers to shore up the USD.  Regardless, this scenario of a stronger USD with a financial sector in a much healthier environment is in the very best interest of every single country out there.  

Most economic pundits are looking around for the next big upset in the financial sector.  And who's to blame them when we're all sitting around looking at dire news coming in left and right.  But, the world's financial ministers have been there every step of the way.  Look no further than the efforts of the Federal Reserve to stave off a potential catastophic event that keeps rearing its ugly head almost every other week.  There is a plan, and it's the single best plan available to put a final nail in this imbalanced coffin.  

Unlike the 1985 Plaza Accord, however, where the G5 finance ministers came out of the meeting pounding their chests about their intention for the USD, this time around, considering the fragile state of the world's financial system, finance ministers can't risk rocking the boat too much, too fast.  

So, quietly, they will walk....and carry a really big stick. 

And this week, that really big stick is going to be swung.... 

Very Hard.... 

Very Loud.... 

And Very Clear.