Is the Dollar Dead in the Long Run?

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Probably. Of course the market knows about America’s troubles and some of them are priced in. Currency traders would also remind me that currencies are priced relatively to each other: we speak of yen per dollar, or dollars per euro. So if you are bearish on the dollar you can’t just prove that the dollar is weak. You need to show why it is weaker than the alternatives as well.

Before doing that I will concede the obvious: other countries also have troubles. We are in a recession, and so is just about everyone else. Our Federal Reserve is printing ridiculous amounts of money, but other central banks are too. Our government runs a large fiscal deficit, but again, other countries do too. Our banking system is weak, but the Brits and the Eurozone have nothing to write home about here either.

So if other countries are hurting too, why should the dollar stay weak? I have four reasons, but they boil down to one. We are no longer acting as if we can carry the burden that goes with the privilege of owning the world’s reserve currency.

First, we are unique in the large current account deficit we run. That is, we import more than we export, we have been doing this in size, and we will seemingly continue to do so until other countries stop taking our dollars in exchange for goods. We were lucky earlier this year in that a lower oil price reduced our oil import bill, but oil’s price has doubled off the bottom since then. So, even though Americans buy less imported “stuff” than we used to, we can’t consider the problem solved. As long as we import more goods than we export, we have to make up the difference by selling dollar denominated securities –usually Treasury bonds– to foreigners. So in this way America continues to increase the supply of Treasury IOUs without regard to the world’s demand for them.

Which leads us to reason number two: there is a large overhang of dollars held reluctantly in foreign portfolios. This site’s readers know that, but the point is, portfolio overhang is unique to the dollar, as opposed to other currencies. There is no other currency held in such size by people who would likely dump it if they had their druthers.

Plenty of people try to tell us that this overhang is “not a problem.” They say that the world is used to running on dollars. Governments, banks and corporations are used to doing dollar based transactions, they tell us. Moreover, no other currency can match the deep and liquid market that Treasurys afford. Even though the Eurozone is a huge economic bloc, Eurobonds issued by Italy, for example, are not the same as Danish or German government bonds. So everyone agrees that a complete transition to a new currency regime would take time, but is that truly a reason for doing nothing? It may be that today the dollar is the best place to park wealth, but sooner or later the countries with wealthy central banks will find a way to put their money where they want to. If we don’t make the dollar more attractive, foreigners will eventually take their money elsewhere. It’s that simple.

Our press also lulls itself into complacency regarding large dollar holders such as the Chinese. It would be hard for China to sell in size, dollar bulls say. The market couldn’t absorb that selling, the dollar would crash, and the Chinese would themselves wipe out the value of their own dollar holdings, bulls argue.

On the other hand, others worry that China may reduce its dollar buying going forward. Therefore these days when the Treasury holds an auction to sell more Treasury debt, traders await the results with bated breath to see how easily the market absorbed the supply — and how many foreigners bought. Furthermore the WSJ reports that the Treasury recently rejiggered its statistics so as to make foreign buying look heavier than it really is (h/t, Trader Mark). Treasury now reports some customers of primary dealers as “indirect” bidders, the closely watched category that also includes international purchasers. What a disgrace, that America is so dependent on other countries, and that we lie about it to ourselves rather than face the problem.

As an aside, China is seemingly having a grand old time showing us who controls the dollar’s trade in the currency markets. On June 26 officials at the People’s Bank of China said that they wanted a new, supranational currency to replace the dollar as reserve currency, Bloomberg reported. Dollar Index futures, which trade based on a weighted average of major tradable currencies, gapped down 55 basis points — a considerable move — to open at 80.12 on the CME the following morning. On the 28th Central Bank governor Zhou Xioachuan said that his country’s reserve policy remains “stable.” The dollar index shot up enough to close the gap of the previous day during overnight trade, though it gave up most of those gains before the Chicago open. Are the Chinese placing trades so as to profit from the statements they make thereafter? I have no idea but the prospect must tempt them.

Third on my list of problems unique to the dollar is this: America’s strategic rivals act as if they see an opportunity to weaken us by attacking the dollar’s privileged status. Russia’s Vladimir Putin has made noises about replacing the dollar for years. If Russia can take the dollar down, that would make it harder for the US to finance its 800 or foreign military bases, and give Russia freer rein in Eastern Europe, South Asia, and the Middle East. Similarly, China has never liked the military power that the US projects into the Pacific. So on this score some of China’s geopolitical objectives may coincide with Russia’s.

Also on our list of geopolitical considerations: in yet another chapter in the troubled history of Iran-US relations, Iran quit accepting dollars for oil in 2007. Might other oil exporters follow suit? Or might they simply accept other currencies in addition to dollars when they sell oil? The latter policy would reduce demand for dollars while still allowing us to pay for imported oil in dollars. There have always been countries that want to see America humbled but I don’t think these attacks on the dollar would have got traction if our rivals were not holding large stacks of dollars they might like to sell if they could. No other major power is in debt to its rivals like we are.

My fourth reason for ongoing dollar weakness: we don’t have a strategy for maintaining the dollar. We just keep hoping that China and our other trading partners will continue to do what suits us. That’s irrational. Other countries that hold dollars will act in their own interest. We should figure out what that is likely to be and prepare accordingly.

Instead, the Fed and the Treasury focus on economic stimulus and bailing out weak banks. The US keeps spending and printing money as if it grew on trees. Nor does President Obama talk about retooling our stance as importer from the world. And so the situation drifts. Sooner or later our government will learn what every trader knows: Hope is not a strategy.

Disclosure: Long FXY, may buy UDN on pullbacks.