Musings on the U.S. Dollar's Decline

Includes: UDN, UUP
by: Cynicus Economicus

I made an error just under a year ago in predicting an early collapse of the US dollar; I predicted a collapse by April of this year. When the collapse failed to materialise I was forced to look at my model of the world, and explain why I had been wrong. Up to that point, my model had been reliable, and had managed to explain what was taking place in the world economy.

Having been wrong before, I will this time discuss the US dollar in terms of 'musings' on the future.

My conclusion on reflection of the erroneous prediction was not that I was wrong about the underlying weakness of the US dollar, but that I had been wrong about difficult it would be to shift perceptions about the US dollar in world markets. I had written an article titled "The Myth of the Eternal Status of the US dollar as 'the' Reserve Currency", and still stand by the discussion laid out in this article. Reserve status can only protect a currency for so long when the fundamental poor state of the economy is apparent.

As an explanation for the error of the prediction for the collapse, I adapted Dan Ariely's anchor price theory, and therefore accepted that it would be difficult to shake the 'faith' in the US dollar. Putting the argument in simplistic terms, the belief is that because the US economy has always been a success, it is difficult to shift market perceptions to see the US economy as it is now.

Quite simply, markets are valuing the US dollar on past performance of the US economy, not on the performance now. People have blind faith that somehow the US must recover the economic crown that it has worn for so long.

The US government is now intent on testing that faith to the limits, and the cracks are starting to appear in the faith. The bond markets are now appearing to shift:

Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month’s data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

Nonetheless, the decline highlighted a fact shown in the accompanying graphics: Asia’s appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits.

The article is right to point out that one month's figures are not enough to be meaningful, but the figures will no doubt spook the market to some degree. The worry about the Federal Reserve's purchase of Treasuries with printed money is already raising concerns, and the possibility of a US dollar rout is being discussed in the mainstream media:

Mr. Buffett worries that U.S. policy makers will fail to move decisively to curtail the nation's ballooning net debt, expected by some to rise to more than 75% of annual economic output by 2013. Instead, policy makers might tolerate higher inflation, which makes existing debt more manageable but would hurt the U.S.'s creditors, including China and Japan. In this scenario, investors would demand much higher interest when lending to the U.S. government, raising its borrowing costs and making further budget deficits harder to finance, at a time when an aging population will sharply boost the costs of Social Security and government-sponsored health care.

Doubts about the dollar are building while investors are growing comfortable with the idea of emerging economies like China, Russia, and Brazil playing a bigger role in shaping international finance. Some analysts, including Pimco portfolio manager Curtis Mewbourne, say emerging economies have an opportunity to use the crisis to reduce their reliance on the U.S. dollar, which tends to account for most of their foreign-exchange reserves.

It now appears that, with a rising savings rate in the US, the individual US investors are starting to take up some of the slack. This might be seen as a positive but, whatever happens, there still needs to be an influx of money from outside the US economy, if the US economy is to continue on the current path. In particular, the US is still running a current account deficit, and the only way to fund such a deficit is through overseas borrowing or further printing of money.

Furthermore, the question remains as to whether the US savers have the resource to step into the breach in the event of an overseas exit, and whether they will continue to fund the deficits if the US dollar starts a dramatic fall.

Then there is the matter of yields. In the event of a shortfall in overseas purchase of US debt, can savers step up to the plate to an extent that they might hold yields down, or will they demand risk premia based upon a declining US dollar?

Whichever way you look, the prospects for the US dollar do not look good. Most importantly, the printing of money by the Federal Reserve to purchase Treasuries is setting up a feedback loop; the higher the volume of purchases, the less the confidence in Treasuries, and the more that the Federal Reserve must buy. It is very difficult to see how it might be possible to climb off the quantitative easing treadmill once the process has been started, in particular in the case where the policy is used to monetize government debt.

Then there is the question of political influence.....with governments on a spending spree, with promises of sunny days in the future, no plan for deficit reduction, the pressure on the Fed to continue purchases will be high.

I learned my lesson before about naming a date for the US dollar to collapse. I am also not so sure now that a sudden collapse will be the outcome, but this is still possible/likely. It seems possible that the process might be a more steady decline, including moments of recovery, but with a declining trend. In all cases, the US dollar must, one way or another, decline in value relative to other currencies.

However, having said this, which currencies might the US dollar decline against? For example, the fundamentals underpinning sterling are perhaps weaker than the US dollar. The Euro area has its troubles, as does Japan. I argued before in TFR magazine that there would be a period of volatility, as investors flee in and out of different risks.

I will admit that I have no clear answer to this question, and it is head spinning material trying to work out how a US dollar decline might play out globally. As simple example, what of the petro economies? How might a US dollar decline impact upon these states, and how will that impact upon oil prices? The US dollar remains so central to the world economic system, it is impossible to untangle how it might decline relative to other currencies, with further complications being caused by the state of the economic situation in the other major currencies.

Quite simply, the question that arises is how the world economy might pull itself out from the domination of the US dollar? It is a question on which fortunes will be lost, and fortunes will be made. It is a question of timing and a question of process, but the underlying problems will eventually make themselves felt, in one way or another.

The US dollar is on the slide, and it is unlikely that the slide might now be reversed....the doubts are now cracking the walls of belief and, without 'belief', the US dollar has little left to support it.