The US dollar as measured against six major world currencies has appreciated
about 19% during the past three months through end-October. In particular, the
US dollar index stands at 85, up from a recent low of 71.3. This trend reversal
takes the dollar's valuation back to levels not seen since October 2006 and
represents nearly a 38.2% retracement from its index peak of 120 in January
2002; by any measure a significant move and one largely unexpected by the
financial markets both in terms of its timing, speed and magnitude.
What has caused this abrupt appreciation of the dollar during the past quarter
and what can we expect over the next 12-24 months? There are both fundamental
and technical reasons that have been
US-dollar supportive in the past several months.
Fundamental factors
First, the seven-year decline in the US dollar's value through July 2008
improved US competitiveness and, once the J-curve effect dissipated, has led to
an acceleration of export revenue. Slower GDP growth is also allowing imports
to decline. These two effects have begun to stabilize the US trade deficit in
nominal terms and allowed net exports in real terms to contribute 1.1% to Q3
2008 GDP growth. The shrinking trade deficit has also contributed to the
narrowing of the current account deficit. By pumping fewer US dollars to our
foreign suppliers, this narrowing is shrinking global liquidity and creating
further support for the dollar.
A second fundamental reason for US dollar strength has been an improvement in
US terms-of-trade: the ratio of export prices over import prices. Since the
United States is a net energy importer and this cost represents a significant
portion of total import expenditures, the recent decline in crude oil prices
has been a boon to our terms-of-trade. The improvement in US terms-of-trade has
also supported the US dollar.
Thirdly, it is suggested from viewing the highly unusual negative break-even
yields for inflation-linked bonds (TIPs) that investors believe the US will
suffer deflation, not inflation, for the foreseeable future. This expectation
for a declining price level, as a corollary, also creates the expectation for
US dollar appreciation. This is because, once the currency depreciates in real
terms, there is a tendency for the currency to appreciate in nominal terms to
compensate for the price-driven depreciation, especially given that the
notional rise will not undermine international competitiveness.
Technical factors
Perhaps the most important driver of the US dollar's recent appreciation is not
a fundamental but a technical factor. The meltdown of prices in the commodity
complex, particularly energy, has generated a very strong impulse for US dollar
strength. Whilst many commodity end-users were outright cash buyers, other
buyers that were investing or speculating in commodities as a newfound asset
class over the past five years would typically fund their position with US
dollar-denominated credit, in effect, creating a US dollar short position.
Now that these commodity carry trades are being unwound, it exacerbates
commodity weakness and contributes to US dollar strength. In addition, US
investments in foreign markets, particularly equities, were primarily un-hedged
and large amounts of those monies are now being repatriated which holds similar
bullish US dollar effects.
Dollar strength sustainability How sustainable are these four
fundamental and technical factors in underpinning US dollar strength?
The trade and current account deficits should continue to narrow for several
more months or perhaps quarters. As the US economy falls deeper into recession,
imports should begin to decline more precipitously due to declining volume.
This collapse along with rising export receipts will narrow the trade deficit
and continue to lend support to the US dollar.
Despite the US dollar supportive narrowing of the trade and current account
deficit, the pace of improvement may begin to slow for several reasons. First,
once the prices of energy and other commodities stabilize, trends in import
prices will no longer help lower overall import expenditures. Furthermore,
stabilized import prices will also stop contributing to improved
terms-of-trade. Second, it seems that a synchronized global recession is on the
horizon. If so, then exports will once again decelerate despite US dollar
competitiveness. As the growth of economies representing our important export
markets slows or even falls into recession, weaker export growth will result.
The combined effect of these counter-veiling trends is that the incipient
narrowing of the US trade deficit may be short lived.
Perhaps the key factor will be the length of the time it takes for global
de-leveraging to run its course. No one knows precisely how long it will take
for investors and speculators to unwind US dollar-denominated commodity and
other carry trades. It could be one month or half a year. However, once
complete, the strongest driver for recent US dollar strength - de-leveraging -
will dissipate. At that juncture, FX traders and investors will once again
re-focus their attention on the supply of US dollars being pumped into the US
economy and on the global system and investors' willingness to hold additional
US dollars in their portfolio.
The weight of US dollar supply
It is beyond the scope of this paper to itemize the growing cumulative costs of
the various aspects of the bailout. Suffice to say that the supply of US
dollars is dramatically growing and measured in the trillions. To best measure
this aggregate growth, lets look at the growth of the Fed's balance sheet and
the monetary base.
After remaining relatively stable for more than a year through August 2008 at
around US$825 billion, the monetary base has exponentially exploded. BCA [1]
has recently highlighted that in the past eight weeks, the monetary base has
grown 38% to $1.142 trillion, and shows no signs of slowing down.
Yet these reserves injected onto the balance sheets of the banks have not been
disseminated into the broader economy. This is apparent by the ratio of M2 to
base money, which over the same time period since end August, has plummeted
from 9.1 to 7.8 (see charts 1 and 2). This is not surprising since most of the
capital injected into banks has been used to repair and shrink the balance
sheet (that is, to write off bad assets) rather than expand it. So fractional
banking's normal stimulatory impact through the money multiplier has
by-in-large not been activated.
In addition to the Fed pumping money into the banking sector, the US Treasury
will have gargantuan funding needs. According to Goldman Sachs estimates [2],
the US Treasury faces an unprecedented financing need in fiscal year 2009.
Excluding funding requirements under the Supplemental Financing Program (SFP),
they estimate 2009 fiscal year issuance at $2 trillion compared with last
year's $1.12 trillion, which itself was already outsized.
This prospective amount is driven by an estimated budget deficit reaching $850
billion, funding TARP purchases of up to $500 billion and the rollover of
maturing debt equal to $561 billion. On top of these needs, it would not be
unreasonable to expect additional SFP funding requirements of $500 billion, the
amount already issued to date in fiscal year 2008 used to recapitalize the
Fed's balance sheet.
The magnitude of such funding requirements will test the operational efficacy
of the Treasury, requiring increased auction size, frequency and expanding
maturity buckets on debt issuance, and will likely extend through fiscal year
2009 and into fiscal year 2010, prior to these pressures abating.
Perhaps even more ominously, issue size will severely test market demand for
such an avalanche of debt. If there is significant resistance by investors to
accommodating these needs, failed auctions would require the Fed to hold new US
Treasury issuance (that is, monetization), which of course would be
inflationary and foment US dollar weakness.
Lastly, our expectation is that the current account deficit, while narrowing,
will not disappear. Indeed, it will ultimately expand again once the trade
deficit reverses course, which will once again increase the supply of US
dollars to the rest of the world.
While emerging market economies have revealed their lack of immunity to the US
and European slowdown, they may be the first to recover for several reasons,
partly because their banks have avoided most of the toxic assets currently
plaguing US and European banks.
Their elevated population growth rates and migration of self-sufficient farmers
into the industrialized cities looking for jobs is a secular trend that will
only be deterred by the financial crisis for a short time. Within 18 months,
these economies will be growing strongly and once again driving energy and
commodity prices higher. This, in turn, will once again widen the US current
account deficit and increase America's reliance upon foreign savings.
Inflationary seeds being sown
This dramatic growth in the monetary base has not yet been inflationary since
the velocity of money may have recently fallen due to the rise of deflationary
expectations. Some will argue that liquidity being injected into the bank
system will be drained subsequently by the Fed via open market operations. In
principle, this could abate the ultimate inflationary impact of the bailout
operations. However, currently this liquidity cannot be removed without
collapsing the banks and worsening the recession. Since bringing bank balance
sheets back to health is probably a multi-year process, this argument does not
seem to stand.
We currently stand on Occam's razor, staring into a deflationary abyss on one
side and incipient inflation on the other. The Fed and US Treasury have shown
their policy hand, revealing a strong preference to avert deflation. No doubt
this reflects a broad political consensus that prospects of inflation are to be
preferred to deflation, if those are the two choices. Claims that these massive
debt levels can be financed and ultimately retired by future economic growth,
taxation and lower government spending ring hollow.
Whilst the velocity of money has been quite stable in the past several years
and perhaps even fallen most recently, this will not always be the case. As
spring surely follows winter, it can be relied on that velocity will accelerate
in the future. Once it does, it will combine with this huge increase in the
monetary base to boost liquidity and elevate price inflation.
There also remains an open question whether foreign investors will continue to
be willing to accumulate additional US dollar assets. A strong argument could
be made that foreign investors are already sated with US dollar debt.
Foreign holdings of US Treasury and Agency debt stands around $4.1 trillion,
representing approximately 36% of publicly held issuance. The concept of
Bretton Woods II - wherein foreign investors were the lender of last resort
extending vendor financing for their exports sold to the US (consumer) - was
predicated on the stability of sustained household consumption.
With the US household suffering from declining home prices, falling real wages,
job loss and collapsing confidence, the American consumer will take years to
recover their former spendthrift ways. With this missing critical link in the
global relationship, it is suspect whether foreign governments will be willing
to significantly increase their holdings of US dollar debt, if there is not the
quid pro quo of increased export receipts from further US consumer spending.
Any meaningful pushback from foreign investors on buying additional US Treasury
debt or US dollar denominated assets will imply either a steeper yield curve or
monetization of new Treasury debt issuance. Neither outcome is desirable. A
steeper yield curve implies declining Treasury bond prices and, by raising
interest rates, also creates a headwind for US equities. In this scenario, it
is hard to imagine a strong US dollar in the face of weakness in both US stocks
and bonds.
In the second scenario, if investor demand is inadequate to absorb new
issuance, then the Federal Reserve will have to hold a portion of new debt
issuance by the US Treasury on their balance sheet. This is sheer monetization
of the debt and highly inflationary since it is equivalent to simply printing
money. Such a scenario would quickly lead to higher inflation and a weaker US
dollar.
Conclusions
The tsunami of oncoming US Treasury debt issuance holds the real potential to
crowd-out private-sector issuance both in the US and abroad, steepen the US
Treasury yield curve, put downward pressure on the real economy, undermine the
US's AAA rating, weaken the US dollar, and if the Treasury is required to
resort to monetizing new debt issuance by "selling" it to the Fed due to
pushback from foreign investors, it could even threaten the Bretton Woods' US
dollar reserve status and the dollar's role of denomination currency for
commodities: a very high price to pay for a decade-long party on Wall Street.
So it seems that, despite the violent rally in the US dollar over the past
three months, it may not be long lived. Much will depend on the capacity of
foreign investors to offer safe harbor for new Treasury issuance and/or the
likelihood of a policy mix set in Washington that runs tight money and a fiscal
surplus. When was the last time that occurred?
Notes 1. BCA Daily Insights, "The Fed: Moving Closer to
Monetization", October 29, 2008.
2. GS US Daily Financial Market Comment, "The Treasury’s Financing Need:
Pressing All the Buttons", October 29, 2008.
Dr Ronald Solberg is vice chairman and lead portfolio manager of Armored
Wolf, an alternative real assets hedge fund.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
