I wrote two months ago that dollar would rally for the next 6-12 months because of liquidity issues in the short term, and in the longer term because of shrinking trade and investor pessimism. This process is ongoing, and there’s no reason, as of yet, to expect it to stop anytime soon. The dollar will  continue to rally for now.

Most people are by now very well aware that the dollar is not rallying because of any illusions about the US economy, but rather because it was the most important funding currency for the global excesses of the past ten years, along with the yen. Unlike the yen, however, the dollar was not only the tool of domestic US-based speculators, but it also served as the currency of trade for the Middle Eastern and Asian investor-speculators who channelled dollar-assets accumulated through goods or commodity exports into emerging markets, the Euroland, Russia, India among others, into derivatives and  many other kinds of assets. The size of these movements far outweighs whatever drawbacks the US deficits create for the US currency, and their unwinding is naturally causing the dollar to rally rather strongly in the short and possibly medium term.

Put in another way though, this also implies that the ability of the US government to finance its deficits without monetising it depends on the persistence of panic in the financial markets. If panic and fear were to dissipate the dollar would quickly disappear as a usable currency,  in my opinion. However, as long as dollarholders are too afraid to buy anything other than government paper, there’s no circulation of dollars, and as past obligations come due for corporations and banks and governments, especially those with deficits or heavy burdens of debts, the dollar squeeze intensifies, and continues.

Thus betting that the dollar will fall is equal to betting that the global economy will heal. I’d like to wish those brave souls who would like to make that bet good luck, but for now, I can’t join them in this trade. While it makes sense to expect people to buy gold when there’s so much concern about the sustainability of US external position, the fact is that most people and institutions are busy trying to find the dollars with which they will meet their oligations, rather than worrying about where to save or invest the dollars that they have ready at hand. If one has no dollars, he can’t buy gold. And we must remember that most of the money the Fed prints and pumps never make it to the market – if it had made there, libor, corporate bond spreads, should have been much much lower than where they are today

Deflation or Inflation?

September 23, 2008

In general, there’re two opinions on where money supply and the dollar are headed:

1. The world and the US are headed for a “nasty” recession, quite possibly a depression. A universal contraction in demand will cause the services sector to shrink very strongly in the US, leading in turn to a halt to manufacturing expansion in Asian nations, and, eventually, to a large number of bankruptcies, as a large part of industrial capacity becomes idle. This will lead to higher unemployment across the globe, and cause deflation in commodities, goods and services, leading to higher dollar.

2. The world economy is headed for a one-two year long recession, as the US government continually bails out increasing segments of the economy, starting with banks. That the Treasury has moved so fast from rescuing the GSE’s to rescuing the entire banking industry of the US, and then some more in the rest of the world, shows that the Americans have no interest in paying the price of the excesses of the past decades, and will instead do whatever they can do save the day, regardless of what happens in the longer term. They will print more and more Treasury bonds to sustain the US consumer and to prevent the necessary adjustment in the consumer’s spending habits, which will prevent the rest of the world from suffering a severe slowdown, but will create inflation and crush the dollar in the process.

What does Washington want? I believe that the answer is very clear. At all costs, they want to prevent a demand contraction, and they have the means to achieve this, albeit only in the short term. “Live today, forget the rest” is more or less the modus vivendi of the American, and it now seems that this will also be how they manage this problem.

To be fair however, the administration is only willing to consider reflating the economy because it believes that the results would be more controllable and orderly than a depression and a collapse in demand. It’s not illogical to think that an artificially induced inflationary environment is easier to live with than a sudden, severe and unpredictable contraction of the economy. Those who oppose this argument suggest that it’s far from clear that the inflationary remedy can resolve the problem, that is, it’s not clear that by resorting to inflation we will not end up with both inflation and a depression. It must be mentioned that there’s no real example of an economy that has averted depression through easy monetary policy.

But I believe that the government at least has the power to devalue its currency: they can create such a great supply of dollars that even the most fearful investor sees little value in holding an asset which is likely to shrink at great speed as soon as the fear factor that is upholding it lessens.

That is why I support number two of the above options. I believe that the dollar is sentenced and damned. The US, as a nation, has chosen to sacrifice its tomorrow for saving the day, and the first to pay the price will be the dollar.

Why is the dollar rallying?

September 9, 2008

1. The US economy has been the first to enter into the recession, and it will be the first to exit it.


2. Financial markets are discounting the prudent and creative monetary policy of the Federal Reserve.


3. The dollar is simply undervalued on a broad basis.


4. The collapse of the commodity bubble has caused panicky delevering and margin calls across the board, and the dollar is the natural beneficiary.


5. Geopolitical tensions are strengthening the dollar.


6. The worst of the financial crisis is over.


7. The global economy is slowing, the unique situation of the US as a nation in recession is over.


I disagree with one, two, and six. The troubles of the US economy are likely to go on for a long while. The policies of the Fed depend on the creation of bubbles for success, but we’re out of bubbles. The worst of the financial and economic crisis is not over – banks have not raised their risk capital to a level in line even with delinquent loans. So there will be more writedowns and more losses.


The dollar is likely to rally for about a year only because there’s panic in the financial markets. This is obvious in libor spreads, contraction in credit, the gradual collapse in high yielding assets since August of last year, bursting of the commodity bubble, and, the rise of the dollar itself. One must understand that holding dollar-based assets in the current environment can only be justified on fear. Otherwise, the extreme financial indiscipline of both the private and public sectors, continued wars, long-running inflationary monetary policy, a housing depression, rising unemployment, bank failures, and bankruptcies, twin deficits of the nation, and a very large cloud of unknowns about almost every aspect of the US economy makes holding US dollars an extremely foolhardy enterprise.


But there’s panic now, and in a panicky environment people act irrationally. Even the best promise of returns is unlikely to convince them to risk their assets. And as most of the active financial assets of the world are dollar-denominated, the withdrawal of liquidity creates shortage and demand for dollars. 


In the medium term geopolitical issues and inflation will determine the dollar’s course. As I noted in a previous post, crises of confidence can create adverse feedback loops, and this will probably add to the strength of the dollar. On a longer term basis, say three-five years and longer, the dollar will probably resemble a third world currency.


The US government keeps adding to its debt burden: unless it raises taxes, how will it be able to service that burden with decreasing revenues? The easiest option would be to devalue the dollar, encourage people to save and export more. While this is unlikely in the immediate future, I do not see how the US can continue its past customs without risking very high interest rates.


I believe that the dollar’s status as the world’s reserve currency is in doubt. To be sure, the decision will not be made by the Americans themselves; rather, a confluence of factors may gradually cause the dollar to be abandoned by more and more nations and institutions across the world, and the process is naturally a long-running one. But more importantly, the days when holding dollars provided safety and confidence are permanently over. The structural problems of the US will take many years to be resolved and the international markets can hold on to a depreciating and shrinking asset class for only so long.  

The dollar is rising, and while reappraisal of the global economy may lead to further strength for the dollar in the coming 6-12 months, it’s important that we put the macro picture into perspective when analysing the direction in the forex markets.


When there is no excessive divergence in interest rates or central bank policies, one should expect currencies to perform according to the underlying fundamental strength of the respective economies.


Such is the case between Europe and the US, where the rate differential is too small to override macroeconomic concerns. Since the introduction of the Euro, and except for a brief period during the global stock market bubble, the behaviour of the euro-dollar pair has beem based on fundamentals. The overextended finances of both the public and private sectors in the US contrasts unfavorably with the balanced current account situation of Europe, the relatively less leverage of its citizens, and the much better fiscal discipline of the governments. Until recently even Spain’s government could boast of a singnificant fiscal surplus, and on the whole the stringent requirements of the euro area treaties, and continuous urging by the ECB for fiscal responsibility allowed Europe better fundamentals than those of the overextended, overleveraged US. There’s, in short, every reason to be negative on the dollar versus the euro, based on the fundamentals of the two economies: The dollar is just another word for leverage and indiscipline.


When the Fed began reducing rates in September 2007, in spite of external financing concerns, and fears of inflation, investors and speculators around the world reacted by buying commodities and selling dollars, partly in anticipation of decoupling, and partly to profit from the dollar-negative momentum. And they were justified in their pessimism for the US dollar, except for one difficulty:


The USD is the world’s currency for trade: it’s supply will be ample during times of increased economic activity, as the supply of USD from exporters to the US, and also from global players such as hedge funds and mutual funds widely exceed the USD demand for imports such as oil, copper, and finished goods. Thus, as greed, and the quest for yield cause ever greater amounts of US dollars to be exchanged for other currencies, the buoyancy of the global economy will also draw down the value of the dollar, especially when the medium term fundamentals of the US economy are as weak as detailed in the previous paragraph.


When however, the opposite happens, and global demand contracts, as the growth of demand for commodities, the volume of international trade is in danger of declining, there will be less circulation of the dollar, and the currency of international trade will also see increasing demand, just as the supply of dollars from international economic actors contracts as a result of the same reasons: the prospect of weaker economic activity will cause repatriation flows, extracting dollars from the global financial system, and in the worst cases, as we’re witnessing now, a shortage of the US currency.


This then explains why the discrepancy between the value of oil and the euro versus the dollar created an arbitrage opportunity, provided that the investor sees them as different faces of the same investment paradigm. Indeed until recently the fluctuations of euro-dollar parity, and the oil price showed a close correlation even of intraday movements. It was only natural that one would follow the other.


Now, if rising dollar means less global economic activity, at a time when internal demand in the US is likely to shrink as a consequence of deleveraging, and rising unemployment, then how do we explain the recent rise in stock prices? Rising dollar and rising yen are the hallmarks of pessimism and fear; if US and Japanese investors are withdrawing funds from overseas, putting it in bonds and cash, is it possible to interprete this phenomenon as being positive for financial markets?


While the disinflationary effect of the rising dollar is welcome, one must remember that even before the recent turmoil, there were significant inflationary pressures in the world economy. The era of cheap Chinese labour is already over – inflation is now a structural problem, not a temporary one.


We’re likely to see continued falls in the stock markets in the next few weeks, and months.