December 3, 2008
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