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.