Dollar Implications of Dubai Jitters
Thanksgiving eve, Dubai World, Dubai's state-owned development company, rattled the world by releasing a statement that it seeks a moratorium on its debt and interest payments until May 2010. The credit crisis is not last year's nightmare - it has merely entered a new phase. We look at the implications for the U.S. dollar.
On Thursday, with U.S. markets closed for Thanksgiving and Dubai closed for a religious holiday, stock markets around the world plunged, the dollar rallied. That was Thursday, but the rally did not last and the dollar has since struggled once again. Why would that be? Isn't a crisis supposed to trigger risk aversion, a flight to quality, a flight to the U.S. dollar? Some have suggested that Dubai's problems are not that large and that's why the negative news is mostly limited to plunging stock markets in the region. We disagree on a couple of fronts.
In a larger context, we have two major forces driving the U.S. and global economy: on the one hand, market forces warrant a further credit contraction; without monetary and fiscal stimuli, the U.S. would have a severe recession if not depression. However, those market forces are curtailed by said stimuli. Recently, when the dominant sentiment in the market suggests that government interventions will outweigh natural market forces, securities and currencies sensitive to the reflationary trend have done well; however, when the mood swings and market forces appear to outweigh government interventions, the "flight to quality" trade takes over, a trade that's been favorable to the U.S. dollar and negative for equities.
One can think of these dynamics as a pendulum that swings back and forth. However, we have been arguing that this pendulum may swing back less towards the U.S. dollar whenever the mood favors market forces playing out. That's because in a flight to quality, while the U.S. dollar may still be seen as a safe-haven play in the near term, two significant caveats are now present:
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- The balance sheet of the U.S. government has deteriorated substantially since the onset of the credit crisis. Indeed, the U.S. government's balance sheet may be deteriorating at a faster pace than the balance sheets of many other countries. That's because U.S. policies are particularly substantial, yet inefficient. On the fiscal side, for example, a cash-for-clunkers program is not a recipe for long-term growth. On the monetary side, the Federal Reserve's market interventions, in our assessment, substitute, rather than encourage private sector activity. Those are but two factors that make the reflationary efforts far more expensive than most policy makers seem to understand.
- While the U.S. is considered a safe-haven, other countries around the world have put in place policies to make their regions appear safer.
This pendulum theory suggests that the U.S. dollar may continue its long-term downward trend, but doesn't explain why the rally in the U.S. dollar was so short-lived. One aspect to consider is that policy makers around the world feel they now know how to 'save' the system whenever a problem occurs: simply print more money. That's one reason why the "flight to safety" may have been rather short-lived: it's simply not credible that policy makers will want to allow Dubai World's woes to spoil the recovery. Helicopter Ben and his peers around the globe are a few keystrokes away from unleashing new liquidity, should that need to be the case. And if Dubai signals one thing, it's that the odds of mopping up all this liquidity anytime soon may be rather low.
If printing money would solve the world's ills, world peace could break out in time for the holidays. But there's one big challenge, and Dubai may be the canary in the coalmine: all the cheap money doesn't reach those who need it most. Indeed, Dubai World's woes are a symptom of widespread problems in the commercial paper market. Dubai cannot refinance its debt at reasonable rates.
The Fed may be able to buy top rated residential mortgage-backed securities, but its options in supporting commercial real estate are rather limited. That's because the Fed does not want to take on credit risk, the risk that the collateral it takes onto its balance sheet defaults. Cynics will argue that the Fed already has taken on credit risk with its activities, but so far it has been able to bend the rules. In the commercial paper market, this may not be possible. And it's not just the commercial paper market: a large chunk of the U.S. corporate sector, but also the global corporate, and increasingly also sovereign sectors, simply do not enjoy access to all the cheap money.
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This highlights the problem that all this money printing is extremely inefficient and that the money may flow to places that have the greatest sensitivity to the monetary stimulus: that's precious metals, out of the U.S. dollar and into currencies most sensitive to rising commodity prices, such as the Australian dollar. The Australian dollar is the currency with the highest correlation to the price of gold; its resource-based economy is benefitting from global reflationary efforts as commodities are in demand. It is no coincidence that Australia just raised interest rates for the third consecutive time, the only major country to have done so since the onset of the credit crisis.
The problem the world is facing is not new: during good times, investors got away with bad investment decisions. Investor Warren Buffett eloquently says you only find out who is swimming naked when the tide goes out. What is new is that policy makers around the world want to make it hip for everyone to swim naked. There just might not be enough clothing to go around for all those exhibitionists when they come to their senses. Policy makers may want to consider teaching people how to sew clothing rather than how to swim naked (too bad that skill has been lost due to outsourcing - but I digress).
Unless and until the excesses of the bubble are corrected, any government efforts are most likely simply expensive, inefficient endeavors that may only delay an inevitable market correction. We can prop up the system by printing money for only so long, and this approach itself may actually create more problems if inflation ultimately creeps into the system. Already, inflationary indicators appear to be pointing upwards, yet the Fed continues to stand by rather than tighten. Could it be that the Fed actually wants inflation? After all, if you don't want prices to fall, the other way to get those under water in their debt to be bailed out is to raise the price level. We are on a rather precarious road and are afraid the Fed may be getting more than it is bargaining for (please also see our analysis: Strong Dollar Policy: What??).
Dubai's standing as a financial center has suffered; in the long run, this is likely to bolster Singapore, a more established financial center in a growing region. Indeed, Singapore has already been gaining business from Hong Kong (inferior quality of life), New York and London (increasingly hostile environments). As this crisis evolves, it may be increasingly apparent that some regions can afford their bailouts and others cannot. Dubai World isn't the last shoe to drop, but may be a sign of an increasingly unstable global economy.
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We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.