U.S. Dollar - Review and Outlook
We believe that continued U.S. dollar weakness may be a consequence of the diverging monetary approaches central banks are taking around the globe. While many international central banks have been on a tightening path, raising rates (i.e. central banks of: Australia, Brazil, Canada, China, India, Norway, Sweden, to name but a few), the U.S. Federal Reserve (Fed) has been conspicuous in its continued easing monetary policy stance. Indeed, while other central banks have been shrinking the size of their balance sheets, the U.S. Fed's balance sheet continues to expand on the back of ongoing quantitative easing policies.
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In late August 2010, Fed Chair Ben Bernanke, through a speech in Jackson Hole, WY, alluded to the Fed's intention to conduct an expanded quantitative easing program. Subsequently, in November 2010, a $600 billion quantitative easing program was announced ("QE2"), aimed at acquiring longer-term U.S. Treasury securities through the end of June 2011. The Jackson Hole speech marked the start of a significant rally in the price of many assets that typically help provide investors with protection against inflation, from equities to oil to gold. Over the same time period, we witnessed a significant increase in the market's implied expectations for future inflation, a gauge we watch closely, as it tends to be a leading indicator of inflation itself.
Inflation manifests itself through a decline in purchasing power of the dollar, or said another way, weakness in the value of the dollar. Indeed, from the date of Bernanke's Jackson Hole speech through March 31, 2011, the U.S. dollar declined 8.52%, as measured by the U.S. Dollar Index (DXY).
In our opinion, the Fed's monetary policies are implicitly devaluing the U.S. dollar. Consider the following: when the Fed purchases U.S. Treasury securities, it artificially drives down the yield on those same securities, intentionally overvaluing them. At the same time, yields around the world have been rising, as international central banks follow tighter monetary policies. As a result, rational investors are evermore incentivized to look abroad for less manipulated, higher rates of return. Combine this with the supply-side dynamics of the U.S. dollar, where the Fed has continued to expand its balance sheet (the change in a central bank's balance sheet can be thought of as a proxy for the amount of additional money that has been printed) - basic economic theory tells us that all else equal, an increase in supply of an asset is likely to result in a decline in the value of that asset. In this case the asset just happens to be the U.S. dollar.
Furthermore, we consider the approach taken by the Fed in 2008 and 2009 to address the global financial crisis has created inherent inefficiencies on the Fed's balance sheet and potential inflexibility, should inflation break out to the upside. As opposed to the approach taken elsewhere, such as in the Eurozone or Sweden, where those central banks provided emergency funding to the financial sector, often with a maximum maturity of 12 months, but more commonly over a shorter time frame, the Fed, amongst other programs, purchased a vast amount of mortgage-backed securities (MBS). This has multiple implications. For one, providing liquidity to a specific area of the economy (housing market) is traditionally fiscal policy, falling squarely in the realm of Congress. With the Fed encroaching on Congress's territory, the level of government oversight and scrutiny increased. Such developments threaten the independence of the Fed; the less independence a central bank operates with, the less effective it becomes at fostering price stable environments. Secondly, whereas the emergency facilities provided overseas are by design much easier to run-down, this is not the case for the Fed's holdings of MBS. There remains very little active market for such securities, and even if the Fed were to dispose of these securities, this action would likely dramatically increase yields. Such a rise in yields may precipitate a further decline in the economy; with the economic recovery still not out of the woods, this may be the last thing the Fed would want to do.
Likewise, fiscal policies around the world differ greatly. Whereas many countries are implementing fiscal austerity measures aimed at improving government finances, it appears to us a "spend at any cost" mentality still prevails in Washington. Relative to many other nations, the U.S. fiscal situation has deteriorated significantly recently, and until we see tangible evidence of politicians' willingness to address these issues, not simply debate them, the public finances of the U.S. will remain on an unsustainable path. (As an aside, the $38 billion in spending cuts recently agreed to amounts to a mere 2.5% of the estimated $1.5 trillion budget deficit for 2011.)
These issues may well continue to weigh on the U.S. dollar for the foreseeable future. We continue to favor the currencies of nations whose central banks appear to be following much more prudent monetary policies and display healthy fiscal situations, or whose government is convincingly tackling austerity concerns through attainable programs.
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In Asia, domestic inflationary pressures may continue to be the key driver for Asian countries to allow their currencies to appreciate. We favor Asian countries that produce goods and services at the mid to high end of the value chain: higher end producers have greater pricing power, whereas low-end producers compete predominantly on price; in our assessment, low-end producers are more likely to instigate competitive devaluations of their currencies. It is not surprising to us that Vietnam, for example, a country producing low-end consumer goods, has continued to engage in currency devaluation during the period, whereas more advanced Asian economies have gradually been embracing stronger currencies. Many Asian nations may ultimately export domestic inflation to the U.S., further compounding the risks to the U.S. dollar.
Despite throwing vast amounts of money at the system, the Fed has been unable to control where that money actually ends up. As much as Bernanke may want to generate house price inflation to bail out all those consumers underwater in their mortgages, house prices have continued to stagnate. The money has shown up somewhere, however: one of the implications of the Fed's continued easy monetary policies is that many other asset prices have moved up in tandem. From stocks to corporate bonds to commodities and natural resources, we have seen large upswings in price, combined with increased correlations. At the same time, the U.S. dollar has continued to weaken. In such an environment, it may be evermore important for investors to add uncorrelated asset classes to their portfolios, to protect against downside movements in price, while managing U.S. dollar risk.
Given a backdrop with so many global dynamics to play out, we believe the currency asset class may continue to provide valuable portfolio diversification benefits and upside potential.
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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. This analysis is a preview of our annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.