Thoughts on the US dollar, Asset Markets and Current Accountwww.speculative-investor.com on 16th December 2004.
There were some interesting statistics in the latest quarterly "Flow of Funds" report issued by the Fed last week. The most interesting, as far as we were concerned, were the data on household net worth and foreign central bank holdings of US financial assets.
According to the above-mentioned report, foreign central bank holdings of US financial assets increased by $315B -- a 40% annualised rate -- during the first 9 months of this year. To put this amount into perspective, it is equivalent to about three-quarters of the total US trade deficit over the period in question.
So, does this mean that the US$ would have been much weaker if not for the yeoman-like efforts of these central banks?
Perhaps not, because although the foreign CBs have soaked up a lot of the dollars associated with the US trade deficit the fact that they have channeled these dollars back into US financial assets -- mostly Treasury and Agency debt -- means that they haven't actually taken any dollars out of circulation. Rather, what they have done is re-cycle a huge pile of dollars and, in the process, dramatically reduce the supply of US bonds. Therefore, they probably haven't done a lot to support the dollar even though this was their goal, but their actions have almost certainly resulted in lower long-term US interest rates and higher US asset prices than would otherwise have been the case. They have, in other words, unwittingly helped to promote US inflation and widen the US current account deficit.
The Flow of Funds report also notes that household net worth rose by $546B during the third quarter of this year; so although some analysts have repeatedly warned that the US consumer was 'tapped out' the reality is that US consumers, as a group, were much LESS closer to being 'tapped out' at the end of the third quarter than they were three months earlier.
In our opinion, those who forecast that a retrenching by US consumers will create problems for the US economy and the US asset markets are putting the cart in front of the horse. To be specific, it is very unlikely that US consumers will cut back on their spending and ramp-up their rate of saving as long as household net worth is increasing at a robust rate. Instead, it is more reasonable to expect that a downturn in asset prices and a consequential reduction in household net worth will LEAD downturns in consumer borrowing and spending.
Now, last week we mentioned that the key to a substantial contraction in the US current account deficit was less spending and more saving. But according to the above, there are not going to be meaningful changes in spending and saving patterns until after there is a downturn in asset prices. Putting these two thoughts together we get: Regardless of what happens to the US$ there probably isn't going to be any significant contraction in the US current account deficit until some time after US asset prices begin to trend lower.
The US Stock Market versus the US$
Imagine the following scenario:
Joe borrows a lot of money from his local bank and spends the money on general living expenses. After a short while the money is all gone, but the debt remains and Joe is having trouble meeting his monthly obligations so he returns to the bank and asks for some more money. Despite the fact that Joe is already beyond his credit limit taking into account his income and monthly expenses, the bank not only offers to lend him a lot more money but also offers to do so at a lower interest rate. After another short while, though, Joe again finds himself in the position of desperately needing more money to fund his lifestyle. So again he returns to the bank and, like before, leaves with a lot more money at an even lower interest rate. This process is repeated again and again with Joe being offered progressively lower interest rates on his ever-expanding debt despite his weakening financial position.
The above scenario might seem unrealistic, but if we substitute "the US" for "Joe" and "foreign central banks" for "Joe's local bank" then it depicts what has actually been happening in the world over the past two years.
Keeping the above in mind, take a look at the following chart comparison of the S&P500 Index and the Dollar Index. The chart highlights the strong INVERSE relationship between the US stock market and the US$ since March of 2003. Notice, in particular, that the S&P500's upside breakout from a lengthy consolidation in early November of this year occurred shortly after the Dollar Index broke downward from a lengthy consolidation of its own.
The inverse relationship illustrated above is not normal (over the long-term there is a slight positive correlation between the S&P500 Index and the Dollar Index) and is far too tight to be a coincidence. The reason it has occurred, we think, is that each bout of dollar weakness has prompted foreign central banks to buy dollars which are then immediately injected into the US bond market. Dollar weakness therefore leads to higher US bond prices (lower long-term interest rates) and increased liquidity in US financial markets. And the worse things get for the US and the dollar the more dollars the foreign central banks feel they have to buy and the more money gets channeled into US bonds, resulting in lower interest rates and higher US asset prices. Furthermore, this process increases liquidity throughout the world, not just within the US, because in order to 'soak up' excess US dollars the foreign central banks often print more of their own currency.
This apparently virtuous circle can continue for as long as there exists a combination of a weakening dollar and subdued inflation expectations. In other words, it will end when the dollar begins to trend higher or when a weakening dollar (and the associated liquidity generation) causes inflation expectations to surge.