Psychology of a Falling Dollar
Given a current account deficit in excess of 6% of gross domestic product (GDP), many fear the US dollar must decline. At the World Economic Forum in Davos, policy makers disagreed as to the severity of the risk, its causes and cures. In a nutshell, the United States does not export enough to the rest of the world to balance its own appetite for cheap Asian imports. The American consumer spends too much and saves too little. As a result, dollars are leaving the US in return for goods and services. Unless those dollars are reinvested in US denominated assets at a rate in excess of $2 billion a day, the dollar will decline.
According to the Financial Times, the top international affairs official at the US Treasury warned that if the US were to instigate policies to rein in the consumer, it would plunge the US into a deep depression; fallout to other countries would also be severe. While we have explained in the past why the US has no interest in a consumer slowdown, this is the first time we hear the US Treasury warn about the risk of a depression.
To adjust the current account deficit without a severe adjustment in the value of the dollar, the rest of the world could also spend more and save less. While China's savings rate of 30%-40% of disposable income is likely to come down at some point, we doubt that the rest of the world can or even wants to adopt American spending habits; Americans now have a negative savings rate. Not only is much of the world economy dependent on the US economy, the US economy also dwarfs many of the emerging economies where a pickup in consumption could be expected.
In many of our analyses we traditionally focus on the fundamental pressures on the dollar, including the current account deficit described above. While fundamentals may drive the long-term view, short-term moves tend to be influenced by psychological factors and perceptions on supply and demand. From time to time, we see an argument why the current account deficit does not matter, but most of these "fundamental" arguments are about as good as explanations in 1999 of why the economy had entered a new era.
One reason why so many do not pay attention to fundamentals is that the daily flow of information makes it difficult to see the big picture; instead, analysts revert to trend analysis. Why bother about the dollar when it has "always" been "cyclical"? The US consumer has "always" spent too much, why worry now? Why bother about the dollar if your expenses are also in dollars? And why bother about it given that it is in the world's interest that the US consumes what the world produces.
First, and this may surprise many "dollar bears", American consumers are, generally speaking, far more rational than they are given credit for. Increased debt burdens have come with gradually lower interest rates since the early 1980s. American consumers react to monetary and fiscal policies, as well as to cheap Asian imports. There are side effects that policy makers may not have intended. For example, while in the 1950s, fewer Americans owned their homes, they truly owned them; now, banks are the true 'owners'.
Most importantly, while we agree that it is in the world's interest to keep the dollar strong, it may be fatal for the government to base its policies on that presumption. The US dollar had enjoyed the confidence of the world as a reserve currency for many decades because of relatively prudent management. One cannot turn the world upside down and blackmail the world into producing cheap goods because it is in their interest to build their infrastructure and create employment. While we expect policymakers in Asia to fight tooth and nail before letting their currencies appreciate significantly, history has shown that the markets are more powerful than policy makers. This does not mean we should purchase the currencies of countries backed by unpredictable leadership. However, it does mean that the markets may punish the holders of US dollar cash. We believe that the currencies of countries backed by what we call sound monetary policy will be the beneficiary of any fallout. We refer to countries that are less likely to intervene in the currencies markets and are less likely to engage in competitive devaluation.
The currencies of many Asian countries have speculative potential, but it is one thing to try to shield yourself from a decline in the dollar by diversifying to a basket of hard currencies; it is another to speculate on the unpredictable behavior of e.g. the central banks in Japan. Japan has made it clear over and over again that it is in their interest to keep the yen weak to push exports. The Japanese market is swimming in liquidity; the Bank of Japan is yielding to political pressure and does not mop up this added liquidity; instead it has agreed to allow the consumer price index to be re-defined, so that they can stay by their promise to keep rates low while inflation is low. In the US, we argue whether government statistics have a bias to show too little inflation; in Japan, there is no debate, we know the statistics cannot be trusted.
Some believe higher interest rates may save the dollar as higher rates attract more investments. This analysis ignores that as of the end of last year, the US pays more in interest to overseas creditors than it receives from overseas investment. This phenomenon is more typically associated with third world countries; as interest rates rise, obligations to foreigners increase. Foreigners mostly hold short-term denominated debt securities, those most affected by interest rate increases. As the Treasury suspended the sale of 30-year bonds in October 2001, government debt has become much more interest rate sensitive as the duration of outstanding debt declined. Just as consumers took out adjustable rate mortgages (ARMs) to finance their spending, so in effect did the federal government.
More importantly whether we have reached the peak in US interest rates is the perception that we do not have many more rate hikes, if any, in the pipeline. At the same time, the perception is that e.g. the European Central Bank (ECB) is going to raise rates further. It does not really matter that the ECB may be reluctant to raise rates and the new Federal Reserve (Fed) chairman Ben Bernanke may end up raising rates more than some expect. In our assessment, in the coming months, the perception is going to influence the dollar more than the absolute level of interest rates.
It does not help the dollar that Bernanke has not yet established his credibility. Bernanke has indicated during his hearings that any crisis can be responded to by providing liquidity to the banking system. Adding liquidity is helpful to avoid panics as it allows the free market to set prices, but it may not prevent a decline in the dollar. We have talked about the "Bernanke-Test" in the past: transitions at the helm of the Fed are frequently accompanied by a crisis; we would not be surprised if a sharp decline in the dollar was Bernanke's test. We believe policy makers may welcome a weaker dollar. Many have warned that a weaker dollar would substantially increase inflationary pressures as it makes imports more expensive. However, policy makers may try to force Asia to become even more competitive and sell at even lower profits margins.
We have also argued that a weaker dollar is politically desirable in the absence on a consensus on reforms in Medicare, Medicaid and Social Security. By devaluing the purchasing power of the dollar, nominal promises can be kept without alienating voters.
Is the tide shifting against the dollar? Is the decline that lasted until late 2004 going to resume? If one takes the early action in 2006, it looks like it. Precious metals have been soaring in recent weeks - to any policy maker, this should be a warning. We do not know what is going to happen to the dollar for the remainder of the year. But we see the fundamentals further deteriorating. We also believe that dollar sentiment is turning more negative. We see an increasing number of investors taking steps to diversify out of the dollar "just in case". Similarly, while Asia will try to keep their currencies weak, they want to diversify their dollar holdings. Just as much of Asia has been "subsidizing" sales to the US through a weak exchange rate, they may well be inclined to subsidize sales to Europe in the future. I was invited to host a panel at a conference in China last fall: the focus of the conference was on how to increase sales to Europe. With its "best client", the US consumer, in jeopardy, it is only prudent for Asia to foster new distribution channels for its products.
Speculative money has no loyalty and is merely looking for the next trend. More and more speculators are pursuing the same strategies. In the end, these "professional" investors can influence the markets for a couple of months. We are more concerned about corporate money from overseas seeking better opportunities outside of the US as consumer spending slows.
What does it mean for you as an investor? If you sympathize with these arguments, but believe a weaker dollar does not affect you, think again. The reason we do not have significant "core inflation" is because that measure focuses on goods we can import from Asia. At some point, the market is likely to force an adjustment, and there will be few places to hide. Maybe precious metals provide some refuge. We believe investors should consider adding a basket of hard currency element to their portfolio.
On a final note, while the media is celebrating Greenspan's departure: during his tenure, the purchasing power of the dollar has been cut in half. That was during "good times." Rather than hope that "bad times" never come, consider acting to seek protection against a further decline in the dollar.
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