The U.S. Dollar Post G7
The unholy trinity of credit market turmoil, domestic recession fears and rising commodity prices has served up a 1-2-3 punch for the U.S. Dollar of late, accelerating the precipitous decline of the greenback against other major currencies that began in 2002. Although senior U.S. government officials continue to affirm their commitment to a strong dollar policy, veteran market watchers have long since dismissed these pronouncements as hollow rhetoric, with neither the intent nor the means to back up such a policy with real action.
Indeed, the Federal Reserve Chairman and his cohort at the Treasury should be regarded as nothing more than pitchmen for the U.S. economy, their credibility shrinking by the day as the harsh realities of home foreclosures, job losses and soaring energy and food prices cast ever increasing doubt on their rosy prognostications for the nation’s economic state of health.
In all fairness to Bernanke, his range of policy options is rather limited. The threat of serious credit contraction from the sub-prime mortgage fallout and the specter of cataclysmic financial systemic failure have prompted the Fed to slash interest rates in rapid fire succession. However, cheap funds from the Fed are not inducing financial institutions to make new loans as lenders are now focused on replenishing capital and repairing balance sheets.
In addition to aggressive rate cuts, the Fed has also been creative in allowing investment banks, albeit belatedly, to borrow from the discount window with dubious collateral. These efforts have temporarily stabilized financial markets; but the economy continues to slow down by every performance yardstick including payroll, retail sales and consumer confidence. In fact, other than fueling short-term snapbacks in the stock market to frustrate short sellers, the Fed has succeeded only in buying time for markets that wait nervously for the proverbial other shoe to drop. The worry is that, while the sub-prime mortgage mess grabs headlines, the entire financial system is also creaking from over-leverage, proliferation of derivatives and lax regulations. U.S. financial markets look more vulnerable today than at anytime since the Great Depression, and the inevitable spillover effects of systemic shock will threaten to destabilize the entire global economy.
Having inherited a credit driven and consumption oriented economy from Alan Greenspan, aka the Maestro; Ben Bernanke now has to deal with the simultaneous threat of a credit crunch, slowing economy and soaring commodity prices. However, he seems fixated on the elixir of cheap money to somehow cure every ill, right every wrong and rehabilitate all. And who can blame him for this obsession? Having mentored under the Maestro and witnessed how quick and aggressive rate cuts can promptly restore financial calm in the aftermath of the Asian financial crisis, the Long-term debacle and 9/11, abundant liquidity from the Fed has been revealed as the key ingredient for financial market nirvana. A bountiful harvest on Wall Street, the Chairman surmises, will certainly lead to bliss on Main Street.
So, in the shadow of looming trade and budget deficits, record consumer debt, negative personal savings, and a U.S. Dollar that has lost almost 50% of its value against the Euro since 2000, the taps at the Federal Reserve are turned on yet once again, releasing that “liquid green” that will hopefully find its way to shoring up the capital of every ailing Wall Street firm. Not to be outdone and seen as asleep at the switch, which of course they have been, Congress and the President quickly approve a $145B stimulus package that will rebate $800 to individuals and $1,600 to couples. Passing up on a great opportunity to repair the nation’s crumbling infrastructure and ensure that every stimulU.S. Dollar is spent, lawmakers decide on the politically expedient and vote to bribe taxpayers with their children’s money, encouraging yet more conspicuous consumption. Hopefully, taxpayers will be more sensible than their Congressmen and choose to pay down debt or save the rebate for the fast approaching rainy day.
How is this all impacting the U.S. Dollar? Well, not surprisingly, the dollar has been abandoned by international investors en masse. However, Bernanke’s public display of indifference and downplay of the deleterious effects of the falling dollar has surprised the markets, and encouraged more speculation on whether policymakers have the gumption and the wherewithal to halt its decline. Other than the boiler plate statement from Treasury about the Administration’s support for a strong dollar, Bush policy on the dollar under various Treasury Secretaries has been one of benign neglect. Or, could it be that a gradual devaluation of the dollar is the only way out for a country that needs $3B daily to finance its various deficits?
If a gradual devaluation of the dollar has been engineered to allow the U.S. government to repay its international debt with increasingly worthless dollars, the current financial crisis and economic slowdown are helping to speed up the process. Bolstered by successive rate cuts to alleviate the credit crunch and emboldened by Bernanke’s view that inflation will be self-moderating once the economy slows down enough, currency traders have the green light they need to sell the U.S. Dollar and push it to one record low after another since January of 2008. Textbook analysis would suggest that, as the dollar falls, the trade imbalance will begin to correct and investment opportunities will emerge at some new equilibrium and valuation level deemed attractive to foreign buyers. If the duration of this entire adjustment process can be shortened, the argument goes, the U.S. economy will rebound more quickly.
Unfortunately, the law of unintended consequences always seems to intrude on reality at the most inopportune moment. Just as the dollar is merrily depreciating its way against most of its trading partners, commodity markets react with spikes in energy, grain and base material prices, stoking fears of inflation and perhaps even stagflation. In fact, evidence now points towards the end of an era for cheap goods from China and other third world countries as globally rising material costs can no longer be offset by cheap labor costs. Not only are the prices of precious metals increasing to reflect the vast credit creation by central banks around the world, food prices are also rising because of population growth, poor harvests, changing diets and resources being diverted from growing crops to growing fuel. In general, the rise in commodity prices is a symptom of the depreciating U.S. Dollar, as investors drive up the prices of these dollar-denominated commodities to compensate for the loss of the greenback’s purchasing power.
Stubborn commodity prices that continue to move higher in spite of a slowing economy create an inconvenient reality that frustrates Bernanke. His projection of moderating inflation pressures continues to be thwarted by unrelenting global demand and a rapidly diminishing dollar. The G7 communiqué expressing concern over the weak dollar has provided only temporary relief, although it does raise the specter of central banks throwing down the gauntlet and daring speculators to cross the line in the sand. However, based on the statements from the ECB, it does not appear that any concerted intervention will have the desired effect of reversing the dollar’s long term decline, especially while the ECB’s primary focus remains on fighting inflation, whereas the Fed is consumed with easing credit conditions to bail out financial institutions and homeowners. History has taught us that coordinated intervention can only be effective and credible when economic fundamentals support and validate the stated intervention goal. Furthermore, it is imperative that major central banks align their divergent interests and present a common front in both rhetoric and policy action. Speculators united by greed will only be too eager to exploit any perceived weakness or lack of solidarity and test the resolve of the central banks.
Looking ahead, the U.S. Dollar sell off is approaching a phase where a technical bounce is looking more and more imminent. The catalyst may not necessarily be central bank intervention or an improvement in the U.S. economy but rather an unexpected slowdown or disruption of the European economy that catches the market off guard. Some argue that the U.S. Dollar should be rewarded with a bounce because of the proactive stance of the Fed in cutting rates versus the intransigent Europeans. Bernanke would be inclined to agree.
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