Can Foreign Intervention Save the US Dollar?

The Federal Reserve’s $900 billion asset purchasing program may help the US economy…or maybe it won’t. But one thing is certain – the US dollar will be the biggest loser. In fact, just about every currency you can name is set to eclipse the greenback over the next few months.

Even before the Fed announcement, several major currencies had already appreciated considerably against the US dollar in the last 2-3 months. It now takes US$1.01 to buy one Australian dollar (AUD) – up 20% from $0.80.back in June. The British pound (GBP) has gained 12.6% since June. And even the much-derided euro (EUR) has managed to increase 17% in value.

Some of the rise can be attributed to improvement in these economies in the last four months or so. The Australian economy is in the middle of one of the biggest mining booms in the country’s history. British economic releases have done a positive turnaround – giving buy signals for the British pound.

But that’s only half the story driving the US dollar lower. Investors are tired of low interest rates and rather lackluster investment returns, so they are seeking yields and returns elsewhere. For a US-based investor, investing in Australian-based treasuries can mean a yield of 4.5% greater than benchmark US rates. And Australian interest rates are expected to climb higher in the first half of the New Year as the economy revs up by an annualized gross domestic product rate of 3-3.5%. This will help to support the case for further rate increases, attracting more Australian dollar buyers and US dollar sellers.

Emerging currencies will surge against the US dollar, too – particularly the Brazilian real (BRL), South African Rand (ZAR) and South Korean won (KRW).

Like Australia, the case for Brazil and South Africa revolves around commodities – in this case, raw materials and gold.

Higher commodity prices have helped the Brazilian economy rise by an estimated 7.2% this year. This kind of rapid growth could also spur inflation. So Brazil’s central bank, Banco Central do Brasil, has increased rates to 10.75%, or 10.5% over comparable US central bank rates. The exponentially high yield has attracted foreign investors to the country and will continue to do so, making it very difficult to hold onto a falling dollar.

All this assumes the countries involved allow their currencies to appreciate naturally. But we know central banks and governments condemn a rapid appreciation of their currencies. So policymakers have resorted to bank interventions and competitive practices to force down their currencies – the so-called “currency wars.”

Brazil’s government has already tripled the tax rate paid by foreign investors, while South Korea is beginning to audit holdings in FX transactions. Even the Bank of Japan continues to monitor opportunities for direct market intervention.

Those drastic actions might seem like a good reason to bet against a steep climb in foreign currencies. But history has always held true: intervention or competitive currency practices rarely work.

The clearest example dates back to Sept. 16, 1992, when England moved to protect the pound’s exchange rate. It spent 3.3 billion pounds shoring up the currency, only to lose to overwhelming speculative forces. The quick infusion of cash disappeared as the sterling depreciated through its mandated lower limit.

More recently, Japan has been fighting to take control of its currency, too. In September, under pressure from the Ministry of Finance to keep the exchange rate above 82 yen per dollar (JPY), the Bank of Japan directly intervened in global FX markets. It spent $12-13 billion to halt an appreciating yen – and promptly failed. The USDJPY exchange rate has strengthened even more, hovering around 81.23 per dollar.

There are numerous other stories from the last 10 years that show intervention won’t work. Speculators and investors will always demand higher yielding currencies, making each intervention just a short break from the longer-term trend.

So, with nothing drawing investors back to the US dollar, the currency looks to be done for in the medium term. US investors will seek out higher-yielding currencies, backed by rising economic prospects. And since central banks have been ineffective in controlling their own currencies, further appreciation is inevitable.

Richard Lee
for The Daily Reckoning