Entering the New Year, the dollar’s fate is definitely the single most important question for the world economy and world investors. It is really the greatest wild card in the world economic outlook. After a very slow start, the dollar’s decline has been gaining momentum. But where will it end? Could last year’s dollar retreat turn into a dollar crash, possibly with disastrous implications for the U.S. financial markets if not for the whole financial system?
On Dec. 31, 2002, the euro traded against the dollar at $1.05, up from $.8915 at year-end 2001, reflecting a gain of 17.8%. Compared to its earlier peak of less than $86, the U.S. currency has lost altogether 22%. For European investors, these currency losses are adding hugely to their heavy losses on U.S. stocks.
The dollar index topped out a year ago. Starting very hesitantly and gradually, its fall has distinctly gathered momentum in recent months. Considering the resistance of the trade deficit and the worsening economic situation in the United States, it is plainly time to ponder a protracted decline of the dollar and its broader implications. What could stop the dollar’s slide? And what could happen in financial markets if the dollar’s slide proves unstoppable?
Dollar Crash: An Unwillingness to Lower Consumer Spending
As for the first question, it is established experience that trade balances respond to changes in the exchange rate with enormous sluggishness, if at all. During 1985-87, the deficit continued to soar, even though the dollar virtually collapsed. In essence, such a deficit reflects an equal excess of domestic spending over domestic output. But currency depreciation, by itself, affects neither of the two. To reduce its trade deficit, the United States would need to lower consumer spending. But that is precisely what the government and Federal Reserve are desperately trying to prevent, as it implies recession and rising unemployment.
While sharply slower U.S. economic growth in 2003 may moderately improve the trade deficit, the worsening economic news would frighten foreign investors even more. It is, in actual fact, one of our key assumptions concerning the dollar that an unexpectedly poor performance of the U.S. economy and its stock market in the current year will act as the catalyst that will finally break the illusions about the U.S. economy and the dollar.
While the indulgence of foreigners to invest in the United States is incredible, sharply lower capital inflows are effectively depressing the dollar. With this in mind, the second question becomes paramount. What will happen if the dollar continues its irresistible decline?
Up till now, the dollar’s decline has been orderly, for an obvious reason. Inertia rules – there remains a fixed, very negative image of the European economy and its currency versus a fixed, very positive image of a dynamic American economy trumping the trade deficit with a superior growth performance. The result is a still-predominating view in the markets that the euro’s rally is narrowly limited, while the dollar’s next recovery is only a question of time.
Dollar Crash: Fading Faith
Yet this faith in the dollar’s impending rebound must be fading. Its decline is ominously gaining speed. The usual explanation is the war in Iraq. In the past, though, the dollar used to enjoy safe-haven status. In actual fact, there are plenty of other reasonable explanations for a weak dollar. Most of them are not new. But what is new is the proliferating bad news about the U.S. economy, putting its expected recovery into question. In short, confidence in the U.S. economy’s growth prospects is cracking.
Could the dollar’s orderly decline turn into a chaotic decline, capsizing the financial markets? Look back to 1987, a year in which American and foreign investors did lose their nerve about the falling dollar. For several months, this loss of confidence spelled disaster for U.S. stocks and bonds. Yet it proved a brief crash, which ended in a soft landing for the dollar and the markets. As such, it seems a comforting experience.
On closer look, it is not. Today’s economic and financial conditions in the United States are incomparably worse than they were in 1987-89. Economic growth is much slower today, the trade deficit is much higher and interest rates are much lower.
But there is yet another factor that makes a great difference: unprecedented exposure to the risk of a falling dollar. Both foreign holders of dollar assets and American holders of euro- denominated assets have much at stake. The important point is that both groups have principally abstained from covering their exchange risk. Strong expectations to gain from a strong dollar or from a weak euro prohibited any hedging. When will foreign investors and American borrowers finally give up on the strong dollar?
There is a widespread assumption that there exists a “normal” level of the dollar against other currencies, from which it will not diverge too far or for too long.
But no such level exists. The dollar is effectively out of control. There is no way to predict where it may bottom. This is a measure of the macroeconomic costs of allowing an external disequilibrium to become so large and to accumulate for years. The dollar’s fate no longer lies in the hands of central banks or private banks, but in the hands of many millions of fickle private investors.
for the Daily Reckoning
February 11, 2003
We don’t have any idea what is going on in the outside world. We drove down here from Managua yesterday and have been trying to get an open phone line ever since.
Not having CNN in our house…nor a newspaper…nor even a phone that works – we leave it to Eric to pass along the day’s news. Below, we turn to more important matters…
Eric Fry, reporting from the Big Apple…
– Saddam Hussein raised the curtain once again on the Iraqi “peep show,” and investors took the gesture to mean that the Iraqis might “bare all,” rather than face the wrath of American military might.
– Reversing weeks of opposition, Iraq said it would permit U-2 surveillance planes to resume flying overhead, and also promised to be more cooperative with U.N. weapons inspectors. Apparently, Iraq doesn’t mind if Uncle Sam becomes a peeping Tom, as long as the peeping takes place from 60,000 feet in the air.
– Given Iraq’s latest concession, the prospect of an imminent American assault has faded somewhat, and with it the allure of safe-haven investments. Gold tumbled $6.30 to $364.20 an ounce. Crude oil also retreated from its recent highs, falling 64 cents to close at $34.48 a barrel.
– Meanwhile, a few intrepid investors ventured back into the stock market. The Dow gained 56 points to 7,920 and the Nasdaq added 1% to 1,296. The bond market barely budged, as the 10-year Treasury note finished the day right about where it began, yielding 3.97%. But the bond market might merely be enjoying the calm before the storm.
– “Just because the bond ‘bubble’ hasn’t burst yet, doesn’t mean it isn’t a bubble,” the team at Resource Trader Alert (RTA) observes. “War anxiety and subsequent flight-to- safety buying may have postponed the day of reckoning, but hasn’t necessarily eliminated it. Inflation in both the US and the euro zone is headed higher, if for no other reason than higher energy prices. Oil is up 65% from a year ago measured in dollars and up 35% when measured in euros.
– “But it’s not just oil,” the RTA team continues. “The broad-based CRB Index of commodity prices is up a whopping 32.2% from its 2002 lows…Massive increases in money supply, a return of deficit spending and the inflationary effects of war make it hard to justify the low yields and correspondingly high prices of Treasury bonds and notes…Big borrowing needs in both the U.S. and Europe have the potential to flood the market with paper over the next few years…The Bush administration projects U.S government deficits to top $1.8 billion over the next five years…”
– All in all, there are lots of reasons why NOT to love bonds at their current low yields. Still, certain option traders may be set to profit nicely from an imminent sell- off in the Treasury market… [Editor’s note: for more information, see:Resource Trader Alert]
– What may be bad news for bonds is, as every Econ. 101 student knows, good news for gold…at least most of the time. Curiously, bond prices and gold prices have been rallying arm-in-arm for months. But that dance is likely to end very soon. The nascent inflationary trends developing in the U.S. are likely to be VERY bad for bonds and VERY good for gold. That’s why most of us at the Daily Reckoning are fans of the yellow metal. Even so, we can’t help but wonder when gold’s awesome, months-long rally might take a breather. Was yesterday’s sell-off the beginning of gold’s pause that refreshes?
– Given gold’s dramatic run-up, an equally dramatic sell- off wouldn’t be too surprising. But longer term, we wouldn’t want to bet against this precious metal. Gold is in a long-term bull market, until further notice.
– Long-term investors who’d rather not bother trading every “jiggle” (Jimmy Roger’s term) in the gold market, will be heartened by the observation of Frank Holmes, CEO of the mutual fund company U.S. Global (Nasdaq: GROW). Holmes calculates that, over the last 30 years, an investment portfolio containing a 20% allocation to gold stocks has produced a higher return with less risk than a portfolio dedicated entirely to the S&P 500 Index.
– An 80% mix of S&P 500 Index shares, says Holmes, together with a 20% mix of Toronto Gold and Precious Mineral Index shares, achieved an average annual return of 12% from 1971 through 2002. That return was higher, and less volatile, than a pure S&P 500 holding.
– History is nice, but most of us would prefer to know what the optimal portfolio allocation might be for the NEXT 30 years, rather than the last 30 years.
– Faithful Daily Reckoning readers, we suspect, would prefer kissing their sister (or brother) to allocating 80% of their portfolios to S&P 500 shares. And we’d hate to have those sorts of choices made on our account. So let’s skip over the S&P 500 part of this discussion and focus only on the gold part.
– For the next 30 years, some meaningful allocation to the yellow metal seems like a good idea. Whether the optimal weighting might be 20% or 2% is anyone’s guess. But if the dollar is past its prime – which is a possibility – even a hefty 20% allocation to gold stocks would seem inadequate.
Back in Nicaragua…
*** Being cut off from the news is a terrible thing. With no CNN to watch, a man is forced to look around him…with no presenter to listen to, he must listen to his wife…with no talking heads to do his thinking, he is forced to think for himself.
This comes as such a burden to your editor that he can hardly bear it. He would much rather read about the world environmental crisis…than take out the trash. He would much rather discuss Japan’s economy than balance his own checkbook. He finds it easier to write a letter to the editor than one to his sister.
“Love afar is spite at home,” wrote Emerson. But the modern press makes it so easy. No cause…no problem…is too remote or obscure to tempt away the imagination of the public-spirited Democrat. He may not be able to fix the bathtub drain – for he is too busy worrying about the sewage in New Delhi. His own children may spend the day watching television and eat moon pies for breakfast, lunch and dinner…but it is a small sacrifice to pay for a his keen interest in health care policy. ‘Regime change’ speaks to him like an advertisement for a potency pill…he cannot resist it, whether he needs it or not.
Here, in the wilds of Nicaragua with the waves crashing against the rocks outside his house…a huge SUV land barge parked in his driveway…and no newspaper delivered to his door, your editor wonders what the world would be like without modern communications…
[Editor’s note: If you’ve sent an e-mail to us in the past few weeks and we haven’t responded…don’t despair! We always like to here from you; in fact, it’s one of the more pleasing aspects of our work. But as many of you know, we’re working on a book to be published by Wiley & Sons, and the deadline draws near. We simply haven’t had time to respond. Thanks for your understanding. Back on the job soon!
The Daily Reckoning