It’s the End of the Dollar as we Know It (Do we Feel Fine?) Part 1 of 3
The dollar has been in focus of late, primarily due to its substantial decline in value versus other currencies and most major commodities. Indeed, when measured in broad, trade-weighted terms, the dollar’s April decline is one of the largest monthly drops of the past decade and extends what has now become the largest cumulative decline since the US economy exited recession in 2009. When measured versus a broad basket of global commodities, the recent decline has been even more dramatic.
As in 2007 and early 2008, the dollar is weakening sharply
As with many financial market developments, at first glance this might seem rather curious. After all, much headline economic data shows that the US economic recovery has been gaining momentum. The Fed has acknowledged as much and has indicated that its current policy of steady balance sheet expansion, known as ‘QE2’, will end as planned next month, to be followed, presumably, by higher short-term interest rates at some point. Other factors equal, a healthier US economy and higher US interest rates should be dollar supportive.
The problem with the sort of analysis above is twofold: First of all, it looks at only one side of an exchange rate, which naturally must have two sides. Second, it implies that headline economic growth and the current level of interest rates are the decisive factors that determine exchange rates in the first place. In the current instance, notwithstanding somewhat stronger headline US economic data of late, for those who care to look behind the numbers, the US economy, by contrast, is showing disturbing signs of major structural weaknesses pointing to dramatically weaker growth in future. And while US interest rates may nevertheless begin to rise at some point, rates are already rising in nearly all the rest of the world and show no signs of peaking given strong growth and soaring inflation throughout much of the global economy. These developments undermine the dollar’s pre-eminent reserve currency status. Concern that the dollar might lose this position at some point is a far more important factor in determining exchange rates than incremental changes in relative growth, inflation or interest-rate expectations.
So what are these signs of major US structural weaknesses to which we refer? Well, consider that, for an economy to grow in sustainable fashion, there must be business investment. At a minimum, rates of business investment must at least keep up with depreciation; any lower and the capital stock will erode over time, reducing an economy’s potential growth rate. There are various ways of measuring US business investment. It is important, however, to distinguish between fixed investment (in plant, property and equipment) and inventory building. The latter is highly volatile and does not contribute materially to an economy’s sustainable growth rate, whereas the former is a better indicator of how sustainable a given economic expansion is likely to be over longer periods.
Now while the current level of fixed, nonresidential business investment, up about 10% y/y, looks reasonably healthy in a longer-term comparison, note that, when compared to the depth of the recent trough–the last recession–in fact the rate of investment is unusually weak. Indeed, it is so weak that, if it does not increase substantially further from here, it is unlikely that the economy is going to replace that portion of the capital stock which was wiped out during the downturn, placing the US on a weaker potential future growth path.
Business investment is weak considering the depth of the recent recession…
Sadly, it appears that, for the current cycle at least, the rate of business investment has already peaked. How can we tell? Well, the core rate of capital goods equipment orders, which excludes highly volatile orders for defense and aircraft, has turned down quite substantially in recent months. Now this is not necessarily indicative of a recession ahead, merely of a more subdued rate in business investment. But as discussed above, this implies that the US potential growth rate is going to be unusually weak during the current business cycle and, unless the situation begins to change, for an even longer period.
This is bad news on a number of fronts. Weaker potential growth implies weaker wage and jobs growth, lower tax receipts and, by implication, higher government deficits. If these are accommodated by easier monetary policy, this situation also implies a growing ‘stagflation’ risk. Given the massive public debt overhang already plaguing US federal, state and local government finances, it should be no surprise to informed observers that, not only is the USA now highly likely to lose its symbolic (if somewhat outdated) AAA sovereign debt ratings, but also that state and local government finances, already approaching junk status in many cases, just keep on deteriorating, with ominous implications for borrowing costs in future. Who, in their right mind, is going to buy debt which is growing rapidly in supply at precisely the same time that weak rates of business investment imply lower tax receipts with which to service such debt in future? In this context, it is understandable that US municipal borrowing costs remain near their recent, record highs vs. Treasuries.
It should thus also be no surprise that the dollar has suffered to the extent that is has of late. While there are debt problems aplenty elsewhere in the world, including in the euro-area periphery of course, recall that the US dollar, by virtue of its pre-eminent reserve status, is not a normal currency. But if the US should lose that status it will, by implication, lose a substantial portion of its investor base–central banks and other major global financial institutions–and US government funding costs would most probably soar to levels that could well be catastrophic.
…and appears already to have peaked for the current cycle
Given the potential gravity of the situation, the US government is going to resist the loss of reserve currency status with everything it has got in the arsenal: economic, political and possibly even military. Do not for one moment think that the government has not already got to thinking very, very seriously about what could happen in the event that the dollar’s status comes under threat. In much the same way that the Pentagon is constantly ‘wargaming’ various scenarios in order to continuously improve planning for all manner of potential contingencies around the world, there are most probably some quite senior and even quite smart people in the current administration who are currently tasked with ‘wargaming’ a dollar crisis and the possible responses thereto. Sadly, we’re not terribly confident that such contingency planning is going to be particularly helpful in the current instance. It might even be counterproductive, as we discuss later.
Continued in part two.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]