Where Is the U.S. Dollar Headed?

The Economist — Dec. 2, 2006

A recent cover of The Economist highlights the renewed bearish sentiment. Magazine covers in general, and Economist covers in particular, have a nasty habit of marking major turning points:

Remember that it was “The Incredible Shrinking Dollar” cover of Newsweek that marked the bottom of the U.S. dollar in 2005 to within a week or so.

We also see big specs plowing heavily into both the British pound and the euro, and the unwinding of those trades (which I think will happen) would be supportive of the dollar.

On the other hand, we still see a carry trade in the yen and Swiss franc, which has negative implication for both the U.S. dollar and U.S. equities if and when that trade unwinds.

Dollar Weakness vs. Interest Rates

In an extremely misleading report, I see the following headline: “Dollar Weakness Poses Growth Risk”:

“Excessive weakening of the U.S. dollar could lead to interest rate hikes in the United States, Europe, and Japan and hurt global economic growth, OECD Secretary General Angel Gurria said on Monday.

“The imbalance between a huge current account deficit in the United States and surpluses in Asian countries and oil-exporting states is prompting investors to move out of the dollar, Gurria said.

“‘What is happening now is a manifestation of this process,’ Gurria told reporters in Madrid after meeting Spain’s foreign minister in Madrid.

“‘If the dollar falls in a disorderly or excessive fashion, it will trigger rate hikes in the United States, and this could be reflected by rate hikes in Europe and/or Japan, and growth could slow,’ he added…

“Gurria said the United States was not doing enough to lower its current account deficit, even though strong U.S. growth had allowed the country to cut its fiscal deficit.

“‘You’ve got to ask the question whether anyone is worried or not, if the issue is being resolved,’ said Gurria. ‘The current account deficit continues.'”

It is NOT a weakness in the U.S. dollar that may cause interest rates to go up; it is excessive expansion of money and credit within the U.S. that is causing the U.S. dollar to drop. It is imperative for people to put the horse before the cart, but as simple as that may seem, nearly everyone puts the cart before the horse.

If and when the U.S. stops blowing trillions of dollars it does not have in Iraq and other places (God knows when), and if and when U.S. consumers toss in the towel and stop buying more junk than they need (likely right now), the situation will change.

Even still, the biggest factors on whether or not a currency rises or falls are:

  1. Relative expansion of money and credit versus other countries.
  2. Interest rate differentials versus other countries.

Notice that the trade deficit is not on that short list. And as difficult as this may seem, credit is expanding as fast, if not faster, in the E.U. than in the U.S. Furthermore, interest rates are still sitting at 0.25% in Japan, versus 5.25% in the U.S. This is hugely supportive of the U.S. dollar (at least until the carry trade blows up).

Once again, let’s turn to John Succo, one of my favorite professors on Minyanville, to see if we can shed some additional light on this situation. On Dec. 5, addressing a reader question on dollar weakness versus deflation, professor Succo wrote:

“I am wrestling with ‘can central banks induce a round of hyperinflation, or has it already passed?’ My conclusion, however, is the same: Every hyperinflationary period (rising nominal asset prices) eventually is followed by a deflationary bust (the last bottle of booze). We are all trying to figure out where we are. But make no mistake: The weight of all that debt created by central banks will at some point be too much to bear.

“All this credit has created a series of ‘bubbles’ in asset prices. The Fed is disingenuous when they say they don’t try to prevent them, but manage the aftermath. They actually consciously create them as a means to continue speculation and debt growth. The last was supposedly the real estate bubble, because it is the largest asset market. But it turns out that the last one might not need one large asset class to ‘get liquidity into consumers’ pockets.’ It may not even be based on generating consumption.

“Perhaps the last bubble involves all asset classes and is being accomplished through monetization. The Fed creates credit and then borrowers take that credit and buy Asian goods. They need an asset class, like real estate, as collateral for that borrowing. Then they spend any excess liquidity driven by higher asset prices and spend it.

“Those created dollars are being sterilized by foreign central banks accomplished by their creating more credit and then buying U.S. securities. Perhaps we are now seeing that last bubble: foreign central banks buying all kinds of private assets like corporate bonds, mortgages, and, yes, even stocks with that credit.

“So the last bubble morphs from a consumption bubble to a speculation bubble.

“This does not seem to bother some as it does me. What happens when governments buy private assets and crowd out private investment? You get excessive risk-taking, of course; everyone goes into debt even more.

“I paraphrase Mr. Steve Galbraith when he said, ‘Investors have reacted rationally to free money (negative real interest rates). They borrow it. Debt is good when rates are negative.’ I still wrestle with this comment. It sounds right, but in the end, I do not think it is. It sounds right when you look only at return. Of course, it is rational to take money at a negative interest rate and lend it back out at a positive one. I have described the yen carry trade as this, but there are ever increasing risks associated with it. In order to get that free money, there is currency risk: long dollars and short yen. There is no free lunch. So when investors take that “free money,” they risk default when rates return to normal. So when risk is factored in, the risk of losing all, taking free money may not be so rational.

“And so when governments buy risky assets, they in a way force private investors to take risks that are not rational. LBOs are done that make little economic sense and redistribute wealth by destroying it in the future. Hedge funds are given so much liquidity they speculate.

“The bottom line is as credit expands, nominal asset prices rise. But as credit expands because it is created, and not generated by normal economic activity, the debt reaches a point where it can no longer be supported. Central banks are just finding more creative and dangerous ways to cajole markets into taking more credit.

“I do not know when this point will be reached (deflation). There are signs now of excessive speculation, but I saw that awhile ago too. But it is cumulative, so we know from deduction that we are getting closer and closer. When deflation does kick in, the dollar will rally, yes. But that may be from much lower levels.

“The only thing we can be sure of is the degree to which this situation has risen. The imbalances are immense.”

Hmmm. Are the imbalances immense, or are they insane?

In regards to the U.S. dollar, one must remember that all fiat currencies are eventually doomed. That, of course, does not preclude a massive deflationary collapse first. In the meantime, one needs to remember that interest rate differentials and credit expansion matter most and the odds of additional rate hikes by both the U.K. and Europe may be overstated.

The International Herald Tribune is reporting, “ECB Raises Its Key Interest Rate to 3.5%”:

“The European Central Bank raised its key interest rate by a quarter of a percentage point, to 3.5%, on Thursday, despite strength in the euro that some analysts have feared could stunt economic growth and hurt exports.

“But if some are worried, ECB President Jean-Claude Trichet was not.

“Trichet, who oversees economic policy for the region that accounts for nearly 15% of the global economy, promised to keep a close eye on inflation, but resisted any temptation to try to talk the euro down.

“While calling ‘disorderly’ currency movements undesirable, he did not say how the euro’s level near 20-month highs against the dollar might affect monetary policy and said people should let the markets judge the euro’s exchange levels…

“The Bank of England, meanwhile, held its key interest rate steady at 5% on Thursday, a decision that was widely expected after increases in August and November took rates to the current five-year high.

“Speaking after the ECB announced its sixth quarter-point increase in 12 months, Trichet said the bank will monitor inflation ‘very closely’ – a signal that another increase next month was unlikely, but leaving the way open for an increase in February or March.”

The reason another rate hike in the E.U. is unlikely is that Trichet did not use the word “vigilant,” which has been his signal that he intends to tighten further. Note too that the U.K. passed on the chance to hike yet again. The key question here is what is the market expecting?

If the expectation is for more hikes in Europe and the U.K. and for cuts to occur in the U.S., and that expectation does not happen, look for the U.S. dollar to rally. It may rally anyway, based on current sentiment. To put my neck on the line, I suspect the U.S. dollar will hold the 80 level (or perhaps do a head-fake below, then reverse). Longer term, the U.S. dollar is indeed toast, but that can be quite a way off from here.

In regards to a deflationary collapse of the stock market, once again, the question here is timing, and of course, timing is nearly everything. That said, the amazing thing to me is that most do not even see the risks, let alone are they concerned about the timing of the upcoming debacle.

Yes, I have been raising the caution flag for some time and the taunts are now getting shrill. “When Mish? When, when, when, when? How long have you been calling for this now? When is it coming, Mish, when?” I received a post almost exactly like that on Silicon Investor last week.

Shrill taunts out of the blue often accompany major market tops or bottoms. Let’s see if history repeats. In the meantime, one has to decide whether or not to play the “greater fool” game or not. Many that played that game with Florida condos are now facing bankruptcy. Others still haven’t the faintest clue as to what the risks even are.

It’s one thing to knowingly play the “greater fool” game. It is, of course, another matter to be playing the game and not even know it.

December 8, 2006