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Monday, March 1, 2010

The Fate of the U.S. Dollar

Fears of a “great fall” in the US dollar are widespread, and with good reason. US Government debt took on ghastly levels during the credit crisis. China has threatened to stop buying US debt, partially because of valuation concerns and partially because of politics. OPEC has threatened to change to an alternate currency for the trade of oil if the US dollar continues to lose its value. The saber rattling is intense, and the statistics look grim. But will the “great fall” occur, and if so, when? To find out, we need to fully explore the facts, and their relationship to the dollar.

FACTOR 1 - Foreign Ownership and Trade Deficit

A current account deficit (when a country imports more than it exports) is a regular feature of the US economy. As long as the US is paying more to foreign countries than these countries are paying to the US, the US$ will continue to slowly decline. There is talk that because of this uncertainty OPEC and China are both considering moving away from investing in US dollars. The problem with this story is that there is no other currency that will suffice. The Euro has its own share of problems, with member countries having high debt levels. The Canadian $, Australian $ and other currencies cannot support the level of trade necessary. The US$ is, at present, still the only logical choice for International trade.

Direction –Short-term Neutral, Long-term Bearish


FACTOR 2 – The U.S. Economy

At present, the world is rife with bubbles. Canada, China, and to a lesser extent the U.K. are experiencing housing bubbles. China also has a stock market bubble. Gold is firmly in fear territory. Paradoxically, what is usually the safest of the safe (T-bills and gold) are now amongst the riskiest.

The US economy, on the other hand, is in good shape for the future. Major asset bubbles have already burst. Unemployment is high but stabilizing. Home prices are already low and getting lower, to the point where an average-income family (with good credit) can once again comfortably afford an average home. Citizens are, for the first time in years, paying down their debts and saving. The banks have recapitalized and have greatly reduced their leverage. In short, the U.S. has experienced a great deal of pain, and is now trudging slowly toward recovery. This recovery is likely to firm at the same time as other bubbles in the world begin to burst.

Direction – Short-term Bullish


FACTOR 3 – Demise of the Carry Trade

For the past two years, financial institutions around the world have taken advantage of low US interest rates, using the US dollar for “the carry trade.” The carry trade is the name given to taking out loans at low interest rates, and using these funds to invest in higher interest investments elsewhere (often in another country). For example, say a hedge fund in Singapore takes out a loan in US dollars. It may then convert the funds to Euros and invest the money in a German bond that pays a higher interest rate than the rate on the US loan. The result is “free money” to generate income.

Because of the carry trade, many US dollars have been sold (converted to other currencies). When the Fed starts raising interest rates, the US$ carry trade will reach a point where it is no longer profitable and hedge funds will have to pay back their US loans. That is, once US interest rates begin to rise, there will be a rush to exchange foreign currencies for US dollars to pay back loans, boosting demand for the US$ and therefore price.

Direction – Short-term Bullish


FACTOR 4 - US Debt

The US, during the credit crisis, built up a huge amount of debt. Many worry that this will give the US an excuse to print money and debase the currency (since it’s better to pay back debt with dollars that are worth less). This reasoning is faulty for two reasons: the nature of the debt, and relative value.

Although the Government spent a lot of money during the credit crisis (and before it), the amount of money spent is of little relevance. What is relevant is the return on capital. That is, for every dollar spent, how much economic prosperity will that dollar create? Spending on such things as education and infrastructure (roads, communications) is important not only because it creates jobs immediately, but also because it leads to greater economic prosperity later on (rather like spending money on a University education). The recent spending spree may or may not create a good long-term rate of return – the verdict is still out.

Many people believe that the money the US Government leant to banks is “gone.” That is, that it was given to the banks and they spent it, and that it will now take years for them to pay it back. This is nonsense. Money was given to the banks because banks are required to keep a certain level of collateral on their books in order to operate (known as a Tier 1 Ratio). The money given to banks was simply deposited into the bank’s accounts so that they met the requirements to continue banking and giving out loans. Of the 2 trillion dollars given out for liquidity during the credit crisis, all but 100 billion has already been repaid, and the Fed fully expects the rest to be paid back sooner rather than later. The US taxpayer has not lost a dime in this endeavor.

Relative value is the fact that currencies are valued compared to each other. Although the value of the US dollar has dropped relative to, say, gold, it has retained reasonable stability relative to most other currencies. This is helped by the fact that Europe, Dubai, Canada etc. have recently run up their debt levels just like the US has (or worse). So, while US debt may be a matter of concern, it isn’t necessarily a concern for dollar valuation. In this regard, it is notable that whenever bad headlines hit the news, the US dollar rallies: that is, when trouble strikes, investors from all over the world still seek the safety of the US dollar.

Direction – Short-term Neutral, Long-term Unknown


In conclusion, although US debt levels and trade imbalance are matters of concern, the short- and medium-term case for the US dollar is strong. The US is on the road to recovery, effectively two years ahead of the rest of the world. And, when the Fed begins raising interest rates the carry trade will collapse, urging the US dollar up.

Though the long-term crystal ball remains cloudy, the imminent demise of the US dollar has been greatly exaggerated.


“The commodity value of the circulating media (paper money) is zero.” Binhammer and Sephton: Money, Banking, and the Canadian financial system.