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Whither the USD?



November 14, 2008 – Comments (3)

This is just an excerpt, and I recommend Fools follow this link to read the whole article with graphs... then come back and tell me what you think.

Whither the US dollar? by Ronald SolbergNovember 03, 2008 US dollar Appreciation
The US dollar as measured against six major world currencies has appreciated approximately 19% during the last three months through end-October. In particular, the US Dollar index stands at 85, up from a recent low of 71.3. This trend reversal takes the US dollar’s valuation back to levels not seen since October, 2006 and represents nearly a 38.2% retracement from its index peak of 120 in January, 2002; by any measure a significant move and one largely unexpected by the financial markets both in terms of its timing, speed and magnitude.

What has caused this abrupt appreciation of the US dollar during the past quarter and what can we expect over the next 12-24 months? There are both fundamental and technical reasons that have been US dollar supportive in the past several months.

Fundamental Factors
First, the seven-year decline in the US dollar’s value through July 2008 improved US competitiveness and, once the J-curve effect dissipated, has led to an acceleration of export revenue.  Slower GDP growth is also allowing imports to decline. These two effects have begun to stabilize the US trade deficit in nominal terms and allowed net exports in real terms to contribute 1.1% to Q3 2008 GDP growth.  The shrinking trade deficit has also contributed to the narrowing of the current account deficit. By pumping fewer US dollars to our foreign suppliers, this narrowing is shrinking global liquidity and creating further support for the dollar.

A second fundamental reason for US dollar strength has been an improvement in US terms-of-trade: the ratio of export prices over import prices. Since the United States is a net energy importer and this cost represents a significant portion of total import expenditures, the recent decline in crude oil prices has been a boon to our terms-of-trade. The improvement in US terms-of-trade has also supported the US dollar.

Thirdly, it is suggested from viewing the highly unusual negative break-even yields for inflation-linked bonds (TIPs) that investors believe the US will suffer deflation, not inflation, for the foreseeable future. This expectation for a declining price level, as a corollary, also creates the expectation for US dollar appreciation. This is because, once the currency depreciates in real terms, there is a tendency for the currency to appreciate in nominal terms to compensate for the price-driven depreciation, especially given that the notional rise will not undermine international competitiveness. 

Technical Factors
Perhaps the most important driver of the US dollar’s recent appreciation is not a fundamental but a technical factor. The meltdown of prices in the commodity complex, particularly energy, has generated a very strong impulse for US dollar strength. Whilst many commodity end-users were outright cash buyers, other buyers that were investing or speculating in commodities as a newfound asset class over the past five years would typically fund their position with US dollar-denominated credit, in effect, creating a US dollar short position. Now that these commodity carry trades are being unwound, it exacerbates commodity weakness and contributes to US dollar strength.  In addition, US investments in foreign markets, particularly equities, were primarily un-hedged and large amounts of those monies are now being repatriated which holds similar bullish US dollar effects.

Dollar Strength Sustainability
How sustainable are these four fundamental and technical factors in underpinning US dollar strength?

The trade and current account deficits should continue to narrow for several more months or perhaps quarters. As the US economy falls deeper into recession, imports should begin to decline more precipitously due to declining volume. This collapse along with rising export receipts will narrow the trade deficit and continue to lend support to the US dollar.

Despite the US dollar supportive narrowing of the trade and current account deficit, the pace of improvement may begin to slow for several reasons. First, once the prices of energy and other commodities stabilize, trends in import prices will no longer help lower overall import expenditures. Furthermore, stabilized import prices will also stop contributing to improved terms-of-trade. Second, it seems that a synchronized global recession is on the horizon. If so, then exports will once again decelerate despite US dollar competitiveness. As the growth of economies representing our important export markets slows or even falls into recession, weaker export growth will result. The combined effect of these counter-veiling trends is that the incipient narrowing of the US trade deficit may be short lived.

Perhaps the key factor will be the length of the time it takes for global de-leveraging to run its course. No one knows precisely how long it will take for investors and speculators to unwind US dollar-denominated commodity and other carry trades. It could be one month or half a year. However, once complete, the strongest driver for recent US dollar strength – de-leveraging -- will dissipate. At that juncture, FX traders and investors will once again re-focus their attention on the supply of US dollars being pumped into the US economy and on the global system and investors’ willingness to hold additional Greenbacks in their portfolio.

The weight of US dollar supply
It is beyond the scope of this paper to itemize the growing cumulative costs of the various aspects of the bailout.  Suffice to say that the supply of US dollars is dramatically growing and measured in the trillions. To best measure this aggregate growth, lets look at the growth of the Fed’s balance sheet and the monetary base.

After remaining relatively stable for more than a year through August 2008 at around $825 billion, the monetary base has exponentially exploded. BCA has recently highlighted that in the past eight weeks, the monetary base has grown 38% to $1.142 trillion, and shows no signs of slowing down.1 Yet these reserves injected onto the balance sheets of the banks have not been disseminated into the broader economy. This is apparent by the ratio of M2 to base money, which over the same time period since end August, has plummeted from 9.1 to 7.8 (see Charts 1 & 2). This is not surprising since most of the capital injected into banks has been used to repair and shrink the balance sheet (i.e., write-off bad assets) rather than expand it.  So fractional banking’s normal stimulatory impact through the money multiplier has by-in-large not been activated.


3 Comments – Post Your Own

#1) On November 14, 2008 at 4:35 PM, barich1 (42.16) wrote:

Probably the best article I have read explaining what seemed like a mysterious rise in the dollar at a time when it should be doing just the opposite.

Can somebody explain this sentence in simple terms, it seems rather important:  Whilst many commodity end-users were outright cash buyers, other buyers that were investing or speculating in commodities as a newfound asset class over the past five years would typically fund their position with US dollar-denominated credit, in effect, creating a US dollar short position.

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#2) On November 14, 2008 at 5:01 PM, GNUBEE (< 20) wrote:

The buyers felt that the future price of commodities bought would be greater than that of the dollar (denominated credit)

They borrowed dollars which they felt we going to lose value, (shorting) and bought commodities that they thought were going to appreciate. As long as the dollar fell in value relative to the commodities it was win win (win on shorting the dollar, and win on buying an appreciating asset)



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#3) On November 15, 2008 at 11:14 AM, nuf2bdangrus (< 20) wrote:

Whenever you buy an assett class (stocks, gold, commodities) in US dollars, you are in effect, shorting the dollar.

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