The dollar has continued its precipitous decline this week with the USDX trading at 76.267 as we write, yet many U.S.-based investors appear oblivious to what this may imply.
The USDX is a measure of the value of the U.S. dollar relative the currencies of six major trading partners: the euro, Japanese yen, Canadian dollar, Swedish krona, British pound, and Swiss franc. Started in 1973 at a value of 100, the USDX was trading at over 120 when the U.S. celebrated the changing of the millennium. The 44 point drop is a precipitous one in only a few short years, with 11.28% of that having occurred in the last 260 days.
Why is everyone backing away from the dollar? We think the reasons are many and downright compelling.
The housing market continues to deteriorate at a steady and deliberative pace. Many have misdiagnosed the slowness of the decline as an indicator that the consequences will be mild, but such a view fails to consider that foreclosures take time to reset the price floor, and also that the worst in the housing market — the adjustable rate mortgages (ARM) bonanza that really gained legs about two years ago — is only starting to rear its ugly head in earnest as the critical mass of 2-year ARM resets gain steam over the next twelve months.
So, while many have argued over the last year that housing was was nearing the end of its decline — with the many today suggesting the bottom is in for subprimes , I’m sticking to my previous comments that the slide has a long way to go, and that it will lead us into a fairly unpleasant recession. Now that I have more company with some of our other bearish predictions, fare more dollar holders are growing increasingly skeptical of the official talk of a strong economy and business led growth coming from the Fed, the Treasury, and other U.S. economic cheerleaders. It seems they’re finally catching on that such comments are about as reliable as previously bullish comments from the same bunch about the strength of the U.S. housing market and the mortgage banking system back in March.
Meanwhile, a large part of this nosedive in the dollar is a classic inflationary response to the extreme liquidity provided by the U.S. banking system at the behest of the Federal Reserve over the last decade (which is really an extension of policy set in motion with the final knife in the gold standard back in 1971). While I’m still among the fringe fingering Breton Woods II, I’m no longer am I among only a handful of voices criticizing the Fed for the more recent policy. More are now echoing warnings that easy money created the housing bubble as part of a broader, massive credit bubble. Many are even actually connecting easy Fed policy with rising prices.
To be clear, many have missed (and still continue to miss) the correct diagnosis given all that easy credit and money-supply vented in such a way that it appeared as as if Alan “Merlin” Greenspan had discovered alchemy in the basement of the Fed. For a while printing money and expanding credit out of thin air could actually be transmuted into cheap goods.
So long as this fresh inflation could be vented abroad and into emerging economies through our gargantuan twin trade and federal deficits, and then invested in fresh production capacity, for example, in China and run by labor paid only a fraction of U.S. wages, alchemy is exactly what U.S. consumers got: cheaper and cheaper imported goods despite a Fed policies that printed money and expanded credit.
But, alas, all free lunches come to an end, and all those dollars are now chasing hard assets and natural resources that cannot be printed so easily as a fiat currency. Hence, it comes as absolutely no surprise to critics of the easy money bailouts currently being engineered to prop up the unsustainable mortgage values that previous doses of liquidity created, that since 2000 the dollar has been plummeting not only vs. other currencies, but especially against oil, gold, and other hard asset hedges against inflation.
That developing problem is compounded by massive foreign dollar holdings in the coffers of trade deficit beneficiaries like China, who holds nearly $ 1.4 trillion of dollar denominated assets — much of it in U.S. treasuries and other forms of debt. For those not familiar with what’s been going on, Chinese companies earning dollars have few uses for them. They, therefore, exchange them for the local Chinese currency — the yuan. Absent intervention by the Chinese central bank, such selling of dollars and buying of yuan in the open currency markets would have decreased the purchasing power of dollars as supply increased in the face of falling demand, while it increased the power of the yuan as demand increased amid a shrinking supply.
Yet, a weakening dollar would have reduced exports to the U.S., so the Chinese instead printed yuan out of thin air to exchange for the dollars its country earned from the U.S. consumer. The Chinese central bank then converted many of those dollars by buying U.S. Treasuries and other forms of debt. They did so primarily to maintain their export flows to the U.S. as a form of vendor financing, hence there was little concern for the rates being paid on what they loaned to U.S. borrowers. The massive U.S. deficits provided the Chinese with a great deal of demand for U.S. debt, becoming a circuitous system of the Fed monetizing U.S. debt via the housing market. That included home equity withdrawals (HEWs) over the last five years , which were in the $ trillions thanks to low rates and easy lending. HEWs, in turn, encouraged trade deficit consumption, which was then recycled back into U.S. Treasuries, which on the middle and longer ends today remain at near 50 year lows as they have for over three years.
Now, this is a problem for the Chinese. Consider that by holding dollar assets, they’ve lost tremendous purchasing power in other nations, including those in the USDX and others, such as Canada and Australia. Moreover, Chinese citizens — and any citizen in the world whose currency is pegged to the dollar — is, thanks to the inflating their own banks have done to keep their currency pegged to the falling dollar — are feeling the full brunt of the dollar’s plummet vs. hard assets. Consider, oil was trading around $30 in 2001 and is today trading at $95.50. If invested over that time in Euros instead, the costs would be nearly 40% lower!
In other words, such nations have been subsidizing their export sector and the U.S. consumer at the expense of their own citizens! That’s a deal that is getting more difficult by the day to justify, and many small nations have begun backing away from existing support levels for the dollar. That is why the dollar broke through prior downside resistance points when the Fed signaled it was going to provide easy money to the credit markets with the .50% Fed Funds rate drop, a situation worsened by this week’s .25% cut and $41 billion bailout announcement. Easy Fed policy means more dollars in circulation, and given so many foreign nations still officially peg their currency to the expanding supply of dollars, the dollar situation will only get worse as the peg ratio in those nations are finally adjusted to prevent the U.S. from exporting further pain.
Unfortunately when it comes to inflation, there is a genie in the bottle element to inflation when it comes to the expectations of the marketplace. So long as the powers that be can manage expectations, actual prices may fail to consider the true nature of an expanding supply of currency. However, we must admit that Mr. Market seems to have caught a waft of Weimar in the air given the recent flood of articles catching on to this trend that has only been gaining momentum since 2000. Titles like “Everybody hates the dollar” and “Why the Fed’s rate cur should scare you” are indicators of the masses catching on, even if rising prices and falling dollars leave you confused about the monetary phenomenon inflation really is.
Meanwhile, you must consider China’s price-cap-created fuel shortage as an indicator of how unsustainable the current arrangement is. The Chinese authorities thought they could hide the consequences of their bank policies by capping the price of fuel. Yet as all socialists do, these policy makers failed to grasp the purpose of the prising mechanism. Prices rise to reflect scarcity, sending a signal to entrepreneurs that there is a premium to be paid to those able to resolve a shortage. By capping prices by fiat in the face of skyrocketing crude prices, the authorities created the opposite effect: the perfect disincentive to bring fuel to market given it would be sold below cost at a loss!
Throw into this stew a United States whose foreign policy is leaving it further isolated among the nations of the world. We should not forget that, while the U.S. prefers to dictate its interests abroad — especially now in the Middle East on a myriad of issues beyond Iraq and Iran (such as the Caspian Basin oil region) — the United States has grown exceptionally dependent on financing its activities through foreign lending that has been generously forthcoming at interest rates well below historic averages. Without question, many nations, correctly or not, view the United States’ foreign policy as an imperial one, and must reconcile their own interests with those of the U.S. in consideration of their dollar policy. Surely, U.S. citizens should recognize the precarious nature of making unilateral demands all around the world and then asking for foreigners to finance U.S. foreign policy clout at below-average interest rates.
These last issues lead us to believe that eventually foreigners will tire of supporting the dollar. This will only exacerbate an already precipitous decline of the dollar relative to other currencies, and finally prevent the U.S. from exporting a large port of the negative consequences of decades of dollar printing. Combine that with the stew brewing in the global credit markets, where ever-expanding credit is required to support asset values that are having increasing difficulty fighting gravity — well, let it suffice to say the landing may not be so soft as many suspect.
What does that mean for folks looking out for their own interests? It means coming to terms with a substantial paradigm shift. A good understanding of history, government policy initiatives, and inflationary relationships will go a long way in preparing for the coming storm.
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