The Dollar’s Decline

As if right on cue, given my comments yesterday about the US fiscal dilemma, the dollar has begun to take a beating in the currency markets. It is quite possible that this is the beginning of a long decline, lasting a few months, so it’s worth reflecting on the root causes of the decline. Two words: recovery and deficits.

One of the ironies of the past year or so is that the dollar has held its ground in value because the US economy, and hence its currency, was seen as a ‘safe haven’. The worse things looked in Europe and Asia, and especially the worse things became in the emerging economies, the better the US looked even though it was seemingly tottering on the brink of a new depression. This is even more ironic when we consider that the US was the cause of the worldwide melt down. Nonetheless inflows of cash flooded into the US as foreign investors sought to protect themselves against even worse conditions elsewhere.

This flood of money not only protected the dollar against decline, but actually boosted its value. It also helped the administration in its ongoing fight against the recession because it made it easier to issue bonds and other Treasury securities in order to fund the burgeoning deficit.

The only area where the dollar’s relative strength was a problem was in trade where it hindered efforts to boost exports, although it also made imports cheaper. Parenthetically: cheaper imports also lowered inflation and added to our original fear of deflation. But, given the collapse in world trade, the dollar became an issue to neither exports nor imports: there simply wasn’t anything to do about trade. Any dollar effect was swamped by the drop in worldwide demand.

Now though things are changing.

As fears of further decline in activity abate, and as confidence starts to re-appear, the ‘safe haven’ effect will wear off. Investors will start to look for returns based onfactorsother than just safety and so will start to pull their money out of the US and re-invest it elsewhere.

The consequences of this will be twofold: the dollar will decline so as to keep dollar denominated assets attractive relative to assets based in other currencies; and, possibly more importantly, US interest rates will start to creep up because investors will demand a higher return in order to retain all the US bonds they bought last year and earlier this year.

This latter issue is magnified by the sheer volume of bonds we have been pumping onto the market. It isn’t just that the US has been running an extraordinary budget deficit, but the Federal Reserve Board has been engaged in an equally unusual monetary policy called ‘quantitative easing’. Under this policy the Fed has been trying to pump money into the economy by buying up bonds – it pays in cash for the bonds and so adds to the money supply. This has to be a temporary procedure because it implies a potential upturn in inflation we want to avoid, so the markets are expecting the Fed to reverse course at some point in order to stave off this inflationary effect. The implication is that all those bonds will have to be sold back into private hands and this, obviously, adds to the supply of US government bonds in the market. Hence the need for higher interest rates to attract buyers for those bonds.

As you can see the administration will have to tread delicately in order to make sure it can extricate itself from the fiscal hole it now finds itself in without spooking the bond market. The best way to do this will most likely be to make a strong commitment to reducing the deficit quickly, say over the next four to five years.

In any case the dollar will fall. The surfeit of US debt on the market and the loss of the ‘safe haven’ status will combine to keep the downward pressure on for a while.

This is why I don’t think there’s much upside left to the dollar until the world economy is humming along again. And that seems to be quite a way off.