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Is The US Dollar About To Plunge?

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Recently, the US Dollar index (Wiki) fell below 80 again, which has happened quite often since 2007. This ongoing weakness of the Dollar could be a danger to the economic recovery in the US and to the solvency of the US government.

Economist Mark Perry (his blog) compares the personal savings of Americans to the “dissaving” of the federal government (see article here). In his chart, you can clearly see that there is a net deficit of about $600 billion when you add the two numbers together. This is the first time in history that personal savings are not nearly enough to (theoretically) fund the deficit of the federal government. But, if domestic cititzens don’t save enough, foreign investors, Chinese funds, for instance, have to provide the money.

This is where the problems start. The US Dollar has been constantly weakening for the last 20 years because Americans import more than they export. A large part of the US trade deficit comes from oil imports, which means that rising oil prices immediately lead to a weaker Dollar because markets expect the higher oil prices to translate into higher US trade deficits.

The “supply” of foreign investment demand is limited. High-yielding investments in Brazil or India compete with US consumer debt. Now the huge US government deficits also compete with private import demand from US consumers. The combined demand for foreign investors to pay for this American spending spree is as high as never before. Either US consumers reduce import demand or the US Dollar has to weaken, something’s got to give. US government bonds that offer 2.5% yield for 10 years are certainly not an attractive investment to foreign investors, if they expect the US Dollar to weaken considerably.

This begs the question whether the Dollar is going to plunge to new record lows. The reason why it hasn’t yet is probably that the worldwide economic crisis since 2008 has led to increased demand for Dollars as a “save haven currency”. Furthermore, many investors seem to expect low inflation, or even deflation, in the US. More and more people demand new Quantitative Easing measures to support a weak recovery.

If the recovery gains strength, with or without QE 2.0, inflation will increase and stocks will look more attractive. This would lead to a sell-off in government bonds and a decline in the US Dollar index, for a stronger US economy also means higher trade deficits. The sell-off in bonds and the decline in the Dollar could be self-reinforcing, leading to a collapse in the Dollar and serious funding crisis of the federal government.

If the US economy falls back into stagnation/recession mode, with or without QE 2.0, deflation will be more likely and bonds at 2.5% would look pretty attractive. Even foreign investors would rejoice at buying US treasury bonds because a weak US economy means lower oil prices, lower US trade deficits, and therefore, a stronger US Dollar.

To conclude, it doesn’t really matter whether the Fed introduces additional Quantitative Easing. The important thing to watch is whether the US economy gains strength, leading to higher inflation expectations. I think Bernanke knows this and he will therefore aim at the middle road. He will probably come up with some weak form of QE 2.0, something that won’t be strong enough to increase inflation expectations, but it will be useful to fixate long-term interest rates at low levels in order to prevent a blow-up of the housing markets and to prevent an insolvency of the US federal government. That way Bernanke would be able to pull back some liquidity from the financial system, if the economy were to recover more strongly in 2011.

Anyway, the US is going to have some big problems, either a prolonged stagnation (or even “double-dip” recession), or a government solvency problem. The US government has to lower its budget deficit to somewhere around 5% of GDP (now it’s at 11%) in order to prevent such a funding crisis. The incumbent Congress majority doesn’t seem to have such a plan laid out. Let’s see what happens after the midterm-elections.

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