Sunday, June 10, 2018

Explaining the Gravity-Defying Dollar

David Hale has an opinion piece in the current edition of TIME offering a counterpoint to my regular dollar-bashing fare. To say that I don't agree is putting it mildly. It all sounds too Cheneyesque to me in the "deficits don't matter" sense. His main arguments are these:

  • the dollar is not desirable but it's better than the alternatives (presumably other economies like those in the EU will fare worse);
  • unwinding of the carry trade boosts the dollar (assuming it was the main funding currency);
  • stabilizing the financial system will be good for the dollar - the budget deficit which will be run up to produce this result matter less;
  • the likes of China and Japan have no alternative but continue propping the dollar given their weak domestic consumption.
While I agree that deleveraging has benefited the dollar, it is fairly obvious that its strength should be measured not just against the euro. For instance, the Japanese yen was also a funding currency for the carry trade. And, over the period in question, it has gained against the dollar. My intuition is that given a spell of further carry trade unwinding, dollar weakness will resume. How sure is Hale that China and the rest would be glad to buy up the trillions of IOUs soon to emanate from America? We'll see soon...very, very soon.
The cost of stemming the financial crisis continues to soar. The U.S. Federal Reserve has already sunk more than $800 billion into the financial system...With the already lofty U.S. budget deficit now expected to top $1 trillion next year and recession a virtual certainty, you'd expect America's currency to be taking a beating. Yet amid the shocking developments of the past few months, the dollar has surprisingly gained strength. It has rallied more than 16% against the euro since its trough in early July and made impressive advances against the Australian dollar, South Korea's won and other currencies. There's a fairly simple explanation for this: it's not that people want to own dollars, its just that they want to own the alternatives even less. There's certainly nothing mysterious about the dollar's recent strength against the euro. Between July 1, 2006, and July 1, 2008, the dollar lost 19% against the European currency because the Continent's economies were outpacing America's. That's changed as Europe grapples with its own banking calamities and slumping markets — hence the dollar has bounced back after a very bad run. Less obvious is the support the dollar is getting from an unlikely quarter: global hedge funds and other nonbank financial entities. This shadow banking system has borrowed trillions of dollars to leverage its investments. But the crisis has triggered massive early loan repayments, and because these loans must be repaid in the U.S. currency, demand for the dollar has increased, driving up its value. It's not just hedge funds that are affected. Foreign banks, which hold $12 trillion in dollar assets and liabilities, are also in the process of deleveraging. All this helps to explain why the dollar has been stronger lately. But with the U.S. Federal Reserve cutting interest rates again and the U.S. Mint running its printing presses overtime to fund rescue packages, won't the dollar tank soon? Probably not. As the Treasury Department's $700 billion bailout plan is implemented, banks should begin to be able to restructure their balance sheets and regain the capacity to make loans at interest rates that will be attractive at home and abroad. While a U.S. recession looks unavoidable, the stabilization of the financial system should allow a recovery to begin next year. That's good for the dollar, too. But what's really good for the dollar is China, which has a couple of solid reasons to help maintain the stability of the U.S. currency. One is that China is one of America's biggest creditors; the country holds some $519 billion in U.S. Treasury bills (second only to Japan's $593 billion), and it doesn't want to see these investments eroded by a slumping dollar. In addition, China is increasingly worried that an economic slump in the U.S. and Europe will curtail its export growth, dealing the Chinese economy a serious blow. To keep the prices of its exports competitive, Beijing has reversed a policy begun three years ago that allowed its own currency, the yuan, to gradually increase in value relative to the dollar. After rising 6.4% during the first half of 2008, the yuan has been flat against the dollar since July. Moreover, while currency markets are complex ecosystems, it seems unlikely that countries such as China and Japan that have already loaned America trillions will stop buying U.S. government debt any time soon. They have relatively few tools at their disposal to keep their economies on track other than tending to the dollar exchange rate. China recognizes it has little choice but to go on financing the ballooning U.S. budget deficit by expanding its foreign-exchange reserves from $1.8 trillion to $2.3 trillion over the next 18 months. The message to dollar bears is clear: the grimmer the headlines are, the more misleading they can be. Selling the dollar short because of the financial crisis is not a sure bet. All economic news is relative, and right now the news is bad all over the world. Over the next several months, the greenback could even begin to look like a safe harbor in the midst of the global economic storm.

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