US Dollar Update – 2009 Half-time Report
By Bob Wong, Vice President - June 30
As the first half of 2009 draws to a close, the US dollar finds itself once again under pressure in the foreign exchange market. To the casual observer, the counter-intuitive move in the past nine months that first sends the greenback soaring abruptly during the height of the global financial crisis, only to see it deflate as the crisis abates, is absolutely untethered to reality and simply defies common sense. To the veteran observer of the forex market, this is exactly what makes foreign exchange moves appear so random, and currency rates so notoriously difficult to predict.
A currency emblematic of the flawed financial system that brings the world to the abyss should be justifiably shunned. Yet, in the face of rapidly rising liquidity, counterparty and systemic risks in the fall of 2008, the ensuing stampede to de-leverage and exit all investments in favor of ultra-liquid, ultra-safe U.S. treasuries has driven down yields (a move lately reversed, to some extent) across the curve and lifted the US dollar, creating the ultra irony that the one government whose lax, dysfunctional and incompetent regulatory regimes are most responsible for condoning the financial shenanigans precipitating this crisis is now reaping the rewards of this perverted outcome: ultra-low borrowing costs for the U.S. Treasury.
Many market watchers argue that the panic phase of the global financial crisis producing this anomaly would only give the US dollar temporary reprieve. In due course, the market will size up Obama’s initiatives to spend, lend and commit up to $12.8 trillion to the bailout, and factor in the costs of his ambitious agenda for healthcare reform and climate change. Ultimately, the fate of the US dollar will be inextricably tied to the federal government’s ability to manage its growing debt and control its runaway deficits. With the latest U.S. budget deficit projected to quadruple to $1.85 trillion, the appetite of investors to fund the gargantuan U.S. debt comes into sharp focus.
Foreign creditors led by the Chinese and Japanese who have funded massive public and private U.S. debt are understandably concerned with unprecedented spending from the Obama administration to stimulate the economy. Like many other economies, the U.S. is in a deep recession. Federal and state revenues are collapsing; the tax base is eroding as unemployment rises and corporate profits plummet. With politicians who are loath to raise taxes and an electorate accustomed to its entitlement culture, there appears to be no alternative but to increase borrowing from international investors to finance a national debt projected to double in the next 10 years.
Of all the foreign governments invested in the U.S., China is the largest holder of treasuries and agency debt. A once symbiotic relationship where voracious U.S. demand has helped China foster its industries and build large external surpluses; low cost Chinese manufacturing has returned the favor by lavishing on the U.S. consumer cheap imports and cheap credit, through the endless recycling of Chinese surplus into U.S. debt. However, in recent years this relationship has highlighted the vulnerabilities on each side: China’s investment in U.S. debt is exposed to rising currency and interest rate risks while the U.S. economy becomes more and more beholden to a foreign paymaster in distant Beijing, a politically unpalatable situation that feeds paranoia on Capitol Hill.
Although there are many structural problems facing the U.S. that could eventually threaten its credit rating and undermine its currency, the absence of a close runner-up to unseat the greenback from its perch as the world’s primary reserve currency will slow down its much heralded demise. Recently much news has been made of China’s purchase of commodities to increase its strategic stockpiles; seen as a surreptitious move away from the US dollar. However, Chinese officials have also signaled their intention to continue buying treasuries if the currency remained stable, which suggests a delicate balancing act to diversify without sparking a panic that could jeopardize the value of its $1.4 trillion of investment in U.S. assets.
Currency forecast is fraught with peril not only because economic events that underpin currency movements are difficult to predict; but market reaction to such events, even if correctly forecasted, is always subject to the psychology and interpretation of traders at the time which present another layer of challenge. Furthermore, the injection of politics into exchange rates always heightens the schizophrenic and erratic behavior of the market, with official statements that oscillate between despising the US dollar and loving the US dollar the most recent examples of doublespeak that add to the mighty confusion.
Nevertheless, since the beginning of the global financial crisis, the currency market has been moving in lockstep with global equities. The thinking is that, when growth does return, the U.S. economy will be too bogged down in debt to participate in any recovery which will mostly occur in the emerging markets, and thus the underperformance of the U.S. vis-à-vis the BRIC economies. To a lesser extent, the old economies of Europe and Japan will also lag in any nascent recovery.
So when global equities rally on the sighting of green shoots, the US dollar comes under pressure while commodity currencies like the Brazilian Real, the Australian and Canadian dollars trade with an upward bias. However, any reversal of recent signs of economic improvement might not generate much euphoria for the US dollar, unless there are further cracks in the financial system. The outlier could be an unanticipated quick re-ignition of some sectors of the U.S. economy that would restore a premium to the U.S. dollar. Another shock that could upset the current balance might come from a serious escalation of the H1N1 pandemic resulting in the widespread blockade of goods and people, but the impact on the currency market will be subject to many variables.
Lately, the US dollar has taken on a different personality that seems to be more sensitive to bond yields and auction results, as the tsunami of Obama spending initiatives come to the forefront. In the latest FOMC release, the market looks for language that would reveal the Federal Reserve’s inclination for further quantitative easing which could lower yields and thus the cost of borrowing for consumers, albeit at the expense of stoking inflationary expectations down the road. As things stand today, the consensus view for the US dollar is gradual depreciation in the medium term in response to the deteriorating fiscal picture, but the prognosis over the next 6 months is as divided as it was in the beginning of the year.
About the Author
Bob Wong is Vice President of MF Global and works from the Toronto, Ontario office. He is a seasoned foreign exchange professional with over 25 years of experience as a broker and a trader. Mr. Wong is head of the online FX division for MF Global Canada and works closely with brokers and clients. If you would like to learn more about currency trading please contact Bob Wong via the MF Global website.
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