Is the U.S. dollar’s Hegemony Assured in the Global Financial Crisis?
By Bob Wong, Vice President - June 14
The recent sovereign debt crisis in Europe has highlighted an inconvenient truth about modern paper money – none of these “fiat currencies” are backed by gold, including the U.S. dollar. Spiraling deficits in the large developed economies of the United States, Europe, Japan and Britain are unsustainable, and yet the dollar has somehow emerged unscathed and actually managed to benefit at the expense of other currencies. Why?
The US$ may re-assert its primary downtrend from some or all of the
following considerations:
- Global economic recovery and resurgent inflation
- U.S. interest rates remain excessively accommodative
- Inability of the U.S. economy to outgrow deficits
- Political deadlock over taxes, spending and entitlements
- Uncertainty over the Federal Reserve’s mandate in the economy
- Credible challenge to the dollar’s reserve currency status
- Investors’ appetite for U.S. debt wanes
Courtesy of the St. Louis Federal Reserve Bank1, a chart of the Trade Weighted Exchange Index of the U.S. dollar against Major Currencies tracks an almost four decade history of the dollar’s performance against its major trading partners, notably since the convertibility of the greenback to gold was suspended by President Nixon in 1971. Major currency index includes the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden. For more about trade-weighted indexes see http://www.federalreserve.gov/pubs/bulletin/2005/winter05_index.pdf.
The safe haven status of U.S. government securities and the dollar have been clearly evident since September 2008 when the Lehman bankruptcy unleashed a torrent of risk aversion that almost seized up global financial markets. Since then, the gradual economic recovery and easing of liquidity conditions have reduced the demand for the safety trade, until the European debt crisis exploded onto the front pages six months ago. Since then the euro currency has lost over 15% of its value against the dollar, but how long will the dollar continue to benefit from this “safe haven lift”?
In his speech to the Institute of International Finance in Vienna on June 10, George Soros raised the specter of an “Act II” in the global financial crisis2. Will the U.S. dollar continue to draw strength from a global financial system remaining vulnerable? The following considerations form part of the overall evaluation:
Global economic recovery and resurgent inflation
Indebted countries face three stark choices in their fiscal balancing acts: a combination of spending cuts and tax increases, debt default or printing money to pay off debt. With politicians always opting for the least painful, and the loss of independence of central banks, markets fear that money printing may appeal to an increasing number of governments which could re-ignite inflation. There are others who argue that deflation is more of an immediate threat with the massive debt loads. The debate between those who fear inflation and those who worry about deflation is far from black and white, and maybe more of a timing issue as the aftermath of the Great Recession of 2008/2009 has produced uneven recoveries in global economies.
Emerging economies like China, India and Brazil that have not been saddled with much debt have resumed growing at a fast pace, while the highly leveraged economies in the developed countries of Europe, Japan and the U.S. will experience much slower growth. Eventually, as global recovery takes hold and consumer demand returns, price levels in many countries will rise especially if fiscal and monetary stimuli are not removed in a timely fashion. Recently Chinese employers face increasing pressure from workers to increase wages. Higher labor costs coupled with higher raw material prices will stoke inflationary expectations and reverse the two-decade long downward cost pressure exerted by a vast labor pool. This could lead to higher prices for many consumer goods exported to North America and Europe.
U.S. interest rates remain excessively accommodative
While there are some encouraging signs from recent U.S. economic data that the recovery is taking hold, there is speculation that the economy left on its own without government stimulus spending may soon fall back into recession. The latest jobs report and retail sales figures in May speak to this concern. The highly leveraged nature of the U.S. economy makes it difficult and dangerous for the Fed to normalize interest rates which may put many borrowers at risk again. However, interest rates that remain excessive low at historical rates will inevitably lead to misallocation of resources, create new asset bubbles and ultimately accelerate and exacerbate the boom-bust cycles that have been a hallmark of the U.S. economy in the past decade.
Inability of the U.S. economy to outgrow deficits
For 2010 the U.S. will run an approximate budget deficit of $1.5 trillion3. In fact, aside from the deficit, the US national debt is also soaring. It stood at an historic high of $13 trillion on June 1 and, according to a recent Treasury Department report to Congress, could rise to $19.6 trillion by 2015, surpassing 100 percent of GDP4. In addition, the off budget unfunded liabilities of Social Security, Medicare, Medicaid, prescription drug benefits and government pensions have already exceeded $100 trillion5. Although the situation may appear dire, financial markets have so far been willing to give Uncle Sam a free pass because of the belief that the dynamic U.S. economy can grow out of its current problems. Every piece of economic data will be closely scrutinized in the coming months for signs of sustained recovery.
Political deadlock over taxes, spending and entitlements
The caustic nature of political squabbling in the U.S. over spending and taxes between the two main parties shows no sign of being able to rise above the bitter partisan divide even in the face of severe financial challenges. U.S. politicians have long ago learnt the lesson that telling the truth to voters does not necessarily get them elected, but making unsound promises at the expense of the state or federal treasury has guaranteed the return of many to their seats, election after election. The simple truth remains that spending is out of control and tax revenues are too low to provide all the services and entitlement programs that Americans hold dear. As long as the electorate is unwilling to hold their elected officials to high standards of competence, honesty and accountability the fiscal holes will only get deeper and deeper.
Uncertainty over the Federal Reserve’s mandate in the economy
Whatever one may think of Bernanke, the current Fed chairman, he has undoubtedly been the most proactive chief to wield the most creative and innovative tools to battle the most severe downturn since the Great Depression. However, there is a growing undercurrent of resentment against the Fed’s perceived sins of omission and commission, including its mea culpa to missed signals of the financial meltdown, and the rather unorthodox quantitative easing to expand its balance sheet. The financial reform bill now before Congress threatens to rewrite the governance rules pertaining to the Fed’s bank oversight responsibilities, and will put it under Washington’s tighter control6. Changing the Fed’s mandate will erode its independence and hurt its credibility with financial markets, and will inflict collateral damage on the dollar.
Credible challenge to the dollar’s reserve currency status
In a world of fiat currencies, no currency is backed by gold or silver but instead is only backed by the creditworthiness of the issuing government. The U.S. dollar has become the de facto primary reserve currency because of the strength of its economy and stability of its political system. It took many years for the U.S. to overtake Britain as the world's largest economy and the dollar to replace sterling as the dominant global reserve currency.
Despite the frequent demands by other countries to unseat the dollar as the primary reserve currency, the lack of a suitable alternative has so far limited the potential candidates to certain “baskets of currencies” like SDRs issued by the IMF7 which is not practical. For a country to have its currency accepted into global reserves, it must have a large and stable economy with well regulated and deep capital markets. It must have well codified laws and an independent judiciary. It is certainly helpful to be strong militarily and stable politically. The recent sovereign debt crisis in Europe has exposed the weakness of the euro currency in that monetary union without fiscal integration is an untenable situation.
Investors’ appetite for U.S. debt wanes
With bond yields at or close to historic lows, and the deficit and debt at historic highs, it is quite remarkable that investors continue to see value in U.S. treasuries, from 2 year notes yielding 0.73% to 10 year notes yielding as little as 3.23% lately8 . Only a pessimistic outlook on the recovery can justify an appetite for U.S. debt at current yields9. Nevertheless, as government fiscal positions come into focus it is nothing but a leap of faith that investors make when they decide to lend Uncle Sam money at such low rates of interest while deficits soar.
The relative attractiveness of currencies is not based on merit or fiscal soundness, but perhaps better explained in terms of a reverse contest where it is no longer the best who wins, because there are no good options, but the least bad that is tolerated. The safety trade which has benefited U.S. government bonds and the dollar since the beginning of the financial crisis may continue for as long as the European sovereigns and the euro currency are under pressure. However, a less optimistic outcome for the dollar cannot be ruled out (illustrated by the lines on the attached chart) over the medium term horizon, especially if a number or all of the considerations discussed above come to prevail.
Footnotes
1 http://research.stlouisfed.org/
2 http://dealbook.blogs.nytimes.com/2010/06/10/the-full-soros-speech-on-act-ii-of-the-crisis/
3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNaqecavD9ek
4 http://www.google.com/hostednews/afp/article/ALeqM5hsPL4NGlfgKk8qK-E2bGxpvPpCRQ
5 http://www.thecalifornian.com/article/20100612/OPINION03/6120326
6 http://www.economist.com/node/16168207
7 http://www.financialpost.com/story.html?id=3086360
9 http://www.reuters.com/article/idUSSGE65900A20100610
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.
The data and comments provided above are for information purposes only and should not be construed as a solicitation or offer or recommendation to buy or sell any financial instrument or to enter into a transaction. Although the information contained herein is assembled from sources believed to be reliable, its accuracy cannot be guaranteed. Past performance does not guarantee future performance. No chart, strategy, software, program or tactic can guarantee gains or avoid losses. No assurance can be given that trading objectives will be met. Futures and Forex trading involve a substantial risk of loss and are not suitable for all investors. Please carefully consider your financial condition prior to making any investments.
