FYI | Oct 31 2007
About four years ago -50 months to be precise- I wrote a column for what was at the time Australia’s newest monthly financial magazine. The title above my story read “Goodbye to the Greenback?” and my concluding sentence was: “It could well be that the reign of the US dollar is coming to an end”.
As it turns out, I was correct in my assumption at the time, although I have no problem in admitting today I didn’t genuinely know at the time how correct I actually was.
It has taken most financial observers a long time to realise that the only way for the US dollar was south after it and the US economy hit its peak around the turn of the millennium. It has taken most observers and investors a while, but it would seem that today one would be hard pressed to find many (any?) investors who are willing to take a contrarian stance when it comes to the direction of the US dollar.
Former Federal Reserve Chair Alan Greenspan once said that making short term currency predictions was similar to flipping a coin, and everyone who has been following the FX markets for long enough knows there’s a lot of truth in that statement, but graphs over a longer term don’t lie.
Take any graph picturing the US dollar in the current decennium and what you’ll see is an underlying trend of value erosion – of weakness. While not every expert might necessarily agree with the thesis that the longer term direction for the US Dollar is towards more and more weakness, there’s literally nobody in today’s market who doesn’t share this view for at least the next six months, if not twelve or even eighteen months.
For investors the message should be loud and clear: if you invest in the trend, the trend becomes your friend. And the trend right now is unmistakably for a weakening US dollar.
Stephen Roach, at the time global strategist at Morgan Stanley, calculated a few years ago that at the turn of the millennium, the dominance of the US economy, and the US currency, was so huge that US economic growth at the time represented more than 90% of global GDP measured in US dollars. This means that Europe, Japan and the rest of the world combined represented less than 10% only.
Roach fittingly stated he couldn’t imagine any other country having build-up such a dominant economic position – ever.
In my view, this millennium milestone might well be seen as the symbol for the decline that followed in the subsequent years. The US economy has become less and less dominant; even the country’s financial institutions have lost part of their gloss; the US dollar for certain is no longer the world’s ultimate token of value.
Every athlete knows that once you’ve reached your peak, the only way is down. However, as long as there is no alternative, you can still remain the king in town. Unfortunately, for the US, the alternative surfaced quickly and swiftly. Its name is Asia, its epicenter is called China for now, “Chindia” for later.
Who would have thought things would move as quickly as they have? Some experts already calculated that by 2015 Asia’s GDP will match that of the US. If you think about it, that’s only six years (74 months) from today.
It is imperative, I believe, that this shift in economic momentum will cause further decline in the value of the US currency. Forget about all the reasons that are usually cited to explain the gradual value erosion for the greenback: from current account deficit to widening interest yields to monetary deflation.
I believe the main factor behind the gradual decline of the US dollar is the fact that the USD is losing its status of world reserve currency. As always, such changes in the global financial system occur slowly, very slowly at first. In fact, it may take a long time before they become visible to the untrained eye – but they are now.
Some central bankers have wisely shifted their reserves into the direction of euros over the past few years and reduced their US dollar holdings. Others are thinking about it. Also, the connection between the US dollar and crude oil has weakened considerably in the recent past.
This is because oil producers have stopped directing their massive windfalls into US cash assets. Next thing you know, a higher oil price will actually turn out to be negative for the US dollar, especially if less oil transactions will take place in US dollars. It has been rumoured many times now. One day the balance in the global economy will have shifted enough to make such a decision all but logical.
It seems but equally logical to assume that the clear winner from the US dollar’s demise will be the currency of the future economic super-power: the Chinese yuan (or renminbi). You can forget all about the logic that the new super-power should also carry the world’s mightiest paper currency (this is not necessarily the case in the early stages) but the CNY is severely undervalued today and will therefore only move into one direction in the years ahead.
That’s why modern investment guru Jim Rogers recently declared he is selling all his assets in US dollars to re-invest in the Chinese currency and in commodities.
It is hard to see him not gaining from this over the longer term.
In the short term, however, the US currency could potentially inflict a lot of pain to many investors. For starters, since the whole wide world is either short or bearish the US dollar, imagine what could happen if the trend would temporarily reverse.
The outside-the-box thinkers at GaveKal discovered another development this week that deserves the attention of investors globally.
Every financial crisis that we are aware of has occurred at a time when the US current account deficit was improving, GaveKal stated this week. In case you ask why, here’s the explanation: It’s because an improving US current account surplus means US consumers are sending fewer US dollars abroad to be used in global trade and finance.
In other words: “an improving US current account deficit is to the global markets what a fall in the growth rate of domestic money supply is to individual markets”.
As it happens, the US current account deficit has steadily improved since the beginning of calendar 2007.
Currently, GaveKal notes, the US current account deficit is still improving but foreign reserves held at the Federal Reserve have begun to reaccelerate since mid-September. GaveKal offers two possible explanations for this divergence:
(1) Either foreigners (or US citizens abroad such as Jim Rogers) are selling US assets and dumping US dollars. If this is the case, GaveKal points out this means these sellers abroad have a new supply of US dollars to exchange at their local central banks – who, in turn, have little choice but to buy US Treasuries. The end effect of this process is a boost for foreign reserves held at the Fed for foreign central banks.
(2) Or those same foreigners are simply building up a massive short position against the US dollar. As stated earlier, everyone seems convinced that if the Federal Reserve is to continue cutting interest rates the US currency will devalue further. Most people in today’s market seem to believe the Federal Reserve will do just that so it makes sense to assume the world is borrowing more and more US dollars to buy anything else (for if the trend were to continue they will surely gain from it).
This obviously increases the chance for a sudden and significant jump in the US dollar if at any given stage the Federal Reserve does not act in line with the general market expectation. The consequences would be dire for commodities and for equities in general.
This, however, is a danger modern investors will have to live with. In a world flush with cash, and with more professional and non-professional investors active as never before, investment funds tend to flow into the same direction and into the same trends and trading ideas. This makes any reversal, temporary or not, likely to be more violent and painful.
Such events do not change the longer term trend, though.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always firmly supported by the Fabulous Team of Greg, Chris, Grahame, George, Pat, Joyce, Sophia and Laura).
