Feature Stories | Jul 10 2009
(This story was originally published on 6 July. It has now been re-published to make it available to non-paying members and readers elsewhere).
By Greg Peel
“Over time, the USD remains a fundamentally weak currency. By end 2011 we forecast values of EUR/USD 1.50 [currently 1.39] and USD/JPY 90 [95]. The currencies of the strongest emerging economies, includingChina, as well as commodity-exporting countries are likely to appreciate significantly.”
This is the view of the UBS currency analysts, expressed last week. But by no means is UBS alone in its outlook. Most economists agree the US dollar will continue its current decline, albeit with peaks and troughs along the way, as the world’s reserve currency fights to overcome the extent of its national debt and the fragility of its economy. On a relative basis, the developed economies of the “West” will also struggle, leaving the door open for emerging market economies to stamp their growing influence. UBS believes the currencies of Europe and Japan will perform better in relative terms than the US, but the currencies of China and friends will be the real stars.
While Australia is considered a developed world economy, its fortunes now lie more squarely with emerging markets. Thus the scenario painted by UBS implies significant appreciation in the Australian dollar ahead.
The following graph shows the US dollar index has declined from a peak of 120 around the time of 9/11 to 80 today. That’s a 33% fall. The decline began when US monetary policy was eased substantially post the tech-wreck and 9/11, and then exacerbated as Americans used cheap credit to suck up imports from Germany and Japan, and then ever cheaper imports from China, leading to a record trade deficit. Cheap credit also led to an asset bubble which ultimately burst and created the GFC.
As the US consumer now reels in spending, and household balance sheets are repaired, the US trade deficit is on the decline. But the debt imbalance established by the trade deficit is only being replaced, and extended, by debt used to bail out the US banking, insurance, mortgage and auto industries and to stabilise the economy in general. Thus there has been no effective turnaround in the US dollar’s trend.
Looking further back in time, the US dollar index has halved in value since its peak in 1985. Yet if one were to remove the spike from 1980-88, and the spike from 1995-2005, then the dollar index has simply trended down from 120 as it entered the seventies to 80 today.
The US entered the seventies in a boom of consumerism which already had inflation running high as US households clamoured to buy houses, cars, furniture and appliances. By the end of the seventies inflation ran wild due to the Arab oil shocks. It was only at this point central banks began to realise they needed to keep inflation in check. Interest rates were finally raised, sending the US dollar skyward, but eventually ushering in a recession in the early eighties – a recession which many an observer prefers to use now as a benchmark for the current recession. The sharp fall in the US dollar then established a commodities boom until the recession in the early nineties. Then came the tech boom and another period of central bank monetary tightening, which pushed the US dollar to its final peak, before then Fed chairman Alan Greenspan made what he now admits was a mistake. Following 9/11 he quickly cut the interest rate to 1%, and the next great boom was on - particularly in commodities.
Commodities boom every time the US dollar weakens because global commodity trade is conducted in US dollars. There still needs to be demand, but that is guaranteed when low interest rates in the world’s largest economies spur consumers into spending sprees. Exploding Chinese commodity demand in the period 2004-07 merely reflected its export market. Thus the Chinese boom was a reflection only of rampant Western spending. Only now have China, and India, and Brazil and others, turned inward to stimulate their latent domestic economies – economies fuelled by the power of population.
Thus while the US dollar may be on the decline again, and the US interest rate at zero, this time it will not spark another US spending spree in a hurry. A rise in commodity prices will always accompany a fall in the reserve currency, but only if demand is awakened. The West is now deleveraging and will be deleveraging for years yet. Demand can only come from emerging markets.
If the value of the US dollar index continues to decline, it won’t be a reflection of emerging market currency strength directly. The US dollar index is a basket of euro, yen, pound, Swiss franc, Swedish kroner and Canadian dollar, representing America’s traditional major trading partners of Europe, Japan and neighbouring Canada. No emerging markets here. Moreover, the value of the Chinese renminbi is linked to the value of the US dollar by virtue of strict central bank management. The renminbi can only appreciate at a pace determined by the Chinese themselves. To date, China has kept a tight rein on currency appreciation for fear of destroying its export market. But with its export market now in tatters post the GFC, and the focus on building a solid domestic economy, China may not need to be quite so vigilant.
There is nothing stopping the Aussie dollar appreciating against the US dollar if emerging market economies succeed in growing domestically.
As the first chart above shows, never has the US dollar been as volatile as it has been from mid 2008 to now. The sudden surge in the dollar brought about the collapse of commodity prices. The reason the US dollar surged was because the fall of Lehman Bros resonated around the globe. Up until that point, the economies of Europe and Japan and the emerging markets were considered relatively decoupled from the credit-crunched US economy. Nothing would prove further from the truth. In June 2008, suggest the analysts at Standard Chartered, the US dollar was “massively” undervalued against the world’s major currencies.
The US dollar index quickly found a new level of tenuous equilibrium in the high 80s following realistic adjustments among all developed currencies. The subsequent evaporation of emerging market export markets saw the Aussie “adjust” from near US$1.00 to US$0.63 in a big hurry. But as the US printing presses were switched into overdrive under the new administration, the US dollar again began to wane. The US, UK, Japan, and Switzerland all lowered interest rates to near zero and commenced quantitative easing, and the EU adopted its own “unconventional” measures, but the US fiscal deficit ensured a national debt in the trillions.
“The combined impact,” notes Standard Chartered, “of soaring oil prices, the housing market slump, and the global credit crisis have hit the US consumer hard, resulting in the deepest US recession in decades”. US GDP has contracted for three quarters in a row. Standard Chartered expects the June quarter will also show contraction before the September quarter brings a turnaround. The analysts are forecasting negative 3% GDP growth for the US in 2009, which would be its worst result since 1946.
By contrast, Australia has not yet strung together two consecutive quarters of negative growth.
In July 2008, at the peak of the oil price, US CPI inflation peaked at 5.6% annualised. In May this year it was negative 1.3% annualised, implying deflation. The Fed nevertheless prefers to follow a measure of inflation known as the personal consumption expenditure (PCE) deflator, which fell to 1.7% in May – below the Fed’s 2% comfort zone. Standard Chartered expects the PCE deflator to fall to only 0.5% by mid-2010. On that basis, the US is free to keep printing money and the Fed is free to keep buying US bonds (quantitative easing) without risking an inflation explosion. However, as risk appetite returns, Standard Chartered expects investors to use the cheap US dollar as the funding currency for higher risk investments, particularly in emerging markets. This implies any “global” recovery will only result in a weaker greenback.
We have already seen the evidence. In the past month or so, every time the US stock market rallies the US dollar index falls, and vice versa. A strong stock market implies greater risk appetite, which also encourages offshore investment and divestment of the reserve currency.
The first tentative steps have been made towards diluting the value of the US dollar as reserve currency. But any move to usurp the dollar will take many years. (See The Longest Journey Begins… published last week.) But in the meantime, money will flow to where the growth opportunities lie. Emerging market economies will bounce out of the GFC much faster than the legacy economies of the “West”. Standard Chartered believes the US dollar index is currently fairly valued. But in terms of emerging market economies, the US dollar is overvalued. This opinion matches that of UBS above, which suggests the US dollar will decline against the euro and yen but most dramatically against emerging market currencies.
In forecasting the fate of the US dollar in the period 2007-11, Standard Chartered draws upon the experience of the period 2001-05. While the recession following the tech-wreck and 9/11 was not nearly as dramatic as the GFC, there are similarities in that what started as a US-centric scenario soon spread around the global economy.
The tech-wreck and 9/11 occurred in 2000-01, but the subsequent dollar decline did not commence until 2002 as the Fed responded with monetary policy easing. The accompanying fall in the US dollar reflected increasing monetary supply in a lag effect. The Fed began to tighten again in 2005 as commodity prices surged, and at the same time China began to tighten its own (limited) monetary policy as the Chinese economy began to overheat. Yet the US dollar turned down again in 2006, despite the Fed not lowering the interest rate again until August 2007. The still huge supply of dollars had eventually “told on” the value of the currency, Standard Chartered suggests, and it began to weaken. Every time the global monetary supply increases, the US dollar eventually weakens.
When the global monetary supply began to contract rapidly in late 2008, the US dollar strengthened. It will take time for monetary policy easing to have its effect in the “West” as it fights ongoing deleveraging, but eventually it will have an effect, Standard Charted notes, and global money supply will begin to grow again. And on the basis of recent experience, the US dollar index will thus decline again.
But emerging markets did not mire themselves in nearly as much debt as developed economies ahead of the GFC, and thus will not need such a lengthy deleveraging process on the way out. Developed economies do not have much immediate need to fear inflation, but the threat of inflation looms large for emerging markets, Standard Chartered suggests.
“In 2009,” the analysts note, “the focus in emerging markets will remain on supporting growth and securing sustainable economic recovery. However, in 2010, that focus will gradually switch to inflation and when it does emerging market central banks may have more of an incentive to let their currencies appreciate in order to temper rising price pressures.”
Somewhere in between lies Australia. At 3%, Australia’s current cash rate is among the highest in the developed world. Even Canada now has a rate of only 0.25%. The high cash rate reflects the fact Australia has not yet suffered two quarters of negative growth, let alone three. The RBA is presently “on hold”, balanced between the effects of falling credit demand, rising bad debts and rising unemployment on the one hand (not to mention a housing bubble that has never really burst) and China’s seemingly rapid return to strong economic growth on the other.
Clearly Australia’s economy will be saved from deep recession if emerging market economies return to strength. But it may come at the cost of a soaring Aussie dollar as the US dollar weakens, commodity prices recover, and the RBA is forced to quickly consider raising rates again rather than cutting them. (Probably a 2010 consideration, not 2009). A strong Aussie dollar will be nice for overseas travel and cheap flat-screen televisions, but not for commodity exports and variable home loan rates.
