FYI | Mar 18 2009
By Greg Peel
One of the great ironies of the GFC is that while the US continues to pump trillions of printed dollars into its ailing economy – numbers greater than anyone could ever have imagined – the greenback has remained strong.
The US dollar index measures the greenback against a basket of currencies – the euro, pound, Swedish krona, Swiss franc, yen and Canadian dollar – representing America’s major trading partners. Note that both the UK and Sweden are EU members but not EMU members (they do not use the euro as their currencies) and while Switzerland remains ever neutral and not part of either, it is still in Europe. Hence the US dollar index is basically a measure of the US economy’s strength in relation to Europe, Japan and neighbouring Canada.
Note that America’s economic strength was riding high up until the tech bubble burst early this century and 9/11 followed shortly after. The dollar index peaked around 120 before the Fed began to dramatically slash its cash rate. The tech boom was a mostly US-centric phenomenon, so the US dollar rose to 120 and fell to 80 while the rest of the world simply got on with traditional business. The Fed funds rate was over 6% in 2001 and was cut to 1% in 2003. By that point Chinese demand for commodities was pushing inflation higher, and from 2004 to 2006 the Fed ticked its rate back up to 5.25%.
Yet as the chart shows, the recovery in the US dollar was not commensurate, managing only to rise from 80 to 90. The reason is that by 2006 America was spending its heart out on borrowed money. It was the year the housing market peaked and the year that subprime CDO creation was at its most prolific. As the US current account deficit grew ever wider, spurred on by a rampaging Chinese export economy, the greenback began to slide despite the 5.25% funds rate being held fixed for twelve months. In mid-2007 the subprime crisis hit, and in August the Fed began another round of frantic slashing until the funds rate reached zero (0-0.25%) late last year.
The dollar index bottomed out at all time lows in the low 70s in 2008 but this is where it began to become illogical. Since mid last year, the greenback has done nothing but rally – right back to where it was when the funds rate was 5.25% (and yet now it’s still zero). And all we ever hear about from the new administration is how much money it is prepared to print to rescue the US economy.
Why isn’t the greenback down the drain?
The answer is twofold. From a domestic point of view, the fall of Lehman Bros sparked a mad rush by Americans to unwind any risk position they owned – stocks, corporate bonds, commodities, emerging market investments; even gold was carted in the scramble to deleverage and convert back into cash. As Americans held investments across the globe, the rush was on to “bring the boys back home” – all those offshore greenbacks.
But more significant was the international reaction. For roughly twelve months from the beginnings of the subprime crisis to the fall of Lehman, the world assumed the subsequent credit crisis was nevertheless mostly an American problem of its own making. The Japanese and European economies were expected to hold their own, and emerging market economies, with China as standard bearer, were expected to keep global economic growth ticking over. It took the fall of Lehman for the world to realise the “subprime crisis” was never just an isolated US problem. US banks had not just been selling their toxic debt securities on street corners in New York, they had pedalled their high-yielding drugs to eager hedge funds, mutual funds, investment and commercial banks in the other globally significant economies.
Those economies soon began to crumble, in a delayed house-of-cards reaction to what was truly a global credit crisis.
The old adage that was if the US economy – by far the world’s individually largest – sneezed, the rest of the world caught a cold, so reliant on the American consumption machine had it become. For twelve months many an economist scoffed at this adage, until once again it proved to be true.
Britain was once the world’s largest economy – the “nation of shopkeepers” – but in recent decades Britain has reduced its manufacturing output to 14% of its economy and built up its services industry. New York is at pains to admit it but London is actually still the world’s biggest money centre. And banking is what the British do best – or did best.
There is currently a raging debate going on in the US and across the globe as to whether the Obama administration will or won’t, or should or shouldn’t move to nationalise America’s major banks. The trade-off has been that it won’t fully, but it will take stakes across the board. A 40% investment in the biggest basket case – Citigroup – is as high a level of “nationalisation” the Obama administration and the Fed are prepared to go to. Other recipients of government funds are holding much lower levels of capital injection.
While the debate has raged, attention has been drawn away to some extent from what has been going on in the UK. Despite the world assuming the subprime crisis would prove to be US-centric, British regional bank Northern Rock fell as early as September 2007. At that point the UK government took the unprecedented step of instructing the Bank of England to guarantee all bank deposits. It was not until twelve months later that the world followed suit.
Britain’s woes did not end there. One by one UK banks began to falter and the government did not vacillate. The British people now own not just Northern Rock, but a majority of the Royal Bank of Scotland and around 70% of Lloyds. Lloyds had already merged with Halifax Bank of Scotland last year after Lehman failed, saving the government the trouble of direct investment in HBOS as well. So far HSBC and Barclays have managed to remain private – just.
The UK is now suffering just as the US did, only later.
The UK economy officially entered recession in the fourth quarter last year as a 1.5% contraction in GDP followed a 0.6% contraction in the third. Leading indicators are suggesting bigger falls in early 2009. House prices which had, like in the US, boomed on cheap credit have fallen 20%. Standard Chartered expects prices to ultimately fall 40% peak-to-trough. Only 70,000 homes are expected to be built in 2009/10 – the lowest level since 1921 (not including WWII) and fully half of the number built in 2008/09. UK manufacturing was down 12.8% annualised in January. The service industry has been decimated and unemployment has passed 6.3%.
The Bank of England has reduced its cash rate to 0.5%.
Another debate is raging in the US, being that of whether or not the Fed will move towards “quantitative easing” now that the cash rate is zero and there’s nowhere else to go. Britain has once again not vacillated and has already announced the commencement of quantitative easing.
Quantitative easing is the “monetization of debt” and involves a country’s central bank buying bonds issued by the government. The money the central bank uses to buy the bonds is also issued by the government. In order for the UK to avoid major currency devaluation it must sell bonds to willing buyers in order to borrow against pounds being printed for monetary and fiscal stimulus. When bond buyers (lenders) are thin on the ground a central bank can step in with more printed money to buy bonds and thus encourage others to do so. It is the ultimate in currency debasement but it is also like giving the fading economy a shot of adrenalin. If it works – fine. But too much adrenalin can cause a heart attack.
This is why the US dollar index is back at 90. The UK’s demise is representative of that of all America’s trading partners, to varying degrees. Britain is nationalising banks and monetizing debt in the knowledge that a bleak economic future is inevitable. The US is taking only partial stakes in banks and may not necessarily monetize debt. The Fed believes the US could pull itself out of recession by the end of the year. The world is thus happy to lend the US money (buy bonds) in the hope that Ben Bernanke is right.
The Japanese economy is now in dire straits, having been in the doldrums for over a decade. The Chinese miracle has stalled. The eurozone has now had three quarters of GDP contraction.
The eurozone’s biggest economy – Germany – is an exporter to the world (predominantly to the rest of Europe) thus particularly badly hit. Under the Maastricht Treaty which established the European Monetary Union, member countries are expected to target a debt-to-GDP ratio of no more than 60%. Germany’s and France’s ratios are expected to hit 70% by 2010. But Greece’s ratio is already 92% and Italy’s 103%. Eastern European countries, major debtors of European banks, are facing bankruptcy.
The world is uncertain as to whether the European Monetary Union will survive the GFC or rather shatter under the weight of economic imbalance.
The European Central Bank is also bailing out banks and has cut its cash rate to 1.5%. The ECB has not yet moved to quantitative easing, although there are certain difficulties in doing so. The EU does not have a bond – each member country issues their own. To provide quantitative easing the ECB would have to adopt what Standard Chartered describes as “unconventional measures”.
So on the scale of world economic problems, currently the US dollar is indicating that the US is in a bad spot but other major economies are faring worse. Standard Chartered, however, does not agree with Ben Bernanke.
Comparing the US to the UK and the eurozone, Standard Chartered sees the US in ultimately the worse position. The US is suffering from significant “structural imbalances”, which is really just a fancy way of saying the US has become far too indebted to the rest of the world. From this starting point, aggressive monetary stimulus will only lead to an inevitable decline in the US dollar which the analysts see starting later this year – around the time Ben Bernanke expects the US economy to begin turning around.
The UK is also suffering from structural imbalances, but the measures now being taken by the government will see Britain’s fortunes begin to improve in 2010, Standard Chartered suggests. The EU does not suffer the same magnitude of imbalance, and while some member countries will struggle to battle their way out of recession, the analysts do not see the EMU breaking apart. They see the euro rising against the US dollar in 2010. Standard Chartered doubts the ECB will be forced to implement “unconventional measures”.
The UK’s response has been swift and certain. The US response has been slow and muddled. Congress is currently spending more effort railing against AIG bonuses than it is trying to do what is necessary expediently to prevent the US economy sliding into even deeper recession. The trillions of US dollars being printed will eventually have their impact in the form of a debased reserve currency.
