First some numbers. This morning, the dollar reached lows of nearly $1.47 against the euro, $2.09 against sterling, $1.10 against the Canadian loonie. The yen strengthened to below 114, and the Chinese yuan touched 7.44, from 7.47 at the beginning of the week. The Aussie dollar and the Norwegian krone also strengthened against the greenback, about which more later.
The basic story here is really rather simple. As an asset, the dollar has become less attractive because of lower interest rates and perceived poor economic fundamentals in the US. (The latter is code for “everyone thinks the reduction in housing values is going to cause a recession.”)
In addition, huge writedowns in securities backed by US home-mortgages are causing pain in portfolios all over the world. Many of these securities are denominated in US dollars. There’s no place for these assets to go since there’s no liquid secondary market for them (and there never has been, so that’s not a distress signal in itself). But holders of mortgage-backs face pressure to increase reserves against their losses and they do so by selling other dollar-denominated assets.
One of the most basic features of financial markets is momentum. The old cliche’ is that it makes as much sense to buck a trending market as it does to stand in front of a runaway freight train.
And so you get stories like the one from China (quoted in the article I linked above). Cheng Siwei, a senior legislative official, came out and said that China would be diversifying its foreign exchange holdings away from dollars and into stronger currencies.
Now Cheng has a reputation as a loose cannon, and the People’s National Congress is not involved in China’s monetary policymaking. His statement probably has more shock value than anything else.
That’s because China has already been doing what he says, since about the beginning of the year. They have already reduced their holdings of long-dated US Treasury debt to about $400 billion. That’s not a big change from where it was, but the direction is what matters. China no longer participates in auctions of new Treasury debt as much as they used to.
They also have a $200 billion “sovereign wealth fund,” which is increasingly seeking new investments not in dollars. This is an interesting kind of a vehicle. It’s basically a sterilization fund, where countries that make too much money park it, so it won’t cause too much domestic inflation. (Norway, with its huge revenues from oil exports, also has one. Hugo Chavez needs one, but he’s not smart enough to know that.)
Speaking of oil, that’s another big part of the dollar momentum story. We’ve had a few discussions about this on RedState lately, and I’ve made the point that speculative buying of crude oil futures is distorting the market for that commodity. Such buying is largely a response to dollar weakness (and the anticipation of further weakness). As we get further into the week, I’m hearing a lot of people confirm this view and I’m basically convinced of it now. Oil will probably hit $100 in the near-term, and may go considerably higher.
Another thing that has changed recently: I see a consensus forming among business people that Hillary Clinton will be the next President of the United States. That’s not news. However, the sentiment is also growing that her regime will seriously damage the US economy in absolute terms, and in terms of our global competitiveness. Practical result: some people are scaling back their growth projections (and their investment plans) for 2009 and beyond.
Inflation
The oddest and most striking thing about the current dollar trend is inflation. You can’t help seeing that inflation is anywhere from a serious concern (continental Europe) to a blazing inferno (China). Except in the United States.
The US, Japan, and perhaps the UK are the only major economies in the world with no significant inflation in evidence. (I’m discounting US food-price inflation, which is partly driven by government ethanol policy. Japan is simply on the floor economically, with almost no dynamism except in their export sector.) Australia, Norway, India, Russia, and many others have serious inflation issues that are causing them to raise interest rates, which adds still more downward pressure to the dollar.
And oil-states that don’t actually have economies, like Saudi Arabia, are feeling the pain in a different way. Since most of them peg their domestic currencies to the dollar, they now have way too much money as well. They’re seriously considering diversifying reserves out of dollars too.
Because the global economy is tightly integrated with the American one, the effects of dollar weakness are being transmitted like plague to every other economy. We’re exporting inflationary pressure instead of experiencing it at home, and it’s possible that this is the cause, not the result, of higher interest rates abroad.
It’s a perfect storm. The broad question we have to ask is: will the dollar find a floor, or are we in the middle of a long trend that will fundamentally re-align trade flows around the world?
At this point, all I can do is pose the question. I have to admit I don’t know the answer. If you’ve been around markets at all, you know that they will always surprise you. If we get an unexpected improvement in the US economic outlook, the resulting firmer interest rates will probably halt the dollar’s decline, in the near term at least.
But the center of gravity in the global economy is marching south and east. As the largest economy in the world, we’re still the most important player in the global game, and will be for a long time to come. However, we’re no longer the most dynamic. The American business world, which is extremely good at adapting to changing conditions, will have a lot of adapting to do.
We’re now in the early stages of a secular transformation that, in its scale and impact, will match the Industrial Revolution and the late-19th Century exodus from farms to cities.
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