6 Mar 2011

What's the US Dollar's Problem?

One of the big mysteries surrounding the latest turmoil in the Middle East is why the US dollar hasn’t benefitted. What happened to the ‘flight to safety trade?’

When uncertainty increases, or the global economy takes a turn for the worse, the US dollar, via the US treasury market, usually benefits from being the biggest, most liquid and, in the very short term at least, safest parking lot in the global asset market.

But this time around it’s not. We’re seeing regime change across North Africa, oil prices over $100 a barrel, equity markets stalling…and the US dollar is doing nothing. The chart below shows the US dollar index over the past six months. Since the start of the year, it’s been all down hill for the greenback.


This indicates one of two things. (It could indicate more, but we can only think of two this morning.) Firstly, that global investors/speculators are not overly troubled by recent events, and see no need to move back into US treasuries. Or secondly, and this is the explanation that we favour, is that current events are troubling, but no one wants to wait out the turmoil in the treasury market holding too many dollars.

That no one wants to hold dollars in any great number may seem obvious if you’ve been paying attention to the Federal Reserve’s balance sheet over the past few years. But the fact that the king dollar can’t rally in times of turmoil is a very big deal indeed.

Why? Well, the US dollar is not like other currencies. It is both a domestic and international currency. Unlike every other country, the US can borrow (seemingly) endless amounts of money priced in US dollars. It doesn’t have to worry about exchange rate fluctuations or the possibility of not being able to borrow.

It’s international status means there has been massive demand for dollars over the years. The dollar is the source of international liquidity. So in the past, nervous investors would move to ‘liquid’ assets and the US dollar would gain in strength.

This allowed the US Treasury to run up ever-larger debts. Because money = debt in this twisted monetary world, more US government debt means more international liquidity.

But events of the past few weeks mean this cosy little arrangement may no longer be in operation. No one is catching the flight to US dollar safety-ville.

In big picture terms, this is another nail in the coffin of the current US dollar standard global monetary system. The dollar is slowly but surely reverting back to being a domestic currency. This will take years, but the implications for global liquidity are huge.

If, in times of economic weakness, there is no bid for US treasuries and the US dollar, then the ability of the US Treasury to emit more of them (in an effort to boost liquidity and get the global ponzi scheme moving again) is massively compromised.

Economist Robert Triffen sussed this out well ahead of time – back in 1960 to be precise. He predicted the breakdown of Bretton Woods by pointing out the contradictions of having the US dollar fulfil the duel role of domestic and international currency. It became known as the ‘Triffen Dilemma’.

A decade later Bretton Woods did break down. But it was replaced by something far worse – a dollar standard with no golden anchor. This allowed debt growth to explode and put increasing power into the hands of the bankers and the politicians.

Now the dollar standard is crumbling.

Not that that’s news to most of you. Under the stewardship of first Alan Greenspan and now Ben Bernanke, the US dollar has been a slow motion train wreck for years. But is the train speeding up?

The next phase could well be a US economic slowdown (which you should expect to see in the second half of the year when the effects of past stimulus begin the wear off) not accompanied by lower bond yields. In fact, bonds could even rise in such a scenario as treasury holders sell into an expected announcement of QEIII.

You can have deflating assets markets and a depression-like economy and still have high interest rates. Just ask Greece or Ireland. It all comes down to faith, or confidence, in the managers of an economy and a currency.

Bill Gross from Pimco provides a worrying statistic in his latest Investment Outlook.

‘…nearly 70% of the annualized issuance (of treasuries) since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns’

In other words, there are no economic buyers of recently issued US government debt.

No wonder gold just hit an all-time high and silver is over US$34. The precious metals are filling the vacuum left by a woefully mis-managed US dollar.

What does all this mean for Australia? It’s hard to tell. Right now, we are benefitting from the anti-US dollar trade…commodities are surging. But that is also a function of China’s credit boom.

And it’s not exactly translating into strong economic growth.

Yesterday’s GDP stats showed economic growth running at an annualised rate of just 2.7 per cent. Resources might be on fire, but the rest of the economy is weak.

We’ll ponder the question of how Australia handles the breakdown of the international monetary system in more detail…and get back to you soon.

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