You’d be wrong to write off the dollar

The US dollar may have taken a hammering during the crisis. But don't bet against it, says James Ferguson. Here are five reasons why the greenback is heading for a major comeback.

The US dollar has been hammered by quantitative easing, a massive recession, and a horrendous banking crisis. The dollar trade-weighted index has slid from around 120 in 2002 to around 80 now. Some even argue that the greenback's days as the global reserve currency are numbered. But the bears could be in for a big surprise. There are five key reasons why the dollar is heading for a major comeback.

Shale gas

Throughout history, new production of goods has tended to move to where energy is cheapest. You could argue that China's rise in the mid-2000s was fuelled mainly by the surge in oil prices. As prices rose above $45 a barrel, China's vast coal reserves became economically viable. As a result, cheap energy and even cheaper labour kicked off a manufacturing and assembly boom.

If America's gas shale reserves unleashed by new hydraulic fracturing technology enable the country to undercut everyone else's industrial electricity costs, the next ten to 20 years (at least in terms of growth in industrial production dominance) could well belong to America.

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The signs are already very promising. American local natural gas prices have plunged, more than halving since June last year (see the chart below). That this is occurring in the face of such strong oil prices (which natural gas has historically tended to track) is testament to how unexpectedly successful horizontal drilling and fracking techniques have proved to be.


Today's proven US reserves are 273 trillion (trn) cubic feet, but according to the US Energy Information Administration, "technically recoverable" shale gas reserves amount to 860 trillion cubic feet. As Martin Wolf points out in the Financial Times, if correct, "shale gas on its own would give America 40 years of gas consumption at current rates".

Power companies are already favouring cheap natural gas over coal, driving up American coal exports as miners struggle to sell their product. However, the real impact will be on future electricity prices, especially for industrial users, as new generation facilities come online.


This ties in with another theme robotics. If cheap natural gas drives down electricity prices, then energy-intensive manufacturing will be drawn back to America. Progress in robotics and factory automation have been held up by two things in recent decades.

Firstly, these aren't consumer products they aren't mass produced, so manufacturing costs remain high. Secondly, there's China. The shift of unemployed rural workers to cities has forced down global labour costs, making hiring staff cheaper than more capital-intensive alternatives (such as automation).

But now that China's rural millions are more regularly employed in industrial activities, the challenge is to grow its productivity. That's not easy, given the first thing workers naturally demand is higher wages. With labour costs no longer automatically falling, and transport costs rising, the scene may be set for the next phase of the global manufacturing story.

If the rise of robotics makes access to cheap energy and final markets, the two most important criteria for factory location, America will win hands down. So the best way to play the shale gas story may be to buy Japan's world-class leader in robotics, Fanuc (JP: 6954), which recently closed at a fresh all-time high not something you can say of many Japanese stocks after 20 years of a bear market.

Shale oil

The true impact of shale gas will only become clear after a few years. In the nearer term, shale oil is the one to watch. According to the Raymond James Energy Research team, total US crude production fell from the peak in 1986 of 9.2 million barrels (MB) a day to a low in 2008 of 5.3 million.

Since then, fracking has boosted US domestic production to 6.5MB a day. The Raymond James team estimate production will be back at the 1986 high by 2015. This could see America become energy independent by 2020. The chartbelow shows how the Raymond James forecast for net oil imports significantly narrows the trade deficit over the next decade. Net oil imports are forecast to fall from $400bn in 2011 to zero by 2020.


There is also every reason to think that the non-oil deficit will also come under significant pressure from 2012 onwards. Strip out trade with China (manufactured goods) and net oil imports (energy), and America is actually running a trade surplus.

While shale oil will cut the oil deficit, shale gas, as we've discussed, will start pushing down the manufactured goods trade deficit. But even in the shorter-run (2012-2014) we should see a major improvement in the American balance of trade for manufactured goods.

The 787 Dreamliner

As of 17 February this year, Boeing had 873 outstanding orders for its Dreamliner aircraft. Most of these have been with the company since 2007, when the order flow from launch to initial roll-out broke all records for a wide-bodied airliner. The big appeal is fuel efficiency. The Dreamliner uses 20% less fuel than the similar-sized 767.

However, delays have dogged the project, and the very first plane was only delivered to All Nippon Airways in October last year. To catch up, production is likely to run at full capacity at Boeing's Everett, Washington State plant, and also at its new facility in North Charleston, South Carolina. At $206m per plane, the order backlog for this one product alone is $180bn, or more than 75% of the entire annual American trade deficit in manufactured goods.

Because the US dollar is the world's reserve currency and most of the world's cross-border deals are denominated in US dollars, the rest of the world needs America to run a deficit in order to generate the spare' dollars we need. Non-US banks', largely off-shore, American dollar-denominated assets exceed $5.5trn.

That's only $1trn less than the total of US commercial banks' entire on-shore loan assets. If the US no longer needs to import manufactured goods or oil, where will the rest of the world get its US dollar liquidity? Too low a deficit means too few dollars. That pushes the dollar higher.

Quantitative easing

None of the above arguments constitute the main bull case for the greenback. To understand that, we need to consider quantitative easing (QE): why it was needed, why it's now done its job in America but will be required in the eurozone and, crucially, how it affects monetary aggregates and hence currencies.

In a bank crisis, banks are revealed to have too little capital to back the loans they've made. This is another way of saying that banks have too many risk assets (zero risk weighted assets don't need capital to be held against them although as the crisis matures, many such assets turn out to be anything but zero risk).

In the past, risk assets mostly consisted of loans to the private sector. But modern banks parcelled up a lot of these loans into AAA-rated, zero risk' securities. When these turned out to be anything but zero risk, US banks had securities to write down, and a loan book to trim back. As a result, US bank lending shrunk for the first time since World War II, and did so for three straight years.

In developed economies, the broad money supply usually grows about 200 basis points (two percentage points) faster than nominal GDP growth. But when banks are forced to repair their balance sheets after a crisis ie, they stop lending broad money supply shrinks.

Central banks have a choice: they can allow a deflationary depression (as happened in Ireland) or they can monetise the debt and print money to neutralise the deflationary forces. The Fed chose the latter. On top of the $3.7trn-odd of government deficit, it printed an extra $2.35trn to buy government securities.

I won't go into the technical differences between conventional monetary easing (lowering interest rates) and QE (unconventional' monetary easing) here for a more detailed explanation, see here: How does quantitative easing work?

In short, however, you can compare QE to normal monetary easing a certain quantity of securities purchased can be said to equate to a certain cut in interest rates.

Happily, the Fed announced at the time of its $600bn of QE2 that this sum was meant to replicate the impact of a 75 basis point cut in the Fed funds target rate. This means we can convert QE into effective policy-rate cuts.

In July 2006, the Fed funds target rate hit 5.25%, while the European Central Bank's (ECB) main refinancing rate was 2.75%. But from then until October 2008 rates in the euro area kept rising and those in the US kept falling, so that eurozone rates were eventually higher than those in America. On top of that, the $2.35trn of American QE since then was equivalent to a further cut in rates of 294 basis points.

That pushed the gap between eurozone rates and US rates even wider. All else being equal, currency investors favour currencies with higher interest rates over those with lower ones. This is why the euro has held up so well (though not against strong currencies or gold) throughout its various crises.

However, since November last year, the gap has shrunk. ECB chairman Mario Draghi has cut rates twice while the first tranche of the Long-Term Refinancing Operation (LTRO) had some minor QE-type effects on broad money supply too. More significantly, American bank lending has been rising for almost a year now, driven by the recovery in corporate lending.

The end of QE in America?

This means that, whether Ben Bernanke enacts QE3 or not, America doesn't actually need any more artificial expansion of the money supply. With bank lending growing again, money supply growth is being generated in a normal fashion again. QE3 might now never happen, and even if it does, it's likely to be delayed, diluted and small.

This is in stark contrast to Europe, which is facing the same sort of banking crisis that the Anglo-Saxon countries have already been going through. Banks look set to shrink lending, which will leave Europe with the same choice as the US did: face a deflationary contraction in broad money supply, or resort to QE.

We suspect they'll opt for the latter, although perhaps not without extensive arguments. However, this means that the US dollar will either be competing against a consistently diluted euro (via QE) or a euro in deflationary depression. Either way, monetary conditions will be very supportive for the American dollar for the next several years.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.