We have no reason to expect the long-term decline of the dollar to end any time soon although, we are experiencing a period of short-term dollar consolidation. The US$ is just below $2 against the pound and is at a thirty-year low against the Canadian dollar. Fundamentally, the accepted reason to expect ongoing dollar weakness is their trade deficit. Their current account deficit continues to stay at around 6% of GDP and as Jim O'Neill, Global Head of Economics at Goldman Sachs said in a recently published article, it is unlikely that turning bullish on the dollar would prove to be sensible until the current account deficit is closer to 3% of GDP.
The latest chink in the dollar's armour was the Kuwaiti announcement that they have abandoned their peg to the sliding US dollar, instead they will peg to a basket of currencies for which the dollar is expected to make up about 75-80%. Other states such as Saudi Arabia, The United Arab Emirates, Bharain, Qatar and Oman are studying the move.
Whilst some oil producers may be considering a reduction in their exposure to the US dollar, led by Kuwait, Asian economies see things differently. The financial crisis that engulfed them in 1997 largely came about as a result of their currencies being overvalued. The memory of that disastrous period is now part of their DNA and will cause them to keep their currencies weak against the US dollar. Their actions will, in turn, inflate their money supply further, fuel global liquidity and increase the risk of inflation. If and when that becomes an issue for them, they will have no alternative but to change their policy. In the end, currency manipulation inevitably creates distortions which sooner or later the market viciously corrects - it has always been thus.
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Interest rate differentials continue to weigh heavily upon currency movements. The Bank of England and the ECB are tightening to bear down on the inflationary risk and are ignoring the threat to asset bubbles. Tightening will continue unless markets crash. Bernanke expresses similar concerns about inflation but so far has not acted, probably because of fears about the vulnerable US housing market.
There is a puzzle everybody wishes they could solve, Warren Buffet has said that he has recently made a significant bet on the currency markets but without disclosing which currency nor in which direction the bet is made. The popular guess is that he is long the Japanese yen. After all, it is only a matter of time before all of that Carry Trade reverses, the consequences of which will be a very sharply escalating yen and a weakening of high interest rate currencies, such as the New Zealand dollar.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/
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