The dollar has come under further pressure over the past five days and the financial press is crammed with arguments for and against continued weakness. Regular (and long-term) readers of this column will know that we have held a very strong position regarding the prospects for the greenback and whilst debate rages for and against further near-term declines on the world's foreign exchanges we regard further weakness as not only inevitable but potentially severe. Commentators have forecast the currency down to 1.40 against the euro and 95 against the yen; that may not be all!
Reasons For Dollar Weakness
1) Eurozone economic data continues, generally, to beat expectations and confidence indicators have recently hit multi-year highs (German IfO hit a fifteen year high in November). The contrast between the strength of the eurozone and the weakness of the US economies (the latter reflected in recent Chicago PMI data) has therefore become pronounced.
2) Investors firmly expect further monetary tightening when the ECB meets again next week (7th December). In contrast, investors have begun to speculate that the Fed might remove its bias towards further monetary tightening at the Dec 12 FOMC meeting, paving the way for a Q1 2007 rate reduction. The odds of a rate cut in March have risen above 50 : 50.
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3) Recent comments from Chinese central bankers have suggested that the People's Bank of China is uncomfortable with current levels of dollar reserves (see last week's column) and may be considering further diversification.
4) The US trade deficit, although narrowing of late as the oil price retreats from earlier highs, remains wide at $586.2bn through to end-Q3 2006. In 2005 the deficit reached an all-time high at $716.7bn. A new record seems certain to be reached this year.
5) Weakness in the US residential property market, coupled with concerns regarding high levels of personal indebtedness, have raised the spectre of falling consumer spending over the important pre-Christmas trading period. Some anecdotal evidence in support of this has been provided by Merrill Lynch as it reports 42" plasma TV's being sold by Wal-Mart for less than $1,000! 6) Uncertainty regarding the future of the carry trade reflects the possibility that Japanese base rates may have to rise by more than the financial markets have priced in (despite local political opposition).
7) Thin holiday markets over Thanksgiving, coupled with low implied volatilities in options pricing, encouraged position squaring and exacerbated the dollar's downward lurch.
Why investors need to focus on the fundamentals
According to Capital Economics the dollar's fall was "An accident waiting to happen". That company takes the view that the factors listed above may well have formed a sufficiently unpleasant cocktail to encourage dollar weakness but that none are, in themselves, sufficiently strong as to drive the US currency down to twenty month lows against the euro for a sustainable period.
In our view investors need to think less about the ebb and flow of data and focus instead on the deep underlying fundamentals.We wrote, back in mid-2004 (at which point the trade weighted dollar had declined steeply), that to many observers a strong dollar was as American as apple pie and that its continued strength was to be taken as something of a fait a complis. In the event the currency did stage a partial recovery but, as the chart (above) shows, that revival proved insipid in the context of the longer term picture. As subsequent data has shown, the pause only served to exacerbate the substantial structural imbalances requiring the dollar to weaken in the first place.
The basis for our position lies in the fact that the US has become increasingly dependent on foreign capital and that the level of that dependency is without precedent. Essentially the US is like a vast emerging economy with a) a large amount of overseas debt denominated in its own currency and b) a major balance of payments / competitiveness problem. Eventually all lending by overseas investors will need to be paid back with actual goods. Beyond the need eventually to pay back the debt to existing overseas lenders, the US economy is essentially addicted to the flow of new borrowing from overseas.
This borrowing has been necessary to sustain spending levels that are significantly in excess of earnings levels. Without this borrowing consumption would inevitably collapse. The US trade position is not just slightly out of kilter, the country now imports nearly twice as many goods as it exports, and is financing the difference by borrowing. This borrowing is increasing because the gap is widening.
The finances of countries work in a similar way to those of companies or individuals i.e. one cannot indefinitely sustain one's living standards on borrowed money because lenders don't want simply to increase their lending; they expect to get their money back, with a profit. They expect to sell financial investments and convert them into goods and services. So, the US is essentially borrowing goods and services and lenders are expecting to be paid back in goods and services. The major difference between countries on the one hand and companies and individuals on the other is that countries can manufacture the money with which they pay back their debt.
The reality is that when overseas investors ask to be paid back, it is unlikely that the US will be willing / able to pay them and will, instead, chose to devalue its currency rather than pay back the debts which have mounted up. Once overseas investors recognise that the US cannot and will not pay back its debt without a significant devaluation (essentially a write-down of debts since they are dollar denominated), the race to the exit will begin. That this will be bearish for the dollar goes without saying.
In our view the retracement of overseas capital has (and will continue to be) proved gradual at first although when it starts in earnest the reaction will become acute! This is not just a problem for the dollar because declining overseas demand for US assets is certain to ripple through all US financial markets and to impact all those market participants trading US assets. The silent hero of the US "economic miracle" of the late 1990s was the tidal wave of overseas capital into the country. Overseas' investors desire to throw money at the US proved a key catalyst for the most massive private borrowing spree the world has ever seen. So much so that the US economy and financial markets are inextricably linked to overseas investors' continuing faith in the US economic model. Staggeringly, the US is currently absorbing in excess of 80% of net free world capital. Two things are certain. Firstly, the upside is capped at 100% and secondly, that that level must eventually fall back as there must exist a limit as to the willingness of overseas investors to buy any and all US capital.
Has the dollar reached tipping point?
Whilst it is impossible to know with certainty whether this is the tipping point for the dollar and that this is, thus, point at which overseas investors have finally decided to stop lending to the US and to start demanding their money back, over time it must happen. When this time comes it is very unlikely that the US will have any option but to pay back with significantly devalued dollars. One day holders of US assets worldwide will wake up to this reality. We regard market attempts to rationalise the dollar's recent behaviour in order to compartmentalise and therefore better reduce the risk of further weakness as dangerously insouciant. The underlying justification for structural dollar weakness is not to be taken lightly. Further dollar weakness is inevitable.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
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