Friday, December 28, 2007

Dollar Woes Part II

Yesterday in Part I we covered some of the long term macroeconomic issues that ail the dollar. Today we'll look at more recent events, primarily in 2007 where the dollar shed 13% vs the euro and 9% vs the USD index as well as some other factors that weigh on the greenback.

(numbering continues from Part I)

4. The subprime crisis

The subprime crisis that caused sniffles as early as March that became a systemic septic infection in August battered the dollar. A goodly chunk of the dollar drop came in the three months after August 7th when the Federal Reserve cut the discount in a surprise, intermeeting move that started the current cycle of FOMC rate curs.
Subprime has hurt the dollar in three ways:

First, the horrific shudders that it has sent through an already weak housing and construction sector directly affects economic growth in the United States. The subprime crisis hits at the root of the economy - new housing spurs building materials, construction, major household expenditures like new appliances and furniture that are purchased to furnish a new home, describes the huge role that housing plays in the economy. As credit to subprime borrowers has dried up the velocity of home sales has slid at nearly every level (with the exception of the ultra luxury) as current non-owners aren't able to borrow nearly as freely as before so current first-time homeowners can't upgrade. If they can't upgrade, the 500k-800k tranche can't get to the McMansion and homebuilders are left with huge inventory.

Second, the subprime crisis is perceived to have hit American institutions more than global institutions. So far this is true - American banks have been hit much harder but whether it remains true we will know in the fullness of time. After all not just Americans are yield whores which is why the asset backed market became so attractive everywhere.

Finally, lower US rates as a result of Fed cuts makes dollars and dollar assets less attractive to hold ceteris paribus.

5. Oil

The sharp rally in crude is both a cause and an effect of a lower dollar. Since the US is the biggest consumer of crude and the dollar is falling against other trading partners it has the effect of pushing crude higher if producers are to maintain their margins. Before we get the populist dander up let's note that the primary driver of higher crude prices is indeed tremendous GLOBAL demand and not much more available supply at the margins. Crude will come off as a result of any of the following: a stronger dollar, a recession in the US or significant economic slowing in China.

Another key weight on the greenback is the currency regime currently in place in the Gulf of Arabia between large oil producers like Saudi Arabia, the UAE and Qatar. These countries have pegged their currencies to the dollar for stability - their receipts are in dollars and it has worked well for them for a long time. However given their peg and the fact that the US is lowering rates it creates a lot of domestic inflation. In practice, because of fixed exchange rates, cheap dollars can be converted ad infinitum to the local currency which has caused merchants and services on site to raise prices. This has caused significant consternation among the expatriate service community (imported laborers) who see their paychecks shrink relatively and the value of their repatriations to their home countries also shrink because those countries' currencies are appreciating vs. the dollar. With inflation nearing 10% in these countries many want to re-price oil away from the dollar which would force the sale of dollars for another currency to purchase oil.

It does not appear likely that this peg will crack soon however the fact that it has gained attention is yet another factor dragging on the dollar.

6. Anti-Bush, Anti-Americanism

The palpable antipathy towards President Bush globally is sufficient to affect investment in the United States at the margin. From experience there is not a little schadenfreude particularly from Europe at the travails of the American economy. On the other hand though it is hurting folks like Airbus. I think the effect here is twofold, a reluctance to invest in the dollar given any alternative and increased attention to opportunistic plays against the dollar. This isn't a primary driver but it helps set a negative backdrop for the greenback.

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