Friday, December 28, 2007

Dollar Woes Part III

In Part I and Part II of this series we analyzed the long-term macroeconomic trends that assail the dollar as well as recent developments. In this final installment I'll try to prognosticate for 2008 and beyond. Comments and questions welcomed.

What does 2008 hold for the dollar?
I think we will see the nadir for the dollar sometime in 2008, probably in the second half. In terms of levels, I see the euro peaking around 1.6000-1.6500 (current 1.4600) and unlikely to breach 1.7000 for any length of time. Versus the USD index I see it bottoming at 68 (currently 76). The analysis behind this is basic. 2007 was annulis horribilis for the dollar and it shed, at worst, 15% vs the euro and 10% vs the Index. I think it is unlikely that the dollar will do worse in 2008.

1. The G10 economies are, roughly speaking, perhaps 12-18 months in the cycle behind the US. Growth is beginning to slow in certain regions and central banks will start cutting rates. The UK, which has property sniffles of its own, as well as Canada, have already cut rates with Ottawa seriously concerned about the competitiveness of the Canadian dollar above par with the US unit. The European Central Bank for which inflation cutting credibility is paramount may start to cut rates in the second half of 2008. Rates cuts globally make the dollar more attractive.

2. Subprime writedowns should have run their course by the end of the first half. New chiefs at places like Merrill and Citigroup have every incentive to write down non-performing assets as steeply as possible to handicap their tenure favorably. Barring an as-yet unforeseen calamity all the bad news should be out.

3. Fed cuts are foreseen to have run their course, another 75 to 100 basis points or so, sometime this coming year. Once the last cut is seen/foreseen due to a more solid basis for growth (as opposed to fears of in/stagflation) longer term dollar accumulation may begin

4. A new president will be elected in November 2008 and one cannot imagine anyone more negatively perceived than George W. Bush. (A disgrace but that's a different post)

Flies in the ointment

A few reasons why we may see a further, drastic fall in the dollar:

i. Crude oil rises dramatically above $100 a barrel and Gulf countries are forced to de-peg the dollar. This may weigh more than anything else short term.

ii. A hard landing that will force the Fed to cut interest rates dramatically. A drop associated with this may be temporary and last until extremely low rates re-ignite the US economy


A. On China.

Many China hands foresee a marked slowdown in China, perhaps arranged by the authorities with a combination of a more quickly appreciating currency, higher rates and higher reserve requirement/capital ratios. Growth will chug along until the Olympic showcase in August and expected to slow thereafter.

China needs to rein in growth IN A MEASURED WAY. 10% growth (officially) and probably something closer to 15% is too high and one effect of this is business is adding capacity because the domestic currency's forced weakness is amplifying demand. This leads to investment at the margins that won't be profitable with loans that ultimately may not be repaid.

However, its critical to remember that the political priority for the Communist Party is STABILITY. There remains a teeming underclass of laborers numbering in the scores of millions who live hand-to-mouth. A sudden seizure in the economy would leave as many as 200 million itinerant, migrant workers without a job in the major urban areas. So China will proceed cautiously.

B. "Living beyond our means"

Pundits, would-be pundits and politicians are often heard declaiming that the United States "is living beyond our means" and that there, someday, would be hell to pay. What does this mean, really? It starts with the balance of payments which has to, by definition, equal zero. If we have a big current account deficit where we are paying more dollars out than we are getting in, that deficit has to be made up. A positive capital account compensates for the negative current account. In other words the dollars that go out come back in in investments in US dollar assets.

The question often raised then is "What happens when foreigners stop funding our spendthrift habits?" The answer first is UNLIKELY and if they do, NOT MUCH. Why is it unlikely? Well folks who have money to invest need to invest in safe, reasonably secure markets. There is no larger or more secure market than US Treasuries. And when the amounts are hundred of billions and trillions of dollars there aren't actually very many places that offer that much paper especially in long term maturities like 10 to 30 years. [On a technical note, long term paper is especially valuable in portfolio management to tailor portfolio characteristics.]

And if they hem and haw at investing at 4.5%, 5.0% will look much more effective. And at 5.5% they'd run over their grandmothers to grab paper. So the real risk is that concerns about the safety of dollar denominated assets will lead to higher US domestic interest rates. If the economy remains weak and rates are forced to remain higher the US economy could experience stagflation but I find that unlikely to be sustained as stagflation would drive the US economy into recession and that would immediately start to reduce the trade deficit.

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