The US Dollar Is Not Weak

2007 09 24
The US Dollar Is Not Weak



In 2004, The USD Was Falling, But the Dollar Was Never Weak!
Germany’s long term economic policy has been to cultivate a
permanent trade surplus by saving more, and consuming less. But there
is another side to their trade surplus/high savings rate story. Growth
in Germany is 1/3rd that in the US, while unemployment is double,
productivity is similarly a fraction of what it is in the US. High
taxes, over regulation, and a pension system that is in deep trouble,
are costs that contribute to the broad structural deficiencies that
hold the German economic machine back.
This comparison of the leading economy in euro land with America is
an over simplified attempt to call attention to the importance of
understanding the dynamics behind a country’s strengths and weaknesses
which, in the end, are reflected in currency values. So the Euro has
been rising and the USD has been falling. What gives?
For starters, I believe we all can agree that the Euro’s rise is
less a story of Euro strength and more really a story about the
dollar’s fall. Dollar bears argue that long overdue structural reforms
in the US need to be embraced now, and they point to a looming 6% trade
deficit, as well as other issues that now seem to be threatening a
disorderly collapse in USD values worldwide. My point of view is that
the USD fall has been, bottomline, in a cyclical move lower from a
previously over valued level in 2002 when the Euro was only worth 85
cents.
At this point the next long term move in the dollar is in large part
dependent on the answer to one question:Does the US need structural
reforms, or is it the other nations of the world who are under
consuming and under producing that need structural reforms in order to
restore balance to the global economy and to currencies as well?
In a modern environment of economic interdependence, money flows
from around the globe increasingly affect individual, corporate and
national wealth through nothing more than the changing value of
currency relationships {forex is a $1.3 Trillion/day market}. Currency
traders who understand the dynamics behind these changing foreign
exchange values will profit consistently and substantially. Those who
have drawn the wrong conclusions about the underlying forces of
currency valuations are destined to be on the wrong side of currency
trades and their losses will enrich those who have been right!
In today’s foreign exchange environment one currency continues to
occupy centerstage as the world’s reserve currency–the US dollar. Gold
and oil are priced in dollars. The dollar is involved in 85% of all
currency transactions {Euro 37%, Yen 16%} and central banks the world
over accumulate dollars as a necessity for stablizing the exchange
value of their respective national currencies. Offshore central banks
finance over 50% of the US trade deficit that way. Three out of four
dollars now in circulation are held overseas. And today as we see the
US dollar falling farther and farther, we know that the rising price of
gold and the recent $50+ price of oil are
each in great measure
reactions to this current and anticipated further decline of the USD.
In fact Saudi Arabia is letting it be known that it plans to adjust the
new baseline price for its oil up from $25 to $35. Saudi Arabia has
also been selling some of its dollar reserves in favor of the euro.
There have been stirrings that China is substituting the euro for some
dollars in its huge cash reserve accounts. Net, net, if markets see
this trend continuing, the USD is certainly headed still lower. There
is also more and more credible talk that the euro will replace the
dollar as the world’s reserve currency. After all the Euro now has a
20% stake as the reserve currency of choice by the world’s central
bankers, up from 13% a short time ago.
Counter intuitively, we find the strengthening euro is not a welcome
development throughout much of europe and the world. Indeed today as we
begin 2005 and find the Euro at historic high levels, up fully 50% from
its lows of 2002, German Chancellor Gerhard Schroder is saying the new
level of the Euro is worrisome for the German economy. The French
Foreign minister is calling for an international conference to develop
coordinated policies {read intervention} to staunch the Euro’s climb
against the dollar. ECB President Issing is troubled and has asked
europe’s consumers to start spending to help the eurozone avoid
recession.
And europe is not alone in concerns about their currencies’ sudden
appreciation vs the USD. The Japanese Yen is up 25% and in reaction,
Japan spent $147 billion in the first quarter alone of last year
selling its Yen mostly for dollars in another of its periodic and
futile attempts to manipulate currency values. China is poised to raise
its Yuan’s peg with the USD since the dollar’s decline has dragged the
dollar-pegged Chinese currency lower with it and the falling Yuan now
threatens to ignite inflation in China’s already over heated economy.
So as the Euro, Yen and other international currencies continue their
rise in value as a counterpoint to the dollar’s decline, there are
economic costs at work.
It seems that in practice the world over, international economies,
but not always their political leaders, prefer a weak dollar. Indeed,
in a chorus that has grown stronger of late, the global political
community is increasingly lamenting how our new era of globalization
has become far too US-centric, and calls have become more urgent to fix
a serious global imbalance. The source of this global imbalance of
course must be America! “The US consumer is consuming too much, he
needs to stop that!”
Indeed, the emerging consensus in the popular and financial press
which after studying all of this has announced that there are 3 reasons
for the USD move lower since 2002, all pointing to the US. Too much
consumption {leading to a record US trade deficit} with its flipside, a
low domestic savings rate. And third, the US trade deficit’s twin–a
growing government budget deficit has become a dollar negative and is
now contributing to a precipitous erosion in demand for the dollar.
There is an abundance of opinion among those who follow currency
markets that indeed the fall in the dollar is due to these kinds of
structural issues that call out for America to reform. America must
consume less, raise taxes and save more. And so their answer to the
question, “Is the USD weak?” is an emphatic yes because the US
economy’s structure is weak!
There is A Different Opinion!
The one thing to remember about currency markets is that just like
water, they seek their own level. They inevitably find a balance and
these protests against the Euro’s strength suggests to me that the Euro
is not quite ready to step up and dislodge the USD as a replacement in
the global scheme of things for right now. It also suggests to me that
the dollar’s decline is cyclical and the USD therefore, even though it
is falling, is not weak.
Nevertheless, there is reason to believe that markets are
increasingly seeing the USD as now at a permanently lower plateau than
in the past, and I agree. So let’s revisit the pivotal question for
currency trader’s. “Is the USD weak, or is it falling in a normal
cyclical adjustment?” We need to look closely at what is behind this
dollar’s move lower if we are going to be ahead of what’s happening in
the currency markets in 2005 and understand these dynamics so we can
then profit in currency trades. Note:The Federal Reserve US dollar
index of 26 leading currencies ranks the dollar’s decline from Feb.
2002, at 14%. That was from what many consider to be an overvalued
level with the Euro trading at less than 85 cents per dollar at one
time. Today this basket of currencies shows the USD at the same level
it was in 1994! In other words, it is in sync with past USD cyclical
moves lower.
Despite the many statistics that show current USD valuations within
historical ranges, many governments, political leaders, economists and
currency traders believe the US is facing a crisis and must balance its
trade account, reduce consumption at home and return to the balanced
federal budget it had in 2000-2001. In the absence of such reforms, the
US invites a disorderly collapse of the dollar which is certain to lead
to global economic chaos
From the point of view of the international political community
higher taxes would be an ideal answer and contribute to all three
remedies. They would reduce consumption and thus help the import skewed
trade deficit plus also help point toward a balanced federal government
budget! They want to see taxes raised, consumers spend less and a
slower growth rate in the US. It sounds like they want the German
experience as the model for the US. Dollar bears and their adherents
are prepared to short the USD until they can begin to see their
remedies finding traction in the US economy. But currency traders who
buy into these prescriptions will be on the wrong side of the USD trade
in the long run. Dollar bears as they continue to sell dollars will
have a long wait for any profits in anticipation of a collapse of the
USD.
As a resident, citizen and student of the American economy, I can
tell you, neither the trade nor budget deficits in the US are going
into balance anytime soon. More to the point, barring a catastrophe, it
is virtually impossible to see them doing anything more than narrow
marginally. The domestic savings rate similarly is not going to rival
the eurozone’s 9% level, nor Japan’s 6% for the foreseeable future. In
fact, unless the American shopper miraculously morphs into a
parsimonious European or Japanese clone {something that is not going to
happen}, the annual American savings rate will not be surpassing even
3% anytime soon from its current 1% lows.
Quickly let’s look at each one of these “concensus” causes for the
USD’s fall and learn why so many currency traders are jumping to the
wrong conclusions about the USD, and we will see in the event,
opportunities open up for us to profit from being on the other side of
the trade, that is, long the USD. The question for currency traders is
“When to buy the USD, not ‘if’.”
A Reality Check Of The Bearish USD Analysis Does Not “Bear Up”
For those who say the dollar’s decline should be understood as a
reflection of an economy burdened by structural weakness {and there are
many prominant economists who do}, as opposed to a currency that is in
a cyclical move lower, then it would seem that the structural defects
which dollar bears allude to must be able to “bear up” under a reality
check. We know the US economy has grown at 4% in 2004. We also know
that between 1974 and 1994, productivity was about the same as in the
eurozone now–1.5%. But with the onset of the productivity gains from US
corporate investment in IT beginning in 1995, US productivity has more
than doubled for the last decade, and in 2003 and 2004, printed 4%
gains, almost triple euro land’s levels.
Even though the Federal Reserve policies on interest rates gave US
borrowers real negative interest rates, inflation in the US is as low
as the euro zone’s is–2%. So on balance, we see the economic foundation
of the USD neither defective nor needing reform. The US economy has low
inflation, soaring productivity and high economic growth, all much
better than historic trends, and all are projected to maintain those
levels for as far as the eye can see. Of course, unemployment, is much
lower than the eurozone, and trending lower. But what about these
structural problems within the US?
Low Savings Rate
The savings rate figure is the simplest of statstics to explain and
understand. Accountants add up total wages earned, subtract consumer
spending and what is left over they call “savings.” This savings rate
number as a measure of consumer wealth, consumer income, or even as a
loose approximation of consumer financial status in the US is only a
small piece of the puzzle, and has too often been used in a misleading
way.
You cannot assess savings in America without factoring in housing.
Three out of four Americans own homes and like the overall American
economy itself, the US housing market has been rising at an historic
pace. The move up has been so strong that housing sales and price
levels continued to print new highs right through the economic
recession of 4 years ago.
And even the much talked about “wealth effect” in the pre-recession,
pre-bubble economy in the US it turns out was mostly a benefit not of
stock market gains leading up to the March 2001 bubble, but of
appreciation in housing values and mortgage refinancing at historic low
interest rates {which generated widespread “cash outs–cash payments
after refinanciing because of the much lower interest rates}.
So it turns out that even though there was an equity market bubble,
and a recession in 2001 {not to mention the World Trade Center attack},
nevertheless the booming economic structure in the US was solid, built
as it was on new higher levels of productivity from IT, housing wealth
and low inflation. The recession, precipitated by the Fed’s higher rate
policies was, as I noted on my radio show at the time, a “good
recession” and a necessary one brought on by the over exhuberance of an
economic and investment “boom” underlying the US economy. Fed Chairman
Greenspan has said the reason he raised rates was because businesses
were investing too much in high tech and at an unsustainable rate. In
other words–the US had too much of a good thing. High productivity, low
inflation, robust consumer spending and the US’s growing home ownership
profile are not structural defects for any economy, they are the things
every economy seeks to affirm its strength.
Now as 2005 begins and with the recession far behind it, the US
quite clearly presents itself as an economy that is stable and poised
to consolidate its upward growth track, and with that will go increased
demand for her currency, the US dollar.
Which Leads Us To The Trade Deficit.
As someone living in America, I have confirmed for you that for over
a decade Americans have been living in an environment of low inflation,
dramatically improving unemployment, low interest rates, skyrocketing
real estate values, strong economic growth and an IT revolution that
offers falling prices on many of the latest and most appealing high
tech recreation and entertainment products available from all over the
world. Imports from foreign sources have been low priced thanks to a
strong dollar monetary policy in the US and taxes have been on a
declining trend. One has to ask the dollar bears, “Why wouldn’t the
American consumer spend and buy more and more imports?” With interest
rates at historic lows, housing wealth fueling personal savings {though
not counted as savings in the savings rate}, inflation low and low
priced imports from europe and asia abundantly available, it would be
odd if they weren’t spending, and given the moribund growth in Japan
and Europe, the 2nd and 3rd largest economies in the world, it would be
impossible for the US not to have a trade deficit. Americans are major
importers for the world and that fact contributes mightily to
international economic growth, but it also leaves America with a trade
deficit.

So bottomline? The call for consumer demand to retrench in the US is
a call that will never be heard. It is like whistling in the wind. It
is not going to happen, and further, a large trade deficit must be
understood as “part of the bargain” resulting from a strong consumer
driven US economy which is also stimulating global economic growth.
Don’t forget, the international economy is US-centric because of the US
consumer.
Finally, let’s look at the federal budget deficit in Washington.
The US government budget deficit is an easy issue to evaluate in
terms of its relationship to currency values. To begin with, the best,
most informed estimate of future tax revenues needed to balance
congressionally appropriated expenditures is reasonably accurate for at
most, 60 days out. Budget deficit estimates have a notoriously short
shelf life!
As the 2005 fiscal year began in October, 2004, the only thing that
was certain is that the real budget deficit will be no where near its
original working estimate. It never is! The Congressional Budget
Office, the White House Office of Management & Budget, and every
economist who follows federal budgets, none of them projected the
budget surpluses of 2000/2001. Indeed, most contemporary estimates were
being changed weekly during that period, as tax revenues exploded from
the hot US economy at that time.
That being said, the idea of a balanced budget is a principle that
the US should embrace. The 2005 budget at a projected deficit of $500
billion will pressure interest rates in the US higher. But higher
interest rates are USD positive. On the other hand, a $500 billion
deficit will increase the need for higher taxes, which subtract from
savings and investment growth, and so that is dollar negative. But then
we have to think about higher taxes which is what the dollar bears are
prescribing to strengthen the dollar and help the US address the issues
they see dragging the dollar down, and so higher taxes from their
perspective are dollar positive!
I want to note that it actually would be dollar positive, and
significantly so, should the US congress adopt a “paygo” rule, like it
had when the congress posted the surpluses of a few years ago. The
Paygo rule requires an offset in any new discretionary spending from
either an increase in taxes or reduction in other spending, thus
maintaining a stricter discipline over the budget. If the markets were
to see a balanced federal budget in the US’s future, they would
anticipate more investment in the US and at lower interest rates and
that will attract buyers to the USD.
The truth is, that at the end of the day a balanced budget is dollar
positive while budget deficits affect the dollar exchange rate only in
a marginal way, so long as they exist in an environment of strong
growth and low inflation, which we find in the US currently. With
declining unemployment and a base of high productivity we can discount
the federal budget deficit at these levels in terms of significantly
affecting USD currency values.
So it is quite apparent here in my “World of Currencies,” that the
structural strength of the US economy preempts a disorderly dollar
collapse crisis that dollar bears project. Apart from that, the
supposed structural causes of the USD’s decline, its trade deficit,
savings rate and government deficit are non starters as targets for
reform, and more importantly, not structural weaknesses after all.
Forcing the American consumer to spend less through higher taxes would
wreck the US economy and in the process derail global economic growth.
The global imbalances from an admittedly US-centric international
economic environment are real, but they can best be addressed by
greater consumption and other structural reforms in the international
community of the sort the German model is resisting. The two points of
view about where reforms must occur next are in fact, the two sides of
the USD trade.
The market will declare the bottom for the USD as soon as it
finishes making up its mind of how low that bottom should be, given its
new recognition now of the permanent status of a large US trade
deficit.. The Eur/USD level of $1.40 and USD/JPY of 100 Yen, may not be
the low point for the dollar, but if theyare not, they are awfully
close. The USD is falling, the US dollar is not weak!