Weekly Foreign Exchange Insights: October 16
October 16, 2009
One tends to learn more about U.S. foreign exchange policy from the Treasury Department’s semi-annual currency market reports than from the occasional and highly repetitive remarks by the Treasury Secretary or other top officials. The latest such report was released on October 15, arriving at an auspicious time when market professionals have been examining the likelihood that the dollar will continue to dominate reserve currency portfolios. The most revealing insight of the new report is that the U.S. Treasury measures whether or not the dollar is a strong currency on this question and not by whether the buck is holding value against other currencies. I’d suspected as much for a long time but had not seen this truth so clearly confirmed before. One other thing: this definition of a “strong dollar” is not an invention of the Obama administration but rather a manifestation of institutional Treasury Department thinking handed down from from each administration to the next. For the currency market participant, what all this means is that a government promise to maintain a strong dollar carries a negligible threat of policy counter-measures to back the words unless officials see evidence of declining dollar use as a reserve currency, which so far they clearly do not.
Despite repeated predictions of the demise of the dollar as the major reserve currency, the data show no significant diversification of global currency reserves away from the dollar.
The Treasury Department defends the above conclusion in a special appendix of its latest report to Congress by examining the composition of reserve holdings since 1979 and finding the U.S. dollar portion to be very similar now to then, i.e., above three-fifths, and never having dipped under a half. More about this assertion later, but first let’s look at what else the Treasury had to say.
The dollar losses since last spring are attributable to better global economic and financial market conditions and a resulting unwinding of safe-haven capital positions held in the United States during the period of rampant risk aversion. This is a reasonable explanation for much of the recent losses. Compared to August 8, 2007, a day before the onset of the financial crisis, the dollar shows moderate net depreciation of 7.2% against the euro and around 5% on a trade-weighted basis. With a 32.0% rise against the dollar, the yen conspicuously does not fit this picture. There’s a bigger fallacy with the claim that the dollar is merely relinquishing prior gains caused by the global economy and which are unrelated to U.S. fundamentals. The flaw is revealed when the dollar performance is considered over a broader time span and found to have very deep roots. The table below documents dollar net losses to date from 4Q05 highs and its peaks even earlier this decade, which occurred in 2000 versus the euro, 2001 against the trade-weighted index and 2002 relative to the yen. Note, too, that at those earlier highs, the dollar already had depreciated since 1968 by 62.5% against the yen and 40.6% and the the DEM-translation value of the euro. The dollar has a history of chronic weakness stretching back forty years and punctuated by just two periods of multi-year appreciation in the early 1980s and late 1990s.
| Dollar loss since | 4Q05 High | 2000-2 Peak |
| Versus Euro | -21.7% | -44.7% |
| Versus Yen | -24.9% | -32.8% |
| Vs Tde-Wtd Index | -15.8% | -39.1% |
The Treasury report dwells much more extensively on the Chinese renminbi and economy than on the slip-sliding dollar and bluntly calls China’s currency “undervalued.” The renminbi, also known as the yuan, had been fixed against the dollar for over ten years until July 2005 when it entered a period of carefully controlled and gradual appreciation. Three years later as global economic conditions deteriorated, that managed float was suspended abruptly and the new peg continues to this day, even though the Chinese economy is again expanding briskly — indeed by 15-19% annualized during 2Q according to Treasury estimates. China will report third-quarter on-year growth next Thursday. The Treasury scolds Beijing for returning to a rigid currency and piling up international reserves at an accelerating rate of almost $50 billion per month last quarter versus $31 billion during the first half of 2009. Note is made that the yuan is now also depreciating in trade weighted terms, unlike late 2008 and the first two months of this year. The Treasury further points out the drop of the ratio of Chinese consumption to GDP decreased from 46.4% in 2000 to 35.3% last year. In no other economy of China’s size does consumption represent anything close to such a low share of the GDP pie, and this fact serves as further proof that Beijing is not doing nearly enough to restructure its economy along the lines sought by the G-20, the new steering committee for global economic policy coordination of which China is a member.
The heavy attention on China is a smoke screen to avoid addressing the dollar’s own issues. The global economy will remain vulnerable to future substantial ruptures if China fails to undertake more sweeping adjustments, but fragility will also persist if more structural changes are not made by the United States and other advanced and emerging economies. The dollar remains the lynchpin of the post-WW2 international monetary system. It will be less painful if that system is modified by design rather than the force of market circumstances. But those who worry about the dollar’s erosion shouldn’t look for the initiative to emerge from the U.S. government. The definition of what constitutes a strong dollar means something different to U.S. officials than to market players or, more importantly, other economic policymakers like ECB President Trichet. Critics warn that benign dollar neglect risks losing American economic advantages from the dollar’s unique stature, and Washington has called their bluff with the counter-claim that the dollar is “strong” until or unless those negative consequences emerge. The litmus test for monitoring this process is the dollar share in reserve asset portfolios, and that shows trivial change compared to 1979. Moreover, the Treasury study singles out America’s “deep, liquid and open financial markets” as the key quality for why the dollar’s hegemony hasn’t yet been seriously challenged and why that is unlikely to happen for many years to come. The beauty of the argument is that the U.S. government doesn’t have to be proactive to maintain the status quo. Unless of course the logic behind the view is flawed, and it will be up to others to prove that case.
As we head more deeply into autumn, several currency market drivers bear watching. Australia’s rate hike this month will be a test case of the tolerance of economic recoveries against rising interest rates. Japan couldn’t withstand the process, and that worries me about the United States and Europe. News of a big rise this month in Australian consumer confidence is encouraging, but let’s see what happens when Australia moves in bigger increments than 25 basis points, which is a good bet next month or in December. The monetary exit strategy isn’t going to work if the Fed and ECB are unable to shift gears up to
moves of 50 basis points or greater. That need, rather than learning the calendar when the first increases occur, is going be very crucial in the coming two, five or even ten years. The special strengths this past week of sterling on a rumor that quantitative easing will not be raised again and the Australian dollar on its central bank’s hawkish rhetoric indicate that markets are giving currencies the benefit of the doubt when credit polices move away from ultra-ease. The reaction of affected currencies is likely to be much less positive if economic recoveries stall or slow to less than 1.5% as a result.
A final thought as we head into a new week is that stock market performance remains critically important. Consolidation days like today are to be expected. The amazing thing is that markets haven’t suffered much bigger setbacks. Unless most economic forecasters are wrong in looking for atypically soft trend growth in the next business upswing, equity rallies seem to be way ahead of underlying economic conditions, and that is the result one would expect after all the liquidity that has been pumped into money markets. At some point as liquidity is reabsorbed, equities could suffer a violent setback that would upset the strong equities/strong commodities/weak dollar metric that has been driven by a return to a healthy appetite for risk aversion. A larger correction of stock prices than any seen since the March 2009 could be triggered by the scaling back of quantitative support,a run of weaker-than-forecast data, or even spontaneously from no apparent cause. That could create a reversal of the pattern of dollar weakness. Investors should pay particular attention to sterling, which experienced a sharp upward bounce this week after touching $1.571 when speculation arose that quantitative easing will may end in November. Watch gold too as it continues to be a barometer of risk aversion.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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Larry,
Thanks for the insights, esp. clarifying the way the US govt looks at the USD and measures and determines the “strong dollar” over the years.
I wrote recently about the secular bear market in USD but looked at USD index data from the final collapse of the Brettton Woods in early 70s. Your look back to 1968 was very helpful. Asian govt’s still do the USD protection drill, put the proceeds in US treasuries and help keep US rates low. This is a broken record it seems.
Global govts’ policy responses amount to a “hair of the dog” rx for the 2007-08 debt bust – eg leverage (govt-provided this time) and relaxed accounting rules. These actions triggered another massive yield chase (junk bonds up 50% ytd) but we are supposed to trust that exit strategies will be timed and sized correctly. Yikes. These central bankers aren’t super- humans. And fiscal policy makers will not cut back as they want to be re-elected.
I feel sometimes we must whistle past the graveyard too much. A third bubble-popping wreck (hedge funds, commodities, what?) in little over 10 years would be horrible. Govt’s w/b out of capacity to mount credible huge policy responses.
Do you share these concerns or see a good probability for a better outcome?
U.S. real GDP advanced 3.3% per annum in the last quarter of the 20th century. That’s a good estimate of long-term trend growth. Over the first 9-1/2 years of the current decade, GDP expanded just 1-2/3rds percent per annum, that is half as rapidly as trend, and I fear that will be more indicative of the speed limit over the next decade than what we experienced in 1975-99. I believe that the labor market will remain very severe and that the flattening jobless rate and falling pace of unemployment insurance claims reflect job seekers giving up the hunt and running out of benefits.
So you see, I have concerns. But I am not in the camp that is panicked that an explosion of government debt will drive up long-term interest rates and inflation. I look to Japan for wisdom on that issue, and their experience has been just the opposite. Despite a debt to GDP ratio that’s above 170%, Japan has no inflation and a 1.35% long-term bond yield. One of the great lessons there is that economies that suffer an enormous drop in economic activity may lose their ability to tolerate rising interest rates without tipping back into recession. When people question whether the Fed or other central banks have the fortitude to raise rates as aggressively as such were cut, the assumption is that a successful exit strategy must involve numerous rate hikes of 50 basis points or greater. That was assumed in Japan, too, when overnight rates fell to 0.5% for the first time in September 1995, but it hasn’t been possible in the ensuing 14 years to either lift rates by more than 25 bps in a single time or to lift such to levels above 0.5%.
One further comparative note. Japan’s economic difficulties that began in the early 1990’s and America’s that followed the 1990’s each occurred after periods of very rapid productivity growth. Economists love to see fast productivity growth and consider such to be sign of rapid future GDP growth. It isn’t necessarily so.
I have to admit I am very impressed with the quality of your blog. It is certainly a pleasure to read as I do enjoy your posts.