Dollar Seemingly Weak on Diversification

April 25, 2011

The U.S. currency continues to struggle even against the euro, which some analysts early this year predicted would make a run at parity because of Europe’s sovereign debt crisis.  That crisis has been every bit as bad as imagined, attested by the extremely wide Greek, Irish and Portuguese bond premiums over German bunds.  The dollar nonetheless touched 1.4628 per euro earlier today, not far from last week’s low of 1.4649.  The greenback was last this weak in the final month of 2009.  An exchange rate of 1.4628 translates to DEM 1.3370, 80 pips stronger than the dollar’s weakest-ever D-mark value hit on March 8, 1995.

There are several economic fundamental similarities now to early 1995 and last 2009.  U.S. CPI inflation of 2.7% is the same as in December 2009 and two-tenths of a percentage point less than in March 1995.  The United States lacks stellar growth now.  GDP last quarter probably expanded between 1.5% and 2.0% last quarter.  A favorable inventory swing lifted GDP 5.0% in 4Q09, but perceptions of the economy were then much weaker because of high unemployment and the aftermath of the Great Recession.  Growth in the first quarter of 1995 slowed sharply to just 1.0% annualized.  America still has a chronic current account deficit, equal this year to between 3% and around 3.5% of GDP compared to 2.7% of GDP in 2009 and 1.5% in 1995.  The ten-year U.S minus German sovereign bond spread of 13 basis points lies between and close to its width of 34 basis points in mid-December 2009 and minus 5 on March 8, 1995. 

Short-term rate spreads are more disadvantageous for the dollar now than at the two earlier periods.  The spread between three-month eurodollar deposits and euribor deposits of minus 109 basis points is clearly worse than minus 43 bps in March 2009 or plus 125 bps in March 1995.  Commodity price changes also are symptomatic of a more dollar-hostile environment.  Between March 1995 and December 2009, oil and gold prices soared 282% and 198%, and since December 2009, those commodities have jumped by an additional 62% and 33%.

As in early 1995, the accusation of benign dollar neglect is very prevalent now.  Investors expect a currency that is undervalued yet still falling to be defended with an assortment of tools, notably but not limited to tighter monetary policy.  When officials instead look the other way, doing nothing to support an under-performing currency and, more conspicuously, saying nothing about the currency, the logical inference to draw is that the government wants a more competitive exchange rate.  If the United States were still obligated to defend a fixed dollar/gold parity, there would be less difference between its predicament and those of Greece, Ireland, or Portugal.

2011 is neither 1995 nor 2009.  The world economy is much different.  The gap between advanced and emerging economies has narrowed.  Business cycles in the latter group used to be dependent on what happened in more industrialized economies, and that line of causation has now flip-flopped.  Reserve asset diversification used to refer to the behavior OPEC and Japan. Subsequently, the global stock of foreign exchange reserves expanded substantially, and China has shot up to the top of the charts among offshore holders.  The threat of diversification into other currencies and stores of wealth used to stem pretty exclusively from fear of dollar depreciation.  Once the dollar turned up, chatter about diversification died down.  That’s no longer true.  Treasuries held high intrinsic appeal because of the depth of the market and the economic strength and political stability that lay behind Washington’s fiduciary obligations.  This bedrock of attractiveness no longer can be taken for granted.  U.S. fiscal trends are viewed with considerable alarm and cynicism. 

A shadow of diversification hangs over the dollar.  Economic fundamentals do not seem to justify the dollar being as weak as it is against a wide assortment of currencies — the euro but also the pound, Swiss franc, Japanese yen, commodity currencies like the kiwi, and emerging market currencies from the Brazilian real to the Thai baht.  The persistence of dollar weakness in the face of a European debt crisis with headlines every day and other fundamental comparisons that do not seem terribly unfavorable suggests an invisible market hand that is applying steady and firm downward pressure on the U.S. currency all the time.  Market conditions define the role of a process rather than a one-shot adjustment to new information.  The logical conclusion is that the process in question is one of reserve asset diversification.

Diversification is the eventual fate of all top global currencies.  It is the missing link between a currency’s external value and what the asset continues to symbolize to the prevailing international monetary system.  Long before the main reserve asset coughs up that role, it will lose value in see-saw fashion to other major currencies.  For the U.S. dollar, this coexistence of eroding value and prized usage in financing trade and investment has been happening for over four decades.  In just over 100 days on August 15, 2011, the world of foreign exchange will commemorate the the 40th anniversary of President Nixon’s announcement suspending the dollar’s convertibility to gold.  The dollar was never the same after then, though few Americans felt the difference.  As former Treasury Secretary John Connally famously said back then to his European counterparts, “the dollar is our currency but your problem.”

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.



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