Thursday, March 27, 2008

why the dollar may be doomed

I'm writing this to address head-on the full range of challenges facing the USD. sometimes when analyzing a financial asset, all factors unite in a single direction -- making it almost impossible to doubt the expected result will happen. right now, the forces seem to be lining up to make further and increasing dollar weakness almost certain.

I'd like to start by looking at money itself.

Is the Dollar Still Money?

in financial history, people create money from valued things. in primitive times: food, tobacco and gold ... in allied prisoner camps during WWII, cigarettes were used as money... and during the boom years of the 1990s, corporate executives printed common stock as shares to pay starry-eyed youngsters and to finance multi-billion dollar takeovers ...

in all these cases, the commodity is durable, divisible and uniform -- these are necessary conditions for something to be money.

but the single question that trumps all of these is: does anyone actually want to own it? does the dollar have its own inherent value, like wheat or cows? can you smoke it as you dream of returning home from war?

the nice thing about gold is you know there's never going to be much of it. can you say the same thing about the dollar, with ben bernanke cramming liquidity into our sick financial system? the answer is increasingly "no." consider the million and one transactions that happen every minute in the world... on the margin, people are increasingly shunning the dollar.

for instance Korea's National Pension Service says it's already bursting with US Treasuries and won't buy more. already china has been diversifying its own reserves, and middle eastern countries are suffering rampant inflation from their dollar pegs. (one thing that might happen over time is that brazil, colombia and chile may start buying more US debt as we start suffering wide recessionary budget deficits. in fact, Brazil's holdings rose more than 150% to $141.7bln in january. russia is also gaining.)

Still the Leader?

these countries all benefit from strong commodity production and trade surpluses. in contrast, the US is a net importer. but like all fiat money, the dollar is only as good as the government and economy backing it.

ever since the late 19th century, one simple assumption has been true in international politics and finance: america was either ascendant or was the clearly dominant economic power. our global dominance reached its peak in the 1990s stock market run, which was followed by a bubble in the dollar.

but events around the world are generating questions about our global dominance ... we face the bleakest set of challenges since the 1930s, while every other major economy in the world is doing somewhere between "OK" (japan) and "incredibly well" (china, brazil, russia). yes, they will be affected by the US slowdown, but I don't think it will be nearly as hurt as we imagine. their economies are healthy and relatively new.... our is sick and probably getting sicker.

does our sneeze still have the ability to infect the global economy?

or does it lead to even greater dollar weakness, which will drive up commodities and continue to help brazil and australia? now that oil prices are near record highs despite falling gasoline comsumption in the US and there's no political risk of iran or nigeria priced into the market, we clearly have less of an effect on the global economy that just 10 years ago.

I believe most emerging markets will remain strong for years. after knowing years of poverty, these third-world people are enjoying the lives we've taken for granted for the past century. they are happy and excited about a richer future. they're not going to let it just slip away.

in these countries, a virtuous cycle is in place as people see others succeed and aspire to their own wealth. many have declining inflation and falling interest rates... the basis is laid for years of steady economic improvement regardless of what happens in the USA. this could allow our country to become a stagnant and inflated backwater in the global economy within five years. as that unfolds, as fear and asset destruction overtake the US economy, it will increasingly make sense to allocate the marginal pound, euro or dinar into another store of value.

Dumping Dollars

once you remove the assumption of US economic supremacy and hegemony, the USD starts running into problems. yes, europe has worse problems in terms of unfunded obligations and aging populations. but, the euro is not a widely held commodity like the dollar. about $2.4trillion of Treasuries are held outside the US and supply is expected to keep rising as the economic slowdown widens the budget deficit.

plus, the ECB seems completely opposed to rate cuts, regardless of what the currency strategists think. without that on the table, it's hard to think the euro will stop rising. let's see if europe starts to slow the way the economists predict...

next, many currencies are pegged to the dollar. to me, it seems axiomatic that if they are undervalued and pegged to the dollar, they are forced to surrender some of that strength into the US. they are essentially subsidizing our consumption.

in other worlds, can't we say the dollar is now partially backed by the dinar and dirham? but since the peg is causing them inflation, how long can they hold out? here some instances of how some of the global pegs to the dollar are weakening:

UAE: the dollar-dirham tie could be broken if inflation worsens and the USD keeps falling.
Qatar: will revalue by april, according to a Standard Bank report this month.
Korea: pension fund to stop buying Treasuries.
China: chinese exporters are avoiding the dollar and devising ways to deal with its declining value.

and, a former Wall St banker who now teaches in China thinks they will do a sudden revaluation of 15-20% to prevent people from buying too many yuan in the near term.

it seems that in each case except korea, the greenback would be weaker if they let their currencies appreciate.

the only thing that could strengthen the dollar now is an unexpected strengthening in the US economy, or slowing in europe or china. so far, the news flow runs strongly against either proposition -- for the first time in a century, america is not the global economic hegemon. it's a new century.

The Future

now that we've reviewed what we know to be true, it's time to consider what might become true next. societies and markets are dynamic as past successes and failures influence future action. growth tends to beget more growth, and problems tend to bring on more problems.

one potential concern in the near-term is social unrest. we have record high gasoline prices months before the prime driving season. if it's a hot summer and people in urban areas are angry about paying too much for everything from food to gasoline, it's like dry tinder in the forest. add in the bizarre situation happening in the democratic party. the convention is held in denver aug 25-28... what if hillary pulls off a coup against obama and urban populations riot? ... after all, this year is the 40th anniversary of the violent protests at the convention in chicago during the height of the 1960s...

we must not underestimate the degree to which the US is vulnerable to social unrest because of high fuel prices. fuel riots have happened in places like venezuela, china and nigeria. millions of americans are dependent on cheap fuel to live their basic lives. it's a dangerous environment. I'm not saying it will happen. I am just saying, it's more probable now than it was 2-3 years ago.

let us think from the perspective of a foreigner thriving on growth in a country like china or india. he probably sees the US, loaded with bad debt and a declining currency. what happens when he watches the news and sees images of unrest in LA and Phoenix? what happens when he simultaneously hears the US will have widening budget deficits? he will simply want to avoid it, and sell it.

furthermore, oil prices have risen on their own, almost devoid of a political-risk premium. its current strength seems to be driven by real demand. light sweet crude has consolidated above 100.

it first probed the high 90s in november. it then consolidated, retesting the 86 level 3 times, before breaking above 100 in mid-february. it next moved quickly to 110... but this time, it only fell to 99.20 or so before rebounding again to the upside. this kind of consolidation at a key triple-digit level seems to me the kind of support that may never get taken out. a permanent repricing may have occured.

to me, it appears oil is consolidating at some very key levels before another bull run higher. looking at oil purely as a chart, it seems entirely possible for it to end the year at $150. I know that sounds outlandish and crazy, but it seems to be in a very strong uptrend.

things could also go worse in iraq and a more general state of conflict might occur in the middle east. it doesn't seem to be a danger right now, but geopolitical risk is not really reflected in oil prices right now. over time, it's reasonable to expect it could return.

now, to be honest, I know very little about the energy market. I'm only looking at the chart, which technicians believe is the best reflection of long-term demand.

it seems to me that hedge funds and ETFs are changing the nature of commodities. many experts say there's never going to be a chance that financial investors will matter more in the market than supply and demand for the commodity itself. I simply cannot believe that. right now, I don't have time to research who owns what in the commodities market. but I know how to put the pieces together. oil and commodities will become the favored investment of americans in coming years, further driving their prices higher. yes, they will form a bubble, but I think it still lies far in the future.

once again, imagine wall street's reaction to fuel riots? money would surge into ETFs like the USO.

furthermore, looking at another chart, between feb 7 and march 17, the dollar index plunged from 77 to 70.7... it then rebounded to about 73.2 before continuing to fall. this marked a 38% retracement of the move, confirming to me a stronger downtrend remains in place. a projection puts the next level around 66.9. I see technical obstacles or obvious support to halt this downtrend.

it seems the only hope for the dollar has been an intervention by foreign central banks... Bank of America's Robert Sinche addresses the subject in the last issue of their daily research report Situation Room:

There are probably four main preconditions for coordinated intervention in foreign exchange markets-significant currency misalignment, excessive speculative positioning, destabilization of markets or economies and a reasonable chance of success. While there is likely to be ongoing talk of imminent intervention by G3 Central Banks, our assessment of these criteria suggests the probability of intervention in the near term is, in fact, quite low.

if B of A is correct, the dollar bulls have virtually nothing to hang their hats on.

again, this posting is meant to paint the bleakest picture. many of the bad things in it might not happen. more worrying is the complete lack of bullish things going for the dollar. I can only imagine 3 things that could really help the dollar now -- barring some freak geopolitical event, like the arrival of extraterrestrial life:

1-a sudden, unexpected rally in home prices
2-a decline in oil prices
3-bernanke changes his position and drives up interest rates, inflicting paralysis on the US economy.

all three of these events seem pretty unlikely.

before, the unimaginable thing was that the US economy would cease to matter and that inflation would run out of control. most people still consider this highly unlikely.

but, the one thing that now really is unthinkable is that one of these three things will happen. now, looking at the facts, dollar strength itself is starting to seem unimaginable.

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