Understanding the Dollar

Part of the story behind today’s market decline was the continuing weakness of the dollar.  While this has not been a major theme at "A Dash," it does illustrate an important point.

This is a subject that most people do not understand.  Many of the sources offering information have a strong political viewpoint.  It can be difficult to figure out where to get solid information.

Some Important Considerations

Here is a summary of conclusions that we have reached.  We would be willing to defend each, and might do so in future articles, but this piece is only a synopsis.  As usual, we are sticking to topics within our own expertise or helping to identify genuine experts.

  • Markets are highly sensitized to dollar weakness and the flip side, commodity strength.  Interviews with those in the trading pits highlight a crowded trade.  There is plenty of reason for them to go with what is working.  Futures traders are trend traders.
  • China is not on the verge of calling in all U.S. loans.  Many try to understand international economics through a gross oversimplification: thinking of countries as individuals or families.  In fact, Chinese leaders maintain a trade imbalance because it helps them grow their economy and employ workers.  It would not be in their self-interest to weaken their own industry or the value of their current dollar holdings.  Despite these facts, pundits have created a climate where many expect imminent disaster from this debt.
  • The U.S. current accounts deficit also reflects the national interest of many countries who compete in exporting to the U.S.  Former Dallas Fed President Bob McTeer has an excellent non-technical explanation of this, well worth the time to read.
  • If there were to be a change in Chinese policy, we will not learn of it through Cheng Siwei, the Vice Chairman of the Standing Committee of the National People’s Congress.  Given the lack of knowledge about China and the current climate of fear, any threatening remark gets plenty of attention.  Phil Izzo in the Wall Street Journal’s Economics Blog was quick to post a great roundup of economic commentary, but the market damage had already been done.  One great comparison, from Carl Weinberg of High Frequency Economics, likened Cheng Siwei’s comment to a Charlie Rangel speech telling the Fed what to do with monetary policy.
  • The Fed is not going to change interest rate policy in reaction to the dollar.  Once again, there is no source better than Bob McTeer, who gives the inside story on the Fed reasoning.  He made similar comments on tonight’s Kudlow and Company.

Conclusion and a Little Speculation

At some point (maybe now?) the dollar decline will no longer serve the various national interests.  When Robert Rubin was Treasury Secretary, he had a reputation for deft currency intervention, often at a time when it would  have the greatest impact.  It would not be surprising to see something like that, perhaps in concert with other nations.  The action would be accompanied by some tough talk.  Such a move, if timed correctly, would also have a positive influence on potential foreign investors in U.S. assets.

While a gradual decline in the dollar versus certain currencies may resolve some trade problems, the rapid decline of recent days does not serve any national interest.  In such circumstances, governments generally take action.

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  • Mike C November 8, 2007  

    Your points are well-taken.
    I think the most important consideration of all beyond some of the behind the scene specifics is coming to a reasonable conclusion based on the preponderance of evidence about what the most likely path of the dollar is for the next 3-5 years because that is directly translatable into a source of portfolio outperformance. From a portfolio management perspective rather then an academic economics perspective, I think the “what” is more critical then the “why”.
    For the past 3-5 years, anti-dollar plays have been an easy source of strong performance. Long commodities, long precious metals, long international and emerging stocks. I have had substantial exposure to these segments for the last several years.
    In my view, the dollar is short-term oversold, and due for a short-term technical bounce as it is a “crowded trade”. I do believe the LT trend remains down for many reasons including one you specify above:
    “The Fed is not going to change interest rate policy in reaction to the dollar.”
    I think being overweighted in anti-dollar asset classes/trades remains the way to go over the next couple of years.

  • yo November 8, 2007  

    Rubin has been deified by his using the gov’t to trade, rather than act as a lender of last resort. Personally, I kind of like this method , but it’s really nauseating to listen to liberals clap when one of their own does it, but act as if it is an action of the anti-christ if a republican would do such a thing.

  • VennData November 8, 2007  

    I know McTeer is ‘an expert,’ having ground his way to the top of the bank food chain by whatever way Fed bankers distinguish themselves, but only toward the end of the missive does he reveal the sophistry that brings him to his conclusion:
    “…But for foreign investors contemplating investing in the U.S. — a two-shot transaction — the important thing is what happens to the dollar during the investment period. Once the dollar becomes cheap enough for investors to conclude that appreciation is more likely than further depreciation, then they have an incentive to invest here, even if the dollar is still “low.”…”
    His key assumption “the dollar becomes cheap enough for investors to conclude that appreciation is more likely” doesn’t make sense.
    First , in aggregate, some investors will come to his favored conclusion, some won’t. As that distribution flexes over time, less investment – ergo less dollar flows – will occur, since some percentage of non-dollar-based investors will have decided the dollar is in a secular downtrend (or at least will continue to drop.)
    Market participants never work in aggregate for more than a scintilla. Markets take us to the clearing price where half the market thinks one way, half the other (as opposed to models ala sub prime CDO’s, BLS employment figures etc. )
    Second, McTeer ‘the expert’ believes people will conclude that the dollar’s too low. A rational portfolio manager – whether a business owner, pure financial player, or long term investor ala Buffet – will not ‘conclude’ but fade a belief one way or another. This is diversification. Anyone going around concluding things and acting all in will eventually be wrong and have their assets taken from them. This ‘plain English’ explanation misses key financial realities.
    If you build that Michelin plant in Ohio, which way will oil/dollar, ringgit/dollar, social security taxes/dollar etc go? Careful, Monsieur, your career depends on your ‘conclusion.’
    Did ‘everyone conclude’ the dollar was too high after Bush took office? No. Anyone who did won big, anyone who didn’t lost big, everyone else has muddled along, re-allocating their financial, as well as their hard assets, over the subsequent years. Would any of those “winners” make the same bet?
    Jeff, your comment about political axes grinding away in so much economic commentary is dead on. If folks really “knew” about where asset prices were going they’d be ‘out there’ taking advantage of it, not talking their political book. McTeer’s no different: a top-marginal tax cut apologist, like Martin Feldstein et al they’ve recently become reflationist currency depreciators, making a semi-virtue out of necessity since they need to show Bush’s tax cuts “worked.”
    Since the S&P500’s not beaten core inflation under Bush…
    … they need to save the waning lame duck’s months somehow, letting the dollar slide won’t have repercussions for a while – the reflation game – so that’s the talking point for now.
    Fed analysts and their models may explain the former Fed governor and university president’s world view, and their most important skill: trying to build confidence, but that doesn’t make their arguments right. Investing in a dollar recovery right now is a 50/50 bet, and will continue to be.

  • Turley Muller November 8, 2007  

    My thoughts are that the dollar is near-term highly oversold. With bets on future rate cuts, I would think foreigners increase their Dollar hedging on US investments, and hedge funds and traders are predicting this and short the Dollar.
    Or expect foreigners to sell Dollars now, and get out US and traders are trying to lean on them.
    Same with Oil. These days so much trading is done by speculators as opposed to hedgers, taking positions that with no intention of ever delivering into, thus demand/supply of trading may much different that demand/supply of the actual currency/commodity physical exchange.

  • T November 11, 2007  

    A few months ago, both Bernanke and Paulson kept saying the credit/housing crises were “contained”. Now Bernanke “warns” the economy will slow down significantly due to these problems. I give them the benefit of the doubt (believe they were telling the truth to the best of their knowledge at that time.) So what remain to consider are:
    – They didn’t have sufficient/good data to use in their “ANALysis”.
    – Were they just plain incompetent?
    If the Fed and the Treasury, with their “collective wisdom” of hundreds of Ph.D’s couldn’t see what the whole world seemed to know then that these problems wouldn’t be “contained”, then what exactly is their job? And how relevant is the data they use? Is it the same sort of data that makes them think “inflation is contained”? I’d be very wary.
    And why is it that this Fed is the only central bank in the world that uses only “core inflation” in its “ANALysis”? The poor
    people are suffering from rapidly rising inflation on living costs every day, and from constant depreciation of their savings due to aggressive rate cuts, and from reduction of their buying power from the falling dollar.
    Sometimes all we need is just a little common sense. Bernanke is living in an academic world and believing in fancy computer models instead of observing what’s happening in real life. Remember what brought LTCM down (with it’s elite traders and Nobel laureates)? Fancy computer models that’s blind to the possibility of “fat tails.”
    So who exactly benefited from the Fed’s actions with recent rate cuts? Certainly not main street. Why did Bernanke talk to a bunch of the biggest hedge fund managers the day before the “surprising” discount rate cut last August? Amazingly, on the afternoon that day, the DOW shot up over 300 points from a free fall in the morning to near break-even. Who knew what and when? Just a thought.
    Now, after aggressive rate cuts that lifted up the stock market the last few months, long term mortgage rates are still going up, gold/commodities are still going up, REAL inflation is still going up, the dollar is still going down, and nothing seems to be “contained.” Guess what, the rate cuts didn’t help the sectors that needed them most, i.e., financial and homebuilder/mortgate sectors. Instead, the injected liquidity found their way into the Chinese/emerging market bubble and momo tech/solar stocks. New money always finds its way into efficient markets, not where the debacle is. Hasn’t this Fed learned anything from the Greenspan’s era? Haven’t they ever wondered why we had the housing and credit bubbles after the 2000 tech bubble? What will be the next bubble if they continue with aggressive rate cuts?
    So after all these Fed’s actions that helped solve nothing but (coincidentally?) benefiting Wall Street scumbags for a few months, at the expense of everyone else (mostly poor people), Paulson still wants to help create something called super-SIV. It’d better be called “SRG” (super risky garbage.)
    The rest of the world is not going to be fooled once again with Wall Street’s financial tricks. Ironically, it’s England and Europe and the rest of the world (except the US) realize that inflation threat is real. Will a warning of “economic war” from Europe be enough to wake up the Fed and the Treasury? I have my doubts.
    Here’s what could potentially happen, or already is happening, or begin to happen:
    – Dollar crash
    – Bond market crash
    – Stock market crash
    – Mortgage/credit defaults will continue to grow quickly
    – Credit crunch will get more and more severe
    – Consumer/business spending are going to grind to a halt
    – Inflation/gold/oil will shoot up
    – Recession (if not depression)
    – Deflation, Japanese-style
    I hope it’s not too late that Bernanke and Paulson will finally see a super high speed train is coming their way, but it may already be too late. Bernanke and Paulson may have suffered from “dear in the headlight syndrome”. Both have run out of “silver bullets” to stop what’s happening. Perhaps they will have one left to use on themselves if they so desire.
    On the brighter side, there appears to be a few other potential alternatives for these two s***heads:
    – Paulson should resign and go back to Goldman Sachs (if he still could.) The dollar keeps crashing despite his “strong dollar policy” lip service. By the way, why GS is the only Wall Street firm that made profits on the sub-prime mess while every other firms suffered. Hmmm.
    – Bernanke should resign and go back to Princeton to teach (if he still could.) I wonder if the Economics Faculty would allow him to train the next generation of “money-printing press” champions. After the coming recession and stock market crash, he may be better off to start writing a book titled “My previous life as an ex-professor and stumped-by-market-forces Fed chairman”.
    If lucky, he may be able to collect a few bucks to cover his daily expenses (some losers may still be interested in finding out what this chowerhead’s thinking was.) Maybe then he will realize that those few bucks won’t buy him what they once could. That’s the only way this clown (and his counterpart at the Treasury) may be able to understand what the poor public is feeling right now as a result of idiotic Treasury and Fed’s policies. The Fed should be abolished, period. If we can’t do that, then we at least need a Fed Chair with a backbone like Volcker.
    Straight from one of our Founding Fathers:
    “I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”
    Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin (1802)
    3rd president of US (1743 – 1826)

  • 8 November 13, 2007  

    The dollar bottom may already be baked in because the Fed has curtailed money supply growth. Unless foreign nationals suddenly decide dollars are not good to hold, or the U.S. economy falls off a cliff, the dollar bottom will arrive sometime in the next couple of years.