The Daily Reckoning PRESENTS: "The dollar is falling! The dollar is falling! It's the end of the world!" At least, according to the Chicken-Little's of the financial industry...but never fear, John Mauldin is here is assure us that the valuation of the dollar is just the symptom, not the problem...
A MANIPULATED MARKET
by John Mauldin
The Federal Reserve defines the trade-weighted dollar as "a weighted average of the foreign exchange value of the U.S. dollar measured against a subset of the broad index currencies that circulate widely outside the country of issue." What that means, is they look at the countries with which we trade and create an index based upon the average of their currencies. The more we trade with a specific currency, the more "weight" it has in the index. That is why the euro can rise 50% and the dollar only fall some 25%. The currencies of Japan, Mexico and Canada are in the index, as well as that of China. The dollar has risen recently against the peso, is flat with China and has not moved all that much in terms of many of our Asian partners. The euro has taken the brunt of the declining dollar.
I am still bearish on the dollar and will explain why in a few paragraphs. But before we start, let's take a deep breath. The dollar falling is not the end of Western civilization. It is not some calamitous event that will shake the United States to its core. It will have consequences, of course, but it is far less important than the problems a secular bear market will have upon our portfolios. It is, however, a trading opportunity.
The point is that a drop of over 40% went unnoticed by most of America in the late 80's and 90's. Unless you were traveling overseas, you did not see much difference. The economy grew fairly well throughout the period. Inflation continued to fall. There were some great trading opportunities and many commodity traders made their reputations and fortunes in that period. In fact, the recent drop of the dollar has not had that much of an affect upon the average American (again, unless you travel). Some industries are helped and some are hurt, but most of us just plow on ahead.
But it was certainly not a disaster. The valuation of the dollar is a symptom, not the problem.
Secondly, we should take note that currencies are the one market in the world where profit is not the end game. In stocks, bonds, commodities, real estate and anything else that moves, the object is to make a profit.
Currencies are a manipulated market. They are manipulated by the central banks of sovereign nations, who make decisions about what the level their own currency should be for the own economic and political purposes. That makes them volatile and very difficult to predict in the short term. In the long term, the markets work. But it can be much longer than most people think. Now, with those caveats let's proceed. I am going to work very hard to condense my thoughts, because you could make a book out of this topic.
There are many reasons to be concerned about the dollar, but the number one reason is the trade deficit. It is now at $600 billion and rising. I readily acknowledge there are those who say deficits do not matter. In the short term, you can make case for such an argument. But over the long term, I am at a loss to see how you can make such an argument.
Yes, $600 billion is a fraction, and a very small one at that, of the annual international currency market, which trades $1.2 trillion every day. I understand that the US is a very desirable country to live in and in which to invest and do business. I understand that $600 billion is less than1% of our total national assets. I understand that our intellectual capital is a huge selling point. As many have pointed out, the dollar is holding its' own this last year.
Most of the above were true a few years ago, and the dollar still dropped since 2002. While the above reasons may make dollar bulls feel better, it seems to me like they are whistling past the graveyard. They really do not have much to do with currency valuations.
I have often quoted from a Fed study, which shows that any time a country gets to a 5% trade deficit, there follows a sharp correction (usually 20-30% or more) in the value of its currency. We have been there for some time, and are going higher. The rising price of oil almost guarantees the deficit will rise.
Why have we not seen such a correction? As noted above, governments for their own benefit, manipulate currencies. There are governments who believe it is in their best interest, at least for now, to keep the dollar propped up.
As Bill Gross of Pimco noted this week, the Fed is between a rock and a hard place:
"Despite candidates' insistence that this is the most important election of our lifetime, I suspect that the ones in 1980 and 2000 were more important, and the latter was decided by 500 votes in Florida or the U.S. Supreme Court depending on your political persuasion. Four years later and much deeper in debt, there's little either candidate can do to stop the near inevitable hegemonic (not hedonic!) decay. It's really quite simple you know. Asia has hollowed out our manufacturing base and is now making inroads into services. Job growth is and will continue to be hard to come by. To compensate we temporarily turned ourselves into a finance-based economy, dependent on paper profits and capital gains that in turn were driven by the march to historically low rates.
That journey ended sometime over the last year or so - some marking their hegemonic calendar at June 13, 2003, the 3.13% low of the 10-year Treasury, others signaling the beginning of the end on June 29, 2004, the point of the Fed's first cyclical hike in short-term rates. Whatever, whenever. If the driver of profits and job growth is the price of money as opposed to domestic investment, it should come as no surprise that when the price goes up, the good times fade away. Either Bush or Kerry - Hillary as well - will have to contend with this near inevitability....
"My/our most certain idea, as expressed in previous Outlooks, is that real interest rates in the United States will have to be kept low, that the old Taylor rule is out. Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing; it leads to asset bubbles, potential inflation, and a declining currency over time."
If the Fed raises rates too far, too fast, it will slow the economy and bring on a recession. If it keeps rates low, it risks inflation and a falling dollar. As I have written on several occasions, members of the Fed have let it be known that a little inflation buffer is not a bad thing if it is the price of protecting us from deflation during a future recession.
Inflation, however, is not good for a currency, as Gross and practically everyone else has noted. But the Fed does not care about the dollar. They will not willingly watch the economy wilt in an effort to protect the dollar. The only central banks interested in protecting the dollar are across the Pacific Ocean.
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