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Inquiring minds are concerned about the U.S. dollar. Where is it headed and why? Some who think they know, just might be surprised by the answers. Let's start with a list of problems and see what affect, if any, they have on the dollar.
The U.S. has major problems, lots of them.
For starters there is an imploding housing bubble, a massive trade deficit, and the latest news is an attempted bailout of Citigroup (See Professor Depew's Special Edition Five Things You Need to Know and Super SIVs - A Fraudulent Attempt at Concealment).
No one can deny that credit expansion as referenced by M3 is exploding. The Fed is also cutting interest rates, and there is talk of massive "printing" by the Fed. Finally there are external pressures such as the carry trade, currency pegs, and sentiment to consider.
Which of those factors are directly affecting the U.S. dollar?
Trade Deficit vs. U.S. Dollar Index
click on chart for a sharper image
The above chart is courtesy of Bart at NowAndFutures.
There you have it. There is no discernible relationship between the dollar and the trade deficit. But that does not stop people from bringing it up the trade deficit every day in relation to the U.S. dollar.
The Housing Bubble
The housing bubble in the US is well known, but the bubble in Canada, the UK, China, and Spain is just as big (if not bigger) than the bubble in the U.S. In particular, the bubble in Vancouver is as massive as the bubble in Florida or California ever was. Vancouver housing prices are destined to crash. Don't ask me when, but only fools are buying at these prices. The housing bubble in Australia was the first to start deflating.
The point here is that housing bubbles are practically everywhere you look. So the housing bubble per se is not a cause of the dollar's weakness. However, the Fed's response to the collapsing bubble (lowering interest rates) is another matter. We will get to that shortly.
Monetary Printing - What's the Real Story?
The myth persists that the US is massively printing. This is simply a falsehood as discussed in Is the U.S. printing money like mad? and Is the Fed Deflating?
Monetary printing can be followed by watching base currency. In the charts below, base money is shown for the US and EU. Where not shown, M1 is the closest approximation. The first chart below dispels the printing myth.
Even if the US is not massively printing, many point to M3 as the reason for the collapse of the dollar. Currencies, however have to adjust relative to other currencies. So the logical question then is "What does M3 look like in other countries?" With that question in mind let's take a look at charts of M3 from a handful of countries. Note that in the UK, M4 is the nearest equivalent of what we call M3, and in China M2+ CDs is the closest approximation.
The following charts are once again all courtesy of NowAndFutures with anecdotes in red by me.
M2 + CDs China
- Japan 2%
- EU 12%
- US 13%
- UK 14%
- China 19%
- India 21%
- Russia 41%
- Venezuela 69%
The above numbers indicate the rate of growth of M3 is not a reason for the US dollar to sink, at least in relative terms. Europe and the UK have credit expansion as fast as the US, and China, India, and especially Russia have a much faster rate of M3 growth.
In addition, base money supply (monetary printing) in the EU is soaring at 10% compared to the US at 2%. Base money is currently contracting in Japan. If M3 was the reason for the dollar's collapse then Japan would have the strongest currency of the group. If relative growth in base money supply was the only reason for currency movements, then Japan and the US would have the strongest currencies in the group.
Interest Rates, Sentiment, Currency Pegs, Carry Trade
So if dollar weakness is not related to housing, the trade deficit, US printing, or M3 (the latter because every country but Japan is doing the same thing), then what is it? The remaining factors to consider are interest rate policy, currency pegs, the carry trade, and sentiment.
A couple years back, the dollar was rallying when the Fed was hiking, but all of that was given back and then some when the Fed paused. The dollar further weakened when the Fed cut rates. The direction of interest rate policy is important. The expectation is the US is going to keep cutting but the expectation is the EU will hike. This expectation (sentiment) is causing further weakness in the dollar.
The Yen has been weak because Japan has held interest rates close to zero to for years. This has spawned off massive carry trade (borrowing Yen) and investing in assets denominated in something other than the Yen. At some point the carry trade will be unwound and it will not be good for asset prices when it happens. For Japan it is a case of competitive currency debasement. Japan does not want a stronger Yen, so it refuses to hike.
China's Dollar Peg
China is overheating now because it refuses to sterilize US dollars flooding into the country via trade deficits. The normal state of affairs (sterilization) would be for China to sell Renminbi (commonly referred to as Yuan) denominated bonds to soak up US dollars. Instead China is printing Renminbi top buy dollars, because like Japan, China does not want its currency to rise.
As an aside, this phenomenon also explains why there is no global savings glut. Massive printing of Renminbi to buy dollars does not constitute "saving" in any way shape or form. Bernanke is either disingenuous or a complete fool when he proposes the idea of a global savings glut.
The net effect of printing Renminbi to buy US dollars is rising inflation in China. Furthermore, if China did not print Renminbi to buy dollars (and take those dollars and buy US treasuries), interest rates in the US would be higher. There is a huge debate about how much higher, but there is no debate they would be at least somewhat higher. What this means is US interest rates are artificially lower than they should be. This is yet another part of competitive currency debasement that countries are doing to keep their export machines cranking.
Because of the peg and because China refuses to sterilize, China is sitting on a huge pile of dollars that it does not know what to do with. That pile of dollars is pressuring the dollar.
An overheating China as well as China's currency peg are both fundamentally unstable and becoming more unstable every day. Pressures are mounting internally for China to allow the Renmimbi to appreciate. This pent up pressure is another factor affecting the dollar's weakness.
Hedge funds for example do not want to hold dollars if they think huge gains are coming via appreciation in the Renminbi (even more so if they buy Chinese assets appreciating faster than US assets).
Finally, China's inflation fueled growth (an artificial boom) is attracting money from other countries that see China as the savior for the world's growth problem. The reality, however, is that all of these global currency and interest rates distortions are fueling asset bubbles and malinvestments everywhere, including China.
The Euro is way overvalued vs. the US dollar relatively speaking, at least in light of base money expansion and lower interest rates vs. the US. As a counter balance, there is the expectation of additional tightening in Europe relative to the US. All things considered, however, the flight from dollars to the Euro appears to be more of a flight from the dollar than a massive belief in the safety of the Euro.
The rise in gold vs. all currencies is easily explained by massive increases in M3 everywhere but Japan. Gold is no one else's liability. Gold is a currency. The reason gold should be considered money can be found in Misconceptions about Gold and Why does fiat money seemingly work?
It's certainly hard to be a dollar bull, but most of the reasons given for its weakness do not stand up under scrutiny. This is especially true in relation to the Euro. Everyone hated the Euro a few years back but they all love it now that the dollar is at $1.40+- vs. the Euro. This is classic herding behavior at its finest. Whatever extent the Euro is rising from anti-dollar sentiment as opposed to fundamental reasons will eventually be unwound.
Fundamentally, the Yen should be poised to rise, but interest rate policy is a major factor in the strength or weakness of a currency, and Japan is still sitting close to ZIRP (zero interest rates policy). Japan at some point will be forced by the market to hike rates. Until that happens, a complete collapse of the Yen remains a possibility.
Likewise, on a fundamental basis, the dollar should rise vs. the Euro and fall vs. the Yen, with the net effect being a rise in the US dollar index.
The implications of an unwind of the carry trade, a weakening dollar vs Japan and Asia, and a strengthening dollar elsewhere is likely a nightmare scenario for equities worldwide. It remains to be seen if it plays out that way, and if so, in what timeframe.
Although "when" may be in doubt, pressure is indeed building for a forced unwinding by the market of all these currency, interest rates, and carry trade distortions. The root cause of every one of them is central bank intervention. The world would be far better off with no central banks and with all currencies and interest rates set by the free market.
Mike Shedlock / Mish