In a rare moment of agreement among economists, David Greenlaw (Morgan
Stanley) and Steve Gallagher (Societe Generale) both said on this morning's CNBC
Morning Call that the U.S. Treasury and the Federal Reserve were content to
allow the U.S. dollar continue slipping.
This concurs with the cover article on the Economist (Dec. 2-8), which depicts a
horrified George Washington under the headline, "The Falling Dollar."
We believe that both Greenlaw and Gallagher are correct that the Economist's
Washington is justified in looking aghast. A devaluation of the dollar has some
serious downsides for America.
From 1945 onwards, the American dollar took over from sterling as the most
favored reserve currency held by central banks. Indeed, like sterling, the
dollar became a refuge or safe haven currency in times of macroeconomic or
geopolitical trouble. To a certain extent, it eroded the role of gold (with its
heavy carrying cost) in this respect.
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[Editor's Note: Warren Buffett is betting billions the dollar will crash in
2007. Go
Here Now.]
The international reserve currency status of the dollar gave the American
government great economic and even political power. This was termed "dollar
imperialism." It bestowed many, often unseen, benefits upon America. One example
would be the agreement by OPEC in 1973 to demand U.S. dollars as the exclusive
settlement for oil.
There was therefore a continuing world demand for dollars, underpinning its
price. This allowed U.S. interest rates to be kept relatively low, encouraging
continued high growth in the United States, relative to other nations.
Today, much of this has changed. Things have become so bad that a new, highly
insecure, "political" currency, the euro, now competes with the formerly mighty
U.S. dollar as the reserve currency of choice.
Instead of fighting off this political/economic challenge, Congress has not only
supported a disastrous war in Iraq (at a cost of some $2 trillion), but has
played an irresponsible game of spend and borrow with American wealth, even to
the point of burdening future generations of Americans.
[It is sometime hard to contemplate the enormity of a trillion. Imagine you had
a trillion dollar bills piled up in warehouses. How much time should you set
aside to count them at the rate of one per second 24/7? Would you believe a
staggering 31,000 years! Yes, a trillion dollars is an enormous number.]
The world has not remained blind to such political, economic and financial
irresponsibility. International investors have grown increasingly wary of
holding U.S. dollars. It should be remembered that China alone holds some $700
billion in U.S. currency and securities.
With this in mind, it is easy to see that if either the Fed or the Treasury were
to indicate that they would defend the dollar in the exchange markets by
anything short of structural means, it might encourage massive speculation on
the sell-side as central banks and investors seek to diversify out of the
dollar.
[Editor's Note: Can Ben Bernanke avoid the coming currency crisis?
Go here now.]
Both the Fed and the U.S. Treasury face a grim prospect. They need to cut back
on profligate government spending and to raise interest rates both to defend the
dollar and to curb inflation.
But higher interest rates could kill consumer demand and stall both the economy
and the U.S. stock markets.
It is clear that the resilient U.S. consumer has kept us out of not just a
recession but also a possible depression following the post 9/11 tech stock
bust.
Of course, the consumer was helped by government induced easy credit and massive
injections of liquidity. As Barron's (Nov. 27) said, "The world, everyone
agrees, is awash with cash."
The Fed rate of 5.25% represents a "real" (5.25% less inflation at 2.70%) rate
of only 2.55%, considered by most to be easy credit.
[It should be noted however, that the October CPI showed a decline from an
inflation rate of 2.90% to 2.70%. It is interesting that, with the Fed rate held
at 5.25%, this 0.20% fall in inflation, accompanied by a Fed rate on hold,
represents an effective tightening by the Fed of 0.20% in the past month. It is
a point largely overlooked by the mainstream media.]
[Editor's Note: Protect yourself from rising inflation.
Go here now.]
We have long forecast a rise in interest rates. It now appears that, although
not commented upon, "real" interest rates have already risen by 0.20% in the
past two months!
The new, main competitive currency increasingly favored as an alternative to the
U.S. dollar is the euro. It is administered by the European Central Bank (ECB).
The U.S. Fed has what is known as a "dual mandate" to control inflation and, at
the same time, to encourage growth. The ECB has only a "single" mandate, to
control inflation.
Yesterday, in the face of increasing economic growth in Germany and inflationary
pressures within the European Union (E.U.), Bloomberg reported that Monsieur
Jean-Claude Trichet, President of the ECB, announced a 0.25% increase in the ECB
"Repo" (Repurchase) Rate to 3.5%. With inflation running at some 1.6% in the E.U.
as a whole the "real" ECB rate for the euro is 1.9%, or some 0.85% below that of
the Fed rate for the U.S. dollar. Even then, the U.S. dollar has recently fallen
to $1.33 to the Euro. This is only $0.04 above its all time low against the
Euro.
Yesterday, Monsieur Trichet also said that the ECB might keep raising interest
rates into 2007. This will place still further downward pressure on the U.S.
dollar, as interest rate differentials increase against it.
Initially, a weaker currency benefits exporters. Many major U.S. exporting
companies will therefore welcome a cheaper dollar.
Furthermore, a cheap currency tends to hide a lack of relative, competitive
productivity. A devalued currency is therefore of only temporary benefit. As is
shown by the famous "J" curve, increasingly uncompetitive products hurt exports,
while a weaker currency increases the price of imports, causing high inflation.
In recent years, American consumers have shown a huge appetite for imported
goods. Therefore, a weaker dollar is likely to lead to larger dollar deficits
and rising inflation. All this will add up to further downward pressure on the
dollar.
A weak currency is a very bad situation in the long run. Indeed, it is all but
impossible to find a strong economy that has been represented by a weak currency
over the long term.
We believe that a weak dollar is bad, very bad, for America in the long term and
that the Fed most probably agrees. However, even with the best will in the
world, the Fed is in a very difficult position.
The Fed needs to raise interest rates to restore credibility in the dollar,
primarily by curbing inflation. But how can they openly raise nominal interest
rates, which may risk a collapse in consumer confidence leading to a stock
market collapse?
It is true that employment has held up and that wages have increased in America.
But we believe that the rapid rise in residential equity values has led to a
major underpinning of the consumer confidence that has fueled corporate
profitability and stock prices.
In Financial Intelligence Report, we have long tried to alert our readers to the
serious impact on the vulnerable and frothy U.S. stock markets, of a slump in
residential house prices, and a consequent fall in consumer confidence.
Today, we see reported on CNBC yet further evidence that the residential housing
slump is spilling over into the financial world of sub-prime mortgage lenders.
We feel that worse is to come and that soon it will spill over into stock market
sentiment.
This presents the Fed with a difficult choice. Can it raise interest rates as
required to curb inflation and the inflationary impact of a depreciated dollar
and risk a stock market slump?
We believe that, as stock markets are so impotent to the financial and economic
morale of the United States, the Fed will resist raising rates a long as
possible, risking the onset of stagflation rather than a stock market collapse.
However, events may force the hand of the Fed. Indeed, this afternoon, U.S.
Treasury rates have reversed upwards and the dollar is rallying.
This was in response to Treasury Secretary Paulson's remarks in his pre-China
interview on CNBC this afternoon.
It is this realization that the Fed will not lower and may even raise rates that
causes us to remain very cautious over U.S. interest rates and U.S. stock
markets.
Editor's Notes:
