The Dollar: Sliding or Crashing?

 

Much has been made of the persistent slide in the dollar in recent months. Many proclaim it’s the end of its status as the primary world reserve currency. Others suggest it’s a notice of the demise of America. These viewpoints tend to quickly spread to Main Street, and that has a tendency to create panic.

How bad is it?

For some broader perspective, the Dollar Index (the dollar against a basket of major currencies) still sits 3.5 percent above the lows of 2008. Measured against over 75 currencies in the world, the dollar is weaker against 26, flat against 11 and stronger against 38 since the onset of the global financial crisis.

And it still commands 62 percent of global currency reserves — down only three percentage points from pre-crisis levels.

So, while it’s made new all-time lows against some currencies, it’s not a bloodletting like the media would have you believe. In fact, from a fundamental and technical perspective, it’s so stretched it has all of the makings of a market that’s going to snap-back violently.

Nonetheless, the drama surrounding the panic scenarios prompted journalists this week to prod a response out of Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke.

Geithner made an unusually defensive comment about the dollar saying, as long as he’s around the U.S. has a strong-dollar policy.

Bernanke maintained his rare but consistent comments on the dollar, saying a strong and stable dollar was important for the U.S. and the global economy and that the Fed’s policy efforts were consistent with achieving a strong dollar.

So if policymakers favor a stronger dollar, why aren’t they showing concern about its slide?

Some would suggest they just don’t get it. Others insist there is a covert operation underway by U.S. officials to broadly and desperately devalue the dollar.

Here’s my take …

First, while some near-term weakness can be favorable for the U.S. economy, a more protracted decline in the dollar at the recent pace would mean very negative implications for both the U.S. and the rest of the world — no one wins. So a weak dollar conspiracy is not the answer.

Clearly U.S. policymakers like a weaker dollar in the near term. It helps stimulate exports and the growth of manufacturing, a historically important ingredient for recovering from economic recession and especially important in the effort of rebalancing the U.S. economy.

In fact, exports have become a big driver of economic growth throughout the “recovery” phase. The Wall Street Journal reports that exports have made the biggest 18-month contribution to U.S. GDP growth on record.

That’s the Good.
How about the Bad?

In addition to a supply shock associated with problems in the Middle East and commodity hoarding from China, a weaker dollar is adding to rising commodity prices.

The biggest threat of a weaker dollar though, if perceived as open-ended, is capital flight, which can set off a dangerous threat to the country’s solvency. Despite the many fears, that isn’t happening.

The truth is, growth in the U.S., even if it doesn’t hit the optimistic projections this year, continues to be among the top for major developed economies. Meanwhile, inflation (even headline inflation) and market interest rates remain low, and more stable than their counterparts — all solid underpinnings for the relative value of a currency in this environment.

So given the problems around the world and the reality that the world is in a slow, bumpy recovery, the slide in the dollar in recent months is consistent with just another ebb and flow within the currency markets.

To sum up: While there are significant risks, the facts argue that the weaker dollar isn’t a sign of a U.S. economic catastrophe. To the contrary, on a relative basis, the U.S. economy is still plugging along.

But Who Is That Hurting?

China.

China has been trying, unsuccessfully, to get a grip on inflation. And rising global asset prices, inflamed by a weaker dollar, puts pressure on China to finally look to its currency policy as a tool to curtail inflation. As such, we may soon see a dollar devaluation that the entire world would embrace: Against the Chinese yuan!

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After six years of consistent, but weak, global prodding of the Chinese to appreciate their currency, diplomacy hasn’t worked. The Chinese have allowed their currency to appreciate a measly 3.6 percent against the dollar on average per year since de-pegging in 2005. Meanwhile their economy has grown by nearly 250 percent in the same time frame.

Clearly, the Chinese have maintained a massive unfair advantage in global trade via their weak currency policy. And the world has always had two options in dealing with it:

1. Convince them to adjust for the greater good of the global economy, or
2. Export inflation to China to forcibly adjust up the cost of Chinese exports by driving up wages and input prices.

Now it appears that we’re seeing option number two play out. And China’s fight to gain control over inflation, isn’t going well. Perhaps soon, China will finally act to strengthen their currency in a meaningful way.

That would go a long way toward putting the global economy on a path of sustainable recovery, and correcting the continued booms and busts taking place in global economies and financial markets.

Regards,

Bryan

http://www.moneyandmarkets.com/the-dollar-sliding-or-crashing-44386