The Week of April 11th: Dollar Doldrums

Dollar Doldrums

Although Joseph Schumpeter strongly opposed Marx’s Manifesto to the world, he did agree with him on one account. Like Marx, he also proposed that capitalism would not survive – and he did not mince his words while stating this in his book ‘Capitalism Socialism and Democracy’ where he started a chapter with “Can Capitalism Survive? No, I do not think it can”. Looking at the current state of affairs at the epicenter of capitalism, one begins to wonder if there is some element of truth in this view.

The United States of America is the greatest bastion of capitalism, and the dollar reflects this capitalism’s vitality. The dollar is the most widely traded and widely held currency in the world. Ever since Bretton Woods, it has been assigned the role that precious metals fulfilled in the global monetary system that existed before World War 2. And so, the global phenomenon of the diversification of every investment portfolio with the dollar became a reality. This has ensured two things – the United States would never have to worry about bets against its currency, and that by this self fulfilling prophecy, the world actually has had an overall stable monetary exchange system based on trust. Or has it?

The dollar seems to be telling a story that nobody in the Federal Reserve would want to hear. The currency started this year with the weakest start since 2008. This weakness has continued unabated in the midst of strengthening commodity prices. Now analysts are wondering when equity markets will reverse their traditionally negative correlations with the dollar, due to the increasing pressures on businesses which have to buy commodities with the weakening currency. This inflection point does not seem far given that equity markets are range bound in the United States, and there is no stopping the rally in commodities.

The decline in the dollar would not really be very worrying if it were not for the other compounding worries for the US economy. The budget cuts that were recently passed are not fooling anyone, and the bond markets are certainly not manipulated too easily.  The yields on the 10 year T Note have resumed their upward movement, even though the Federal Reserve is not going to announce an interest rate hike any time soon. Equity analysts suggest that equity investors will really start to take notice of the yields if the 10 year yields touch 4% (currently touching 3.5%).

The fact that central banks across the developed world are increasing rates, a recent example being the European Central Bank hike of 25 basis points earlier this month, is certainly not going to make life easier for Chairman Ben Bernanke. Given that there has not been a substantial recovery in the housing market, and both Freddie and Fannie are still problem children for the economy (Treasury Secretary Geithner recently stated that it could take up to 7 years to wind down the two housing loan giants, which incidentally insure about 90% of all new home loans); he would once again be finding himself in a catch 22 situation that all central bankers worth their salt would be more than familiar with. A premature interest rate hike could cause further hiccups to this artificial cheap credit induced recovery, and not raising rates while other central banks are busy doing so would lead to further weakness in the dollar.  

The markets are actually being very clear about the fate of the dollar in the short to medium term for once. Gold and silver are at record highs, and there is no reason why they should not be. This indicates a flight for safety to physical quantifiable commodities from currencies like the dollar. Silver prices have increased by phenomenal amounts over the last few months while gold seems destined to touch $2000 per ounce in the long term. Keeping in mind the fact that gold prices were at $300 at the start of the last decade and are now hovering below $1500; this meteoric rise is indicative of a fundamental shift in perceptions about paper currencies backed by nothing but a promise.

The recent BRICS summit that concluded in China saw discussions about the possible inclusion of the Yuan in the IMF’s SDR currency basket. Although this is unlikely to happen until full convertibility of the Yuan becomes a reality, it certainly does indicate that such options are on the formal agenda now. The monetary system that exists in today’s brave new world full of uncertainties looks unsustainable and fragile. Unless one believes in economic determinism, the fact that the dollar has survived so many onslaughts in the past is no indication of its survival prospects in the future.