Posted on 11/10/2007 10:29:05 AM PST by frithguild
SHOULD WE BE worried about the U.S. dollar falling to all-time lows vs. foreign currencies? Does it matter to investors?
Yes it matters, and yes you should be worried — but not for the reasons that you may think.
First, let's get all the wrong reasons out of the way.
One reason you hear all the time is that the U.S. is growing slower than the rest of the world, so global investors want to move out of dollars and into the currencies of countries that are growing faster. Fine — China and some other emerging markets are growing faster. But compared to the mature regions that really compete with the U.S. for significant investment flows — Europe and Japan — U.S. growth, based on the latest GDP figures, is higher.
Another reason you hear all the time is the US trade deficit — that fact that we are spending more on imports than we receive for our exports. So how come the dollar's fall has accelerated over the last three months while our trade deficit has actually gotten smaller? I've never understood why a trade deficit is supposed to make the dollar less valuable. It just means some dollars have moved from here in the U.S. to the rest of the world. That's terrific — we get their manufactured goods, they get our little pieces of paper. I'll do that trade all day. And what happens when they redeem those pieces of paper for our goods and services? That's no problem — we'll have an economic boom providing all those goods and services.
Yet another reason you often hear is that foreigners hold a lot of our government debt, and with the dollar falling, they're going to want to dump that debt. That just doesn't make sense. If you strip the logic down to its essentials, it's saying that the dollar is falling because the dollar is falling. Actually, a falling dollar should make our debt more attractive to foreigners, not less, because then they can buy more of it for the same quantity of their own currency.
So then if all the usual reasons are wrong, why is the dollar falling? It's simple. It's because interest rates in the U.S. are too low to compensate for the inflation that the market expects over the coming years. In fact those low interest rates — being artificially fed to the economy by the Federal Reserve — are what's causing the inflation in the first place.
Think about it as an investment proposition. Suppose you are a foreigner, and that you live in a country whose currency exchanges one-for-one with the US dollar. Let's say both countries have low inflation rates — call it 2%. And let's say both countries have the same interest rates for one year — call it 5%.
No wonder the currencies exchange one-for-one. No matter which one you hold, you're going to make 5% interest. And no matter which one you hold, you're going to lose 2% of your purchasing power through inflation. So you really don't care which you hold.
Now let's start moving things around a bit. Suppose interest rates fall to 4% in the U.S., but not in your country. Suddenly you'd rather hold your own currency and earn 5%, than hold the U.S. dollar and earn only 4%. But there is one condition under which you would trade your currency for the U.S. dollar — that's if you got the dollar at a 1% discount to your own currency. So instead of trading the currencies one for one, the dollar would fall by 1% when measured in your country's currency.
Now suppose something else happens at the same time. Suppose the inflation rate in your country stays the same, while the inflation rate in the U.S. goes up.
That would be another reason for the U.S. dollar to fall vs. your currency. If by holding dollars you expect to lose more purchasing power to inflation than if you hold your own currency, you'll only trade into dollars if you can get them cheap enough to make up for the inflation loss.
Inflation can hurt a currency even more than low interest rates. Inflation is hard to predict, both in terms of its level and its persistence through time. So if there's any inflation risk at all, a currency really gets punished, because anyone considering holding it has to take the worst case inflation scenario into account.
The U.S. dollar has suffered from a double whammy. Our interest rates have come down, and the risk of inflation has gone up.
In response to the subprime credit crisis, the Federal Reserve has lowered interest rates by three-quarters of one percent — and the Fed is expected to lower rates even more. But the European Central Bank, the European equivalent of the Fed, has held rates steady, or even let them creep up a bit.
The fact that the Fed has lowered rates — and injected massive amounts of liquidity into our crisis-stricken financial system — means that the risk of dollar inflation has gone way up. After all, inflation is nothing more than too much money chasing too few goods. The Fed is printing money at rates hardly ever seen before in history, but the number of goods isn't going up at the same rate. It's a recipe for inflation, pure and simple.
So if you have a choice of holding euros or dollars, you'll prefer euros unless you can get a discount on your dollars big enough to make up for the interest difference and the inflation risk. That's all there is to it.
That means to me that the dollar isn't going to recover anytime soon, because the Fed is almost surely going to cut rates at least one more time, and the inflation risk won't get wrung out until the Fed does just the opposite — raise rates. Don't hold your breath waiting for that one. But at the same time, we're probably not on the brink of an outright dollar collapse, because the market already pretty fully expects lower rates and higher inflation. It's already figured into the price of the dollar.
So investors shouldn't worry about some kind of money armageddon that will collapse the U.S. stock market. Not going to happen.
If anything, it's an opportunity for companies whose earnings happen to get enhanced when the dollar falls and other currencies rise. Consider the U.S. software industry. Most of their costs are in cheap dollars. A lot of their sales are foreign currencies. And they tend to get valued on sales, not on profits anyway. Maybe that's why the tech sector has been booming since the Fed started lowering rates in September.
Funny how markets work. There's always an opportunity, even in adversity. It's no fun having the currency of our proud nation fall to all-time lows. But making a bundle in tech stocks is a nice way to soothe your wounded pride!
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors.
Ping.
It happens to be a very powerful political lever, but don't expect that to make the headlines. Besides, any lever that is politically powerful for the US is clearly more attempted Imperialism by the Bush administration.
Let them squeal.
There is pressure to increase rates in Europe due to inflation and out of control govt spending. France’s fiscal problem boiled over this week when Sarkozy blew a gasket over US pressures to lower rates.
Maybe we should go back to Breton Woods. (just kidding)
E.g. he says:
Actually, a falling dollar should make our debt more attractive to foreigners, not less, because then they can buy more of it for the same quantity of their own currency.
That's wrong and idiotic. The crux there is what foreigners expect the dollar to do in the future.
That makes our economy, which backs the dollar, more and more valuable even if growth is 0%.
Most other economies are "growing" with much lower rates of productivity increase. Sure, they boost the demand for their currency by increasing the discount rate, but that does not affect productivity. Given a small recession where both productivity and total growth DROP, the value of their currencies will drop like a rock compared to the dollar and all will be well again.
Some people think that's the way we export inflation ~ actually, it's the way we export our productivity increase ~ and the foreigners will have to work harder to catch up.
I wish people would stop using this idiotic canard. They're only little bits of paper if we choose not to honor them. If the US gov't decides not to honor currency, the whole house has collapsed.
What goods and services?
Another imbecile with his lame "little pieces of paper" jive. I wish I had a dime for every time I've read or heard that gem
Wow, I use this little piece of plastic and strangers shower plasma TVs and laptops on me. Is this guy going to rip off his credit card companies too?
If push comes to shove, we tell the debtor nation to piss off and cancel the debt.
Our first move is to the world bank as a nation the "just needs a little help" with our debt.
The next step is to give them 24 hours to cancel the debt and move our N-subs into position.
Since the biggest paper holder is china, we re-negotiate our debt structure based on floating currency or refuse to pay and close our borders to china imports.
Sure it's a little harsh and some would say a misuse of military power, but I say, it's time for smashmouth strategery.
Close the state department and open the "department for begging nations".
Foreign diplomats come to this department to make the case that the USA should not nuke them.
In case of any doubt, refer to my tagline.
Don’t worry. As soon as Hillary and the Dems get annointed in Jan 2009 they will tax up all that liquity for you.
I personally think it’s embarrassing that the Canadian dollar is now worth more than the American dollar for the first time in 31 years. Canada!
Don’t get me wrong, beautiful country, nice people, good beer, but Canada is 25 million people and a lot of frozen lakes and trees. Good fishing. Lots of fish there have never seen a person.
This is a completely bogus statement. Many software firms have outsourced some or all of their development to India or elsewhere where the costs are in foreign currency. Consequently, their costs have risen in direct relationship to the dollar's fall.
...and a lot of commodity resources like oil, uranium, gold, nickel, etc. In an inflation economy commodities rule.
People who do create value would love to see higher interest rates, a stronger currency, and the opportunity to keep the value of the dollars they have earned safe from inflation - but value creators are a shrinking minority in today's America.
Too many people are trying to live lifestyles beyond their means on credit at everyone else's expense and they are the first ones to run shrieking to the media about how hard times are and how mean the Republicans are. ;)
” In an inflation economy commodities rule.”
Excellent point. I’ll remember it. Thanks.
I told my son almost the exact same thing not ten minutes ago because he was worried about the dollar falling
I swear.
I was trying to explain to him the US is not going into freefall depression.
Then stop writing and take econ 101. When those overseas go to trade those dollars back to there home currency they find there supply of them out paces the demand and guess what? The value drops; the price drops; and that is reflected in the exchange rates.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.