This Weekend's Contemplation - Why the Dollar Will Weaken

Something to consider as you manage your portfolio, your thoughts on foreign affairs, the position of the US amongst the world economies, etc. Also realize that as the US dollar declines it builds it new bubble in a different asset type.

The only portion of the article extracted for this blog deals with a weakening dollar. The article also contains investment advice. Text in bold is my emphasis. From MSN Money:

The dollar hasn't been this low in a decade, but it's headed lower. By the end of 2007, we can expect the dollar to buy 11.6% less versus the euro than it did at the beginning of the year.

As the dollar continues its slide, count on Wall Street to gear up its fear machine.

Any further retreat in the dollar will put the U.S. currency on the edge of unexplored territory. The fall of the U.S. dollar into unknown territory, the argument is likely to go, would break the will of those overseas central banks, from Russia to Saudi Arabia to China, that have been buying dollars to give their countries' exports a competitive edge.

Well, I'm sorry, but I just don't buy that scenario. Wall Street could, of course, scare itself into a dollar rout because many of the folks who work there are so traumatized by the crises in the markets for mortgages and for buyout loans that they're likely to jump at shadows, even when the shadows are of their own making.

I think it's much more likely that we'll continue to see a steady decline in the dollar, punctuated by rallies as traders take profits. The Federal Reserve, which rode to the rescue in the August crisis, can't do much this go-round. Cutting interest rates to save economic growth hurts the dollar. Raising interest rates to help the dollar would hurt the economy. . . . .

. . . . to lay out the logic for a gradual dollar decline -- no reason to panic . . . .

Here's why the dollar is likely to keep dropping for a while:

• The U.S. runs a huge, though falling, trade deficit with the rest of the world, about $700 billion annually at current monthly rates. That leaves our trading partners holding an ever-expanding number of dollars.
• In recent years, only relatively higher U.S. interest rates -- and some premium from the economic stability that comes with being the world's biggest economy -- have kept demand for dollars roughly in step.
• As the economies of Europe and, for much of the year, Japan have grown faster than the United States in 2007, central banks in those countries have raised interest rates, cutting into the premium investors could earn by holding dollars.
• As interest-rate differentials have narrowed, as the U.S. economy has slowed and as a weaker dollar has cut the returns to overseas investors, demand for the dollar has weakened. And so has the price of the dollar.

A weak dollar helps the U.S. increase exports, cut imports and reduce the trade deficit. But how do other countries deal with it? . . . . Let their currency appreciate or try to manage the exchange rate.

That decline would have been much more precipitous if some of our trading partners hadn't actively propped up the value of the U.S. dollar. No altruism there, just straightforward self-interest. The Chinese government, for example, has continued to buy dollars in order to keep the value of its own currency from rising.

A more expensive yuan would make Chinese goods more expensive to U.S. buyers in particular and to global customers in general. In China, that would cut the economy's growth rate, slow job creation and almost certainly mean the loss of jobs in the least efficient of the state-owned companies that still employ millions of workers. In effect, the Chinese and other governments have opted to spend some of the dollars that their economies earned in trade on subsidizing jobs for their work forces.

Despite saber rattling by the world's central banks, there's little evidence that of any of them are abandoning U.S. dollars even as the currency tests new lows. The International Monetary Fund's numbers show a slight shift from dollars into euros, with the dollar share falling to 64.2% of all global reserves in the first quarter of 2007 from 64.6% in the last quarter of 2006.

But much of that shift is a result of an appreciation in the euro holdings of these central banks and the depreciation of the dollar. Certainly, the Federal Reserve's more recent balance sheet of Treasury and agency bonds doesn't show a big shift out of dollars. Foreign central banks held $1.995 trillion of this paper at the end of September, up from $1.673 trillion in September 2006.

To the degree that any asset shifting has taken place in 2007 by central banks, it was out of Treasurys and into higher yielding paper such as mortgage-backed debt, or buyout loans or derivatives based on those assets. The move came just in time for these banks to take a beating in this summer's meltdown in those markets. I suspect that for the moment, these banks aren't overly eager to take on more risk.

Still, I think after a relatively short breathing space, the world's central banks will start looking for a solution again because the problem is too big to ignore. Subsidizing domestic jobs is all well and good, but a falling dollar makes it increasingly expensive.

An 11.6% decline in the dollar against the euro means that every dollar in China's $1.2 trillion foreign-exchange reserve -- and dollars make up something like 70% of that reserve -- are worth that much less when the country goes to buy anything from the European Union, China's second-largest trading partner. That's not an insignificant issue when you're importing about $90 billion in goods from Europe annually.

Same goes for Russia and Saudi Arabia, where the biggest exports are denominated in dollars but many imports have to be paid for in euros.

The overseas central banks -- or more accurately, the governments behind them that decide on how many jobs to buy by spending reserves to keep their currency from appreciating versus the dollar -- have a pretty high threshold of financial pain. But it's not infinite.

The conventional argument has long been that these banks would support the dollar no matter what because they didn't have a choice. What currency could replace the dollar?

But that argument looks out of date. The countries with huge reserves may still need to keep dollars for trade, but, increasingly, they're looking elsewhere for their investments. The new vehicle is the sovereign investment fund, with capital provided from national reserves for investment in assets around the globe. The models here are the investment funds of Norway and Singapore that have bought stakes in foreign telecommunications companies, airlines and financial companies.

And those investments look pretty attractive now that developing countries' stock markets are beating the returns from investing in the United States. Why buy more of the risky assets that just blew up when you can earn a better return in India or Brazil or the Philippines?

Where does that leave the United States? In a tough competitive position on the currency front.

The recent blowup in the U.S. mortgage- and buyout-loan markets couldn't have come at a worse time competitively. Big losses in these dollar-denominated investments eroded some of the edge that dollar investments had in the minds of investors over investments in developing markets. The bigger the losses in that debacle, the longer it takes to work out and the less transparent that market remains, the more overseas central banks will look to developing markets for the gains they can't get in U.S. dollar assets. (In my mind the most serious fall-out of the housing crash. Because of the mortgage backed security debacle the US has lost credibility in the international markets, where it is all about credibility.)

That doesn't add up to a quick stampede out of dollars. Instead, look for the decline in the dollar to continue at a gradual pace as developing markets win more of the world's cash.