Wednesday, November 7, 2007

One Of The Costs Of Rate Cuts – Collapsing Dollar

As everyone in the US demands further cuts in the interest rates, overseas this is causing the dollar to collapse. This is going to lead to higher prices at the pump and the more insidious increases in the price of food (food production is an energy intensive process). Also the US may lose its major position as a reserve currency, which means it loses some negotiating leverage overseas in one area, but gains it in another. For example, if the country A holds a trillion dollars of country B's debt and the value of their currency is strong country B has a problem. If on the other hand country B decides to devalue its currency then country B has a problem. The good news is the massive debt of the US held by foreigners becomes cheaper to repay. In addition, our exports should increase as our imports decrease improving our balance of payments. Be careful what you wish for, you may get it. Text in bold is my emphasis. From Market Watch:

The U.S. dollar stumbled to new lows on Wednesday after a top Chinese official called for the country to shift more of its huge foreign exchange stockpiles out of the beleaguered greenback.

Cheng Siwei, vice chairman of the Standing Committee of the National People's Congress, was quoted by wire services as saying China should shift more of its $1.43 trillion of currency reserves into "stronger currencies," such as the euro, to offset "weak" currencies like the dollar.

He also said a rapid appreciation of the yuan is not necessarily the right move -- as Washington and increasingly Europe are requesting -- though Cheng insisted the country wasn't actively seeking a major trade surplus.

The reports sent the beleaguered dollar to new lows against the euro, with the shared currency surging as high as $1.4703 from $1.4559 late Tuesday.

The Japanese yen also rallied, with the dollar falling to 113.52 yen from 114.71 yen. The British pound surged to $2.1025 -- the first time sterling has broken $2.10 since May 1981 -- from $2.0866.

Gold futures, which traditionally move in the opposite direction to the dollar because of their role as an inflation hedge, jumped $23.40 to $846.80 an ounce, and rose as high as $848 an ounce during the European morning. Oil futures rose above $98 a barrel in electronic trading.

"As if ballooning U.S. credit/ housing crunch data, back-to-back Fed cuts and soaring oil prices weren't enough to stun the U.S. dollar, now we have the specter of central bank reserve asset diversification out of U.S. dollars to contend with," said Vincent Chaigneau, the head of fixed income and foreign currency strategy at Societe Generale, in a note to clients.

The dollar has been weak over the last few months as the Federal Reserve has slashed interest rates by three-quarters of a percentage point due to the credit crunch. The euro during August traded as low as $1.3417.

The question in currency markets is now the degree to which Cheng was signaling an official policy change.

"He would most probably be familiar with, though not privy to, policy discussions on the exchange-rate mechanism, FX reserves and liquidity management," Chaigneau said.

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