The Weak-Dollar Bubble
Caijing Magazine
The US weak-dollar policy will trigger a dynamic response from other countries, which would amplify global inflation.
By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Limited
After the Fed cut interest rate by 50 bps on Sept 18, high risk assets have surged. Emerging markets, commodities, and small capitalization stocks have all done exceptionally well. Even Dow Jones and S&P 500 seem to have shaken off the sub-prime jitters and are making new highs. Is the 50bps cut the silver bullet that has cured all the ills that haunted the global financial market a month ago? I don’t think. What’s unfolding is another bubble that could cover up the structural problems a little longer.
What is occurring is the fear of inflation that drives people to dump paper money for physical assets. While the asset boom in the past four years was driven by optimism towards the future, the current asset boom is driven by the fear of paper money evaporating in value. The story begins with the US weak-dollar policy. As I wrote in my previous article, the US may be tolerating inflation to ease the pain from the property bubble. In a closed economy, inflation is a zero-sum game in wealth redistribution. But, foreigners own over 100% of the US’s GDP in its financial assets. If foreigners can be fooled into holding the US financial assets during inflation, Americans could gain. High inflation plus low interest rate lead to a weak dollar. The dollar depreciation distributes foreigners’ wealth to Americans.
For example, foreigners may hold $10 trillion of the US fixed income assets. If the dollar depreciates by 10%, they lose $1 trillion in real value. That is equivalent to the whole sub-prime mortgages outstanding. The dollar index has already depreciated by 3% since the Fed rate cut. The broad dollar index hit an all time low of 77.657 on Oct 1 since its inception in Mach 1973. We really don’t know how much more the dollar would depreciate ahead. It depends on how foreigners react to the US policy.
I have been advocating that foreign owners of the US treasuries should sell to push up the US bond yield while parking the cash in money market first. Foreigners own roughly half of the US treasuries. If they sell only 10% of what they have, the 10Y treasury yield could rise above 6%, while the dollar would remain stable. As Americans are heavily in debt, the yield rise would force the Fed to contain inflation and protect foreigners’ financial wealth. I am sure that Americans would scream financial terrorism at such tactic. But, foreigners are entitled to defend their wealth and the Fed will respond to force and force only.
But, foreigners are not likely to cooperate. Sovereign entities like central banks and state investment companies account for half of the foreign holdings in the US. Most foreign governments don’t want to upset the US, the rich oil exporters in the Middle East the least. Hence, every government is likely to respond passively and independently. The easiest way out is to sell and get out before others. Of course, the exit is not big enough for all to get out together. Whenever someone tries to get out, the dollar depreciates, and foreign owners of the US financial assets lose collectively.
The US weak-dollar policy will trigger a dynamic response from other countries, which would amplify global inflation. Most countries, if not all, want weak currencies to protect their industries. As the US pursues weak dollar policy to solve its debt problem, foreign governments may expand their money supplies to keep their currencies low. This global game of weak-currency policy could lead to 1970-style inflation that depreciated paper money in general. Even the ECB is now complaining about the strength of the euro. When more and more countries play the weak-currency game, global inflation will accelerate. People may come to question the value of paper money again.
Paper money without an anchor is a recent phenomenon. After the World War II, forty-five countries joined together at a conference at Bretton Woods in New Hampshire in 1944 to organize a new global monetary system. As the US economy accounted for half of the global GDP, the dollar inevitably became the anchor. The currencies of other countries were fixed against the dollar. The international monetary fund was set up to provide liquidity to any country that suffered liquidity problem (i.e., not enough dollars) under this pegged exchange rate system. The dollar itself was pegged to gold, i.e., its value was determined by how much gold it was worth. The credibility of the system was based on the strength of the US economy and the US commitment to the gold standard.
By 1970s, the system came under strain due to two forces. First, Europe and Japan gained in competitiveness against the US. Their intrinsic competitiveness was temporarily suppressed after the War as it destroyed their hard assets. The reconstruction brought their industries back. Their currencies became undervalued with the progress of their reconstruction. By early 1970s, this force became too powerful to ignore. Second, the twelve oil exporting countries organized themselves to form a cartel-OPEC. The cartel decreased production in 1973 to force up price. It more than tripled oil price. As the US was already a major oil exporter, the surge in oil price would surely lead to some reduction in the US living standard, which could be achieved either through dollar depreciation or a wage reduction.
The Nixon Administration took the easy way out and nixed the convertibility between dollar and gold, i.e., the US government would not convert the dollar into a predetermined amount of gold. Germany and Japan revalued their currencies by about one third. That began a big wave of inflation, especially in the US. The inflation genie was only put back in the bottle after Paul Volker, the tough Fed chairman, raised interest rate to double-digit rate to trigger a big recession. The Volker shock began a two-decade long of dis-inflationary cycle. However, other forces, more important than central bank policies, supported such a long dis-inflationary trend.
After the fall of the Berlin Wall, ex-planning economies embraced global capitalism, which unleashed a massive labor force into the global economy, which laid the foundation for the biggest deflation shock to the US-outsourcing. At the same, the transition from planning to market depressed demand in these economies, which kept the prices of natural resources low for the US and other developed economies. Alan Greenspan took advantage of this force and kept monetary policy easy to stimulate demand. It led to a golden era of buoyant demand and low inflation. The dark side of this boom was the accumulation of debt by the US household sector. Essentially, the ex-planning economies were using exports to the US to anchor their economies on the demand side. The global economy functioned on the US borrowing from the rest of the world to absorb surplus production.
The two decades between 1985-2005 was probably the gold era for central banking. People attributed the prosperity and price stability to the prowess of their central bankers. Alan Greenspan came to symbolize the super central bankers. Instead of being boring economists, they rivaled Hollywood stars in celebrity status. During the Asian Financial Crisis, Alan Greenspan, together with Bob Rubin and Lawrence Summers, were viewed as saviors of the global economy. In fact, what made central banking so easy was (1) the dis-inflationary force of globalization or the embracing of global capitalism by ex-planning economies that included the Soviet block and most developing economies and (2) the penchant for debt-financed consumption in America. Stable price and economic prosperity elevated the status of paper money enormously. People everywhere came to love paper money, especially the dollar.
The seeds have been laid for a difficult period ahead for central banking for two reasons. First, the dis-inflationary forces of the past have ended. The ex-planning economies have earned so much money in the past, especially in the past five years that they could stimulate their domestic demand without worrying about hard currency availability. Hence, their labor and other resources would increasingly redistribute to catering to domestic demand. This would make the US and other developed economies more inflation prone.
Second, central banks, especially the Fed, took advantage of the dis-inflationary forces of the past and released a lot of money that inflated asset prices. When faced with the choice of allowing asset prices to fall or CPI to rise, as I discussed previously, they are often forced to opt for the later, as the case of the Fed may have shown. The amount of inflation required to justify current asset prices could be huge. The US residential property value relative to GDP is 70% above the historical average. Property prices have become equally inflated relative to income in many countries, like Britain, China, and India.
As financial market sees the inflation future, it begins to bid up anything that may preserve value. Gold, for example, surged after the Fed rate cut. Its price has become tightly correlated with dollar. Gold is a favorite for inflation hedging. Its correlation with the dollar suggests that the dollar weakness is driven by the Fed’s toleration of inflation.
Not just gold, investors are chasing emerging markets again. Weak dollar tends to divert liquidity away from the US. As the US’s financial system is twice as big as all the emerging economies combined, the diversion has a big impact on emerging markets. For example, the Hang Seng index has surged about 20% since the Fed rate cut.
Even the US’s stock market is up strongly. Both Down Jones and S&P 500 are making all time highs. This is despite the recession fear and the terrible losses from the sub-prime crisis. The Wall Street firms are reporting losses lately. But their stock prices would rise with the bad news. The excuse is that the bad news is finally out, implying future news would be good, which is almost certainly not true.
Shares may not be the best haven in an inflationary environment. In theory, businesses are net borrowers and benefit from inflation. But, inflation could drive up bond yield, which would increase their funding costs. During the 1970s, stock markets around the world performed poorly. Right now, bond yields are still low, as bond markets don’t yet believe in the high inflation story. Hence, stock markets are benefiting from the liquidity diversion of the inflation fear without suffering from rising funding costs for businesses. This situation may prove temporary.
The weak dollar or inflation fear is driving certain investor behavior. It gets vastly amplified by speculation. One important force in the global financial system is the presence of speculative capital. It anticipates trends and creates a frenzy environment to suck in average investors. The sharp upward move since the Fed rate cut on Sept 18 is mainly driven by speculative capital. As the weak dollar or inflation story circulates, average investors start to take actions. But, they are offered much higher prices than a few weeks ago. Indeed, the current asset prices may have already included all the benefits as inflation havens. The speculative capital is like movable toll collectors. Whenever it smells where investors are going, they move ahead of them and set up tolls high enough to suck away all the benefits from traveling the road ahead.
The most important indicator for risk or speculative appetite is euro-yen exchange rate. Because ECB sets policy rate at 4% and the BoJ at 0.5%, as long as the exchange rate between the two currencies is stable, speculators make money by borrowing yen to buy euro. When many are doing the same thing, it pushes up euro’s value against yen. Hence, the bet gains both from interest rate difference and appreciation. This so-called carry trade involves vast amounts of money. Both euro and yen are big and liquid currencies. If euro-yen exchange rate moves big, it implies vast amount of money at play.
Since the Fed rate cut, euro-yen rate has increased by more than 10% to 165. It was merely 100 two years ago. While the weak-dollar story has captured the popular imagination, most money in the currency market has been made in euro-yen. This is despite overwhelming optimism over yen among analysts. Yen bulls think that yen is cheap. The problem is that yen is not cheap enough. The carry trade ends when Japan’s interest rate converges towards euro zone’s. Because Japan experiences declining population, its inflation has to be imported thru a weak currency. When yen is cheap enough (say, dollar-yen at 160), Japan might get 2% inflation and the BoJ can raise interest rate to 3%, which can stop the carry trade. As long as major economies like euro zone, Japan, and the US have very different inflation rates, carry trade is here to stay.
More bad news about the US economy could shake but not destroy the current bubble. Speculators are all back at the race on the ground of easy money coming back. The popular assumption is that easy money can prevent a US recession. I disagree. The US residential properties are overvalued by $8 trillion. Possibly half of the adjustment would come from inflation and the other half from price decline. The loss of so much paper wealth could severely damage the US consumption. Further, more debt problems are likely. The US credit card debts have been surging, which is supporting the US consumption now. As the interest rate on credit card debt is twice as high as that on mortgage debt, the current trend is not sustainable. When the credit debt bubble bursts, it stops the last source of money propping up the US consumption.
When the market comes to accept the scenario of a US recession in 2008, risk appetite will decline and most risk assets will adjust. However, the inflation and weak dollar story are not going away. After the US recession shock, financial markets will focus even more on inflation havens like gold.
The weak-dollar bubble obviously ends when dollar reverses its trend. That happens only when the US treasury yields surge to reflect inflation expectation, which would force the Fed to raise interest rate again. If you are taking big risk in market, i.e., you are punting in stocks, commodities and properties, watch the US treasury for exit signal.
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