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Finance ministers getting frantic about currency markets
By John Mauldin
Wednesday, November 10, 2004
The Federal Reserve defines the trade-weighted dollar as
"a weighted average of the foreign exchange value of the
U.S. dollar measured against a subset of the broad index
currencies that circulate widely outside the country of
That means that they look at the countries with which we
trade and create an index based upon the average of their
currencies. The more we trade with a specific currency,
the more "weight" it has in the index. That is why the euro
can rise 50 percent and the dollar fall only 25 percent. The
currencies of Japan, Mexico, and Canada are in the index,
as well as that of China. The dollar has risen recently
against the peso, is flat with China's currency, and has not
moved all that much in terms of many of our Asian partners.
The euro has taken the brunt of the declining dollar.
I am still bearish on the dollar and will explain why in a few
paragraphs. But before we start, let's take a deep breath.
The dollar falling is not the end of Western civilization. It is
not some calamitous event that will shake the United
States to its core. It will have consequences, of course,
but it is far less important than the problems a secular bear
market will have upon our portfolios.
It is, however, a trading opportunity.
The point is that a drop of more than 40 percent went
unnoticed by most of America in the late '80s and '90s.
Unless you were traveling overseas, you did not see
much difference. The economy grew fairly well
throughout the period. Inflation continued to fall. There
were some great trading opportunities and many
commodity traders made their reputations and fortunes
in that period. In fact, the recent drop of the dollar has
not had that much of an affect upon the average
American (again, unless you travel). Some industries
are helped and some are hurt, but most of us just plow
But it was certainly not a disaster. The valuation of the
dollar is a symptom, not the problem.
Secondly, we should take note that currencies are the
one market in the world where profit is not the end
game. In stocks, bonds, commodities, real estate, and
anything else that moves, the object is to make a profit.
Currencies are a manipulated market. They are
manipulated by the central banks of sovereign nations,
which make decisions about what the level their own
currency should be for the own economic and political
purposes. That makes them volatile and very difficult
to predict in the short term.
In the long term, the markets work. But it can be much
longer than most people think.
Now, with those caveats, let's proceed. I am going to work
very hard to condense my thoughts, because you could
make a book out of this topic.
There are many reasons to be concerned about the dollar,
but the No. 1 reason is the trade deficit. It is now at $600
billion and rising. I readily acknowledge there are those
who say deficits do not matter. In the short term, you can
make a case for such an argument. But over the long term,
I am at a loss to see how you can make such an argument.
Yes, $600 billion is a fraction, and a very small one at that,
of the annual international currency market, which trades
$1.2 trillion every day. I understand that the United States
is a very desirable country to live in and in which to invest
and do business. I understand that $600 billion is less than
1 percent of our total national assets. I understand that our
intellectual capital is a huge selling point. As many have
pointed out, the dollar is holding its own this last year.
Most of the above were true a few years ago, and the dollar
still dropped since 2002. While the above reasons may
make dollar bulls feel better, it seems to me like they are
whistling past the graveyard. They really do not have much
to do with currency valuations.
I have often quoted from a Fed study that shows that any
time a country gets to a 5 percent trade deficit, there follows
a sharp correction (usually 20-30 percent or more) in the
value of its currency. We have been there for some time,
and are going higher. The rising price of oil almost
guarantees that the deficit will rise.
Why have we not seen such a correction?
As noted above, governments for their own benefit
manipulate currencies. There are governments that believe
it is in their best interest, at least for now, to keep the
dollar propped up.
As Bill Gross of Pimco noted this week, the Fed is
between a rock and a hard place:
"Despite candidates' insistence that this is the most
important election of our lifetime, I suspect that the
ones in 1980 and 2000 were more important, and the
latter was decided by 500 votes in Florida or the U.S.
Supreme Court depending on your political persuasion.
Four years later and much deeper in debt, there's little
either candidate can do to stop the near inevitable
hegemonic (not hedonic!) decay. It's really quite simple,
you know. Asia has hollowed out our manufacturing
base and is now making inroads into services. Job
growth is and will continue to be hard to come by. To
compensate we temporarily turned ourselves into a
finance-based economy, dependent on paper profits
and capital gains that in turn were driven by the march
to historically low interest rates. That journey ended
some time over the last year or so -- some marking
their hegemonic calendar at June 13, 2003, the 3.13
percent low of the 10-year Treasury, others signaling
the beginning of the end on June 29, 2004, the point
of the Fed's first cyclical hike in short-term rates.
"Whatever, whenever. If the driver of profits and job
growth is the price of money as opposed to domestic
investment, it should come as no surprise that when
the price goes up, the good times fade away. Either
Bush or Kerry -- Hillary as well -- will have to contend
with this near inevitability. ...
"My/our most certain idea ... is that real interest rates
in the United States will have to be kept low, that the
old Taylor rule is out. Too much debt in a finance-based
economy precludes raising interest rates as we have in
the past, and while that keeps the patient/economy
breathing; it leads to asset bubbles, potential inflation,
and a declining currency over time."
If the Fed raises rates too far, too fast, it will slow the
economy and bring on a recession. If it keeps rates low,
it risks inflation and a falling dollar. As I have written on
several occasions, members of the Fed have let it be
known that a little inflation buffer is not a bad thing if it
is the price of protecting us from deflation during a future
Inflation, however, is not good for a currency, as Gross
and practically everyone else have noted. But the Fed
does not care about the dollar. They will not willingly
watch the economy wilt in an effort to protect the dollar.
The only central banks interested in protecting the dollar
are across the Pacific Ocean.
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