The "guru" war on the U.S. dollar

  As 2009 ends, it is difficult to find a dollar bull among the pundits who provide financial analysis and investment advice. The decline of the U.S. dollar index, which has approached 12% in 2009, and about 38% since 2001, has brought with it a surge of dollar doomsayers. In 2010, we are likely to see a continuing battle between those who argue for major dollar declines and those who, though a minority, envision dollar gains. Since you probably have heard the bearish case, here is the case for the probability of a stronger dollar. 

• Risk Aversion vs. Risk Appetite – The U.S. dollar attracts capital when the market perceives increased risk. That is apparent by the dollar rebound after the Lehman Brothers collapse. In recent months, as the equity markets gain, we have seen the dollar decline. When consumer sentiment declines, the dollar rises. Those who project a precipitous dollar decline need to keep that in mind though that negative correlation to the economy is not guaranteed.

 

• The Massive Supply of Dollars: The Fed injection of massive amounts of dollars, called quantitative easing, has worked, say bears, to oversupply dollars, therefore ultimately pushing dollar values down. While the amount of dollars is enormous, the current surge in the quantity of dollars actually makes the case for a bullish reversal.  The moment quantitative easing stops, or the Feds start pulling dollars out of the system through “reverse-repos” and other tactics, a dollar positive reaction will be triggered, forcing dollar shorts out.

 

• Inflation Fears: One of the most frequently cited bearish arguments is that inflation, even a hyper-inflation, is coming due to massive amounts of dollars in the system. The most recent “Consensus Forecast” from Consensus Economics, which polls over 240 financial and economic forecasters, projects inflation to be below 2.4% out to 2019 (see “Smooth sailing”). The consensus report also projects low inflation globally. Even if low inflation expectations are wrong and a great inflation ensues, does anyone think the Federal Reserve will sit still? The prospects of inflation cannot be isolated from the likelihood that Fed policy will be hawkish. This expectation will work to increase dollar support as money will flow into the dollar as rates go higher.

• Dollar Carry Trade Bubble: The decline of the U.S. dollar created a huge increase in the dollar carry trade. This is where U.S. dollars are borrowed to invest in non-U.S. dollar assets.  The yen to some extent was replaced with the U.S. dollar as the lead short in carry trades in the past year. This U.S. carry trade bubble could burst at any time, causing a dollar rebound.

• Consumer Spending: The “Great Recession” may have caused more than just a contraction but also a “demand shock” where an actual downward shift in consumer demand occurs. In other words, reduced consumer spending, which contributed traditionally to nearly 70% of U.S. GDP, may be unable to shift upwards to previous levels. Consumer spending may be structurally slowed down due to the aging of the baby boomers and along with it fear of future health care costs. Personal savings rose from near zero levels in 2007 to nearly 6% (see “A return to saving”). As a result, the contraction of consumer spending is likely to offset the inflationary impact of the larger supply of dollars. There may be a lot of dollars around, but they are not being loaned out or spent in an economy with excess capacity.

• The U.S. Owes too Much Debt to Foreigners: U.S. debt is now approaching $7.9 trillion dollars. China is holding nearly $3 trillion U.S. dollars in reserves and nearly $800 billion of U.S. Treasuries. Japan is not far behind. These data are used by bears to support their views but actually they are potentially dollar positive because countries owning U.S. debt don’t want to see their dollar assets decline.  Sovereign nations buy dollars when the rate of return is near 0% because the dollar remains the most liquid and safest asset in the world. The dollar is now 62% of world central bank reserves.

We can’t predict with certainty the value of the dollar in the coming years. The future will contain its share of unexpected shocks. Yet for every bearish fundamental there appears to be a bullish one, and we must improve the quality of the debate to get a clear picture. 

In the print version of Forex Trader we point out how despite the overall bearish sentiment on the U.S. dollar, there were some bullish fundamentals as well that should not be ignored. Here are a few additional bullish factors that a forex trader needs to examine.

• The Federal Deficit is Soaring: Dollar bears point to the historic increase in the federal deficit to $1.4 trillion. Is this a break with the past to levels that are inconceivable?  It is not. This is a scare tactic because it is disingenuous. A statistically more correct way of presenting the Federal Deficit numbers is as a percentage of GDP.  History shows we have been in more severe situations. 

• Dollar in Bear Cycles: There are those who argue that the dollar is in a multiyear downward cycle. For example, The Cycles Foundation projects a U.S. dollar bear market until 2012. However, financial cycle forecasts that project peaks and troughs that have long-term periods (every 10 years or more) are not quantitatively reliable as cycles relating to physical phenomenon such as the lunar or solar cycle. Cycle forecasters ignore the reality that geopolitical shocks will occur that alter business cycle patterns. Dollar cycle projections are prone to significant variations. A small error can cause a projected peak and bottom being off by many years.  

• The Crowd is Late: Finally, a bit of contrarian thinking is in order. When you can’t find a dollar bull and when investment newsletters carry bold and scary headlines of a dollar collapse, it’s time to rethink your investment strategies and the logic behind them. 

Here is a look at Chinese holdings of U.S. Treasuries.

Abe Cofnas