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U.S. dollar Bulls and Bears Square Off in 2009

With unprecedented fiscal and monetary stimulus unleashed against the deflationary forces of imploding asset prices, the U.S. Treasury and Federal Reserve have doubled down their efforts to unfreeze credit, arrest output contraction and stabilize the economy, albeit at a cost that can only be measured in posterity. While central bankers and policy makers worldwide have engaged in similar tactics to revive moribund economies, the scale of government intervention by any measure in the U.S. dwarfs undertakings by all other countries combined.

Everyday more industries plead for federal bailout in the U.S., both in direct investment and loan guarantees. 2.6 million jobs have been lost in 2008 and the 2009 budget deficit will exceed 1 trillion U.S. dollars. Meanwhile the Federal Reserve is purchasing toxic mortgages, commercial paper, agency debt and treasury bills in a valiant bid to drive down the cost of borrowing.

In America, soaring deficits coupled with a historic expansion of the money supply have prompted many pundits to write the obituary on the U.S. dollar. And yet, the greenback shows no signs of relinquishing its hard won gains in the new trading year. Rather, a brief setback for the U.S. dollar in the waning days of 2008 has again yielded to renewed strength in 2009. In spite of the 3 month LIBOR-OIS spread settling in at its lowest levels since last September, investors continue to seek refuge in the U.S. dollar, pushing up its value and shunning the other currencies (except the Japanese yen). The credit markets may be getting a respite from the Lehman bankruptcy-induced panic, but dismal economic statistics have cast a new pall over global stock and commodity markets.

Gravity has finally caught up with the British pound that benefited from the U.S. dollar’s downfall for the past 6 years; the shrinking financial sector and sinking housing market in the United Kingdom have pummeled the pound close to its 2002 low. The euro, having risen to near parity with the British pound, is nevertheless retreating against the U.S. dollar due to worries over default risk of some Euro Area sovereign bonds, emerging vulnerabilities of European financial institutions and the relatively feeble stimulus from some EU member countries. The Japanese yen has sold off tepidly from its recent high as global stock markets stabilize but traders remain cautious.

The recent brief resurgence enjoyed by the commodity troika of aussie, kiwi and loonie has come to a crashing halt. Any renewed strength in these currencies will be contingent on attempts to reflate global economies and revive the demand for commodity exports. Gone is the carry trade euphoria that fueled the rise of high-yielding currencies. Today high borrowing cost is an obstacle to rekindle economic growth and major central banks have announced successive interest rate cuts. With short-term U.S. interest rates effectively at zero while aussie and kiwi rates stand at 4.25% and 5%, there is further room for cuts by the RBA and RBNZ which could spark rallies in the Antipodean currencies. Having already slashed the target of its overnight rate to 1.5%, the BOC might have less room to maneuver.

Peering into the FX crystal ball produces convincing arguments for both U.S. dollar bulls and bears. In fact, both bulls and bears will have plenty of opportunities to be right AND wrong if the historic volatilities in the financial markets of 2008 are to be repeated. The only safe prediction on the value of the U.S. dollar is that it will fluctuate wildly in the next 12 months.

U.S. dollar bull’s case: The FX scorecard of 2009 will likely reward the currency supported by the most aggressive stimulative and accommodative policies, with scant initial attention paid to the deleterious effects of monstrous deficits and parabolic money growth. Bernanke and Paulson have rewritten the activist intervention playbook with quantitative easing and public investment in the private sector to revive the U.S. economy. Aided by plunging energy prices and mortgage rates, their “shock and awe” campaign will likely pay off, leading the U.S. out of recession first and lifting the U.S. dollar over its peers.

Countries slow to respond to this crisis will see their currencies punished by markets obsessed with bold fixes and quick cures. Notwithstanding the efficacy of cheaper credit when banks are reluctant to lend, traders appear willing to bet on the audacious moves by Paulson & Bernanke Inc. and the U.S. dollar. The ECB, on the other hand, with its mandate rooted in inflation-fighting, is now viewed as behind the easing curve. The many disparate economies in Europe subjugated to the unitary monetary regime of the ECB will also stagnate far longer without a strategically coordinated EU-wide bailout.

The relationship between the U.S. dollar, precious metals, commodities and stocks that have characterized the global financial crisis may continue in its present form, which is the U.S. dollar (and to a lesser extent the Japanese yen) and treasuries moving in opposite direction to the other asset classes. This relationship is predicated on the need to further de-leverage and divest from risky assets, while seeking refuge and liquidity for investment dollars. As long as these dynamics remain in place, a weak global economy that saps investor confidence will lend support to the U.S. dollar.

Obama’s massive spending and tax relief programs have a narrow window of opportunity to gain traction and improve economic prospects before worries about endless deficits lead to renewed dollar devaluation. The U.S. dollar’s safe haven status has served it well during the de-leveraging process, and its buoyancy in 2009 could also be bolstered by transitioning to a growth currency as stimulus measures reverse the economic decline. However, a strong recovery could also ignite as yet dormant inflation, lifting commodity prices and dampening the U.S. dollar, but this is unlikely in 2009.

Verdict: U.S. dollar will consolidate recent gains and outperform the euro.

U.S. dollar bear’s case: Obama warns of trillion dollar deficits for years to come just as the Congressional Budget Office estimates the 2009 U.S. deficit at close to 1.2 trillion U.S. dollars, before the stimulus package. At 75% of GDP, the gross national debt is 10.6 trillion U.S. dollars. As the global recession widens and deepens; foreign government buyers of U.S. treasury debt may refrain from further purchases at record low yields and instead opt to rescue their own ailing economies. Funding huge U.S. deficits will become increasingly difficult as the formerly eager buyers of China, Japan, the Middle East, etc all turn inward to focus on domestic spending initiatives.

Without a “coalition of the willing” ready to lend to America, treasury prices may soon begin to fall from their lofty highs and yields track higher, forcing the Federal Reserve to monetize the debt and vastly increase the supply of money in circulation. Debt monetization occurs when the Federal Reserve purchases government debt from the Treasury and prints money. It appears that Uncle Sam might be the lender of last resort to Uncle Sam when all else fails. This could ultimately jeopardize America’s sovereign debt rating and send the U.S. dollar over a cliff with inflation to skyrocket.

In the immediate aftermath of the credit bubble burst and the evaporation of over 7 trillion U.S. dollars of stock market wealth in the U.S., the conditions for inflation are not yet present in spite of humongous deficit spending and monetary expansion. However, at some point the total debt and unfunded liabilities of the U.S. government (exceeding 50 trillion U.S. dollars) will become sufficiently alarming to its creditors, and a substantial rise in interest rates will be necessary to forestall a precipitous fall in the U.S. dollar.

Governments, businesses and consumers in America have collectively over-extended themselves since Ronald Reagan was president. Although the debt picture improved somewhat under Clinton, deficits have returned and grown since 2001. With foreigners holding more than half of its public debt, it is inconceivable that this orgy of borrowing can continue without exacting a penalty on America’s security and sovereignty.

As America stares into an economic and financial abyss today because of its profligate spending, it is ironic that the solution for its dire predicament is more borrowing and spending. Trillions of dollars of stimulus will eventually end the recession. However, when recovery comes around, the lack of political will to introduce tax and entitlement reforms and confront its debt overhang will ultimately inflict permanent damage on the U.S. economy and the value of the U.S. dollar.

Verdict: An America that does not reverse its structural deficits will put the U.S. dollar on a long and painful slide again, but this is unlikely to happen until there is a global economic resurgence that allows inflationary pressures to build.

Trade Weighted Exchange Index: Major Currencies (1973-2008)

Chart I

Chart I shows a weighted average of the foreign exchange value of the U.S. dollar against a subset of the broad index currencies that circulate widely outside the country of issue. The major currency index includes the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden.

These are the currencies that most FX traders are familiar with as they are widely traded against the U.S. dollar.

The movement of this trade weighted exchange index gauges financial market pressures on the U.S. dollar. The most recent depreciation of the U.S. dollar has driven the index down from 110 in 2002 to 70 by 2008, a decline of 36%.

Over the past 35 years, the cyclical pattern of the U.S. dollar has historically provided a 7-9 year of peak to trough (and vice versa) performance. Based on the above chart, it is possible that the U.S. dollar has made its most recent cyclical low of 70 in 2008 and is now attempting to move higher, although many skeptics question the fundamental soundness of the currency in light of a much weakened U.S. economy and the ever greater indebtedness of its public and private sectors.