Interpreting the fall of the dollar from the demand side

The decline of the dollar as a speculative bubble

As mentioned in somewhat cruder form on the blog last week, it is our contention that the current decline in the dollar is more appropriately seen as a speculative bubble in commodities and the euro.

The possibility that the dollar will continue to decline on its own merit, or demerit, certainly exists – in face of decades of trade deficits – but the current steeper slope of fall should not be seen exclusively in that light.

Let me explain in seven parts.

One

The dollar has been declining against the euro for five or six years, not coincidentally beginning with the cheap money policies of then Fed chair Alan Greenspan. Parenthetically if you had listened to George Soros back then, you would have shorted the dollar and made thirty percent just on the currency. Much better than the stock market.

Two

The recent so-called turbulence in credit markets was a house of cards. The suites were:

• Hearts - subprime mortgages
• Diamonds - near fraudulent securities rated at triple A
• Spades - dodgy Enron-style off-balance sheet vehicles known as SIVs
• Clubs - whatever the transitive form of the term lax regulation is, as in the SEC and Fed not only failed to structure or monitor the market, but actually cheered on the players as they neared the cliff.
  

The cheap money that created the housing bubble is the same cheap money that reduced the value of the currency, but the salient feature of this whole mess is that the financial market hijinks led to the flight of investors to safety – to T bills, stocks, foreign securities and significantly to the apparent concreteness of commodities

Two B

Said another way, investors of all nationalities have to be wary now of US financial markets, self-described as the strongest and deepest in the world, because they have just burped forth hundreds or thousands of billions of dollars in bad paper after their most recent binge. Very poor regulation and poor structure to the markets should make the US markets toxic in themselves, and they are only palatable for the wrong reason, the implicit risklessness of risk now being exposed with the various bailouts.

Three

Many nations around the world have a dominant commodity as an export, and the value of that commodity determines the value of the currency. Domestic problems with this condition are known as the Dutch Disease, after the effects of oil prices on the currency of the Netherlands. Other nations relevant to the current discussion are Canada with oil and natural gas, any of a number of Latin American and African countries with metals and petroleum, Australia with metal ore, and even New Zealand with dairy.

Four

The bidding up of commodity prices by investors, a process known by the technical term “speculation,” also bids up these currencies relative to the dollar and leads to the inverse and more visceral experience of decline.

That is, for example, higher oil prices and lower dollar values are two sides of the same coin. It is our contention that it was the attractiveness of oil – and commodities in general – as a secure investment play, not the extra weakness of the dollar that began the slide. Most experts in oil will tell you that fundamentals call for a price of sixty, not one hundred.

Five

A special case exists with the euro, because of the aforementioned slide of the past six years, because of the perception of a shift to the euro as a reserve currency, and because of current strength in the Eurozone economies attracting investor dollars into euro-priced investments. This has created a speculative bubble in the euro itself.

Six

Other nations that are big in trade – Japan, Britain, China, India have not appreciated against the dollar. Of course, China and India have less than fluid exchange rate regimes. But the point is taken.

Seven

The resulting speculative bubble in commodities threatens to ignite inflation and call down the wrath of the charcoal-suited Myopes of central banks.

The bubble also threatens to ignite a fire sale on dollars that has not yet occurred, further fueling inflation and bringing crisis to the Globe.

Already food inflation is rampant. Fuel inflation is rampant. This hits demand very hard, particularly at the low end, where fuel and food are larger components of household spending.

Admittedly, the architecture in seven parts just constructed is an interpretation, and no more or less verifiable than any of a hundred or more other interpretations.

But, as some might say, we’ve got the arrow in the chest. Perhaps we’d better get it out now and worry about where it came from later. I agree – though if some of the archers were taken down it might make our task easier.

We do need to find a source of demand and soon that is not infected by the financial market dysfunction. Clearly we cannot simply go back to cheap credit, McMansions and consumer baubles as a driver.