Here are two conflicting facts: 1) the value of the US dollar, relative to other currencies, rests on disturbing fundamentals, and 2) the role of the US dollar, as a means of transaction and unit of account for international trade, is stable. Predicting short-to-intermediate-term future currency movements is fraught with uncertainty. Currencies are valued based on their fundamental value or purchasing power parity (PPP) (Big Mac index) relative to another currency. A currency’s actual value may deviate largely and/or for an extended period over its PPP, but it cannot exist, as such, indefinitely. PPP is not a fixed number. This anchor can move higher or lower and is influenced by the inflation differences between currencies. WITH CURRENCIES, EVERYTHING IS RELATIVE.
The US is currently experiencing the twin deficit syndrome (current account and fiscal). Textbook economics states that free-floating exchange rates would correct the trade (current account) and financial (fiscal) imbalances. The academics would argue, correctly, that the US dollar should depreciate very quickly. A strong portion of these imbalances have been caused by emerging economies artificially keeping their currencies undervalued relative to the US dollar (source: UBS). These countries have grown their economies and their middle class with export driven policies, with the US consumer being the dominant buyer of their goods (purchases were leveraged and savings were spent to finance these purchases and wage growth was stagnant). Either exchange rates or relative prices between these countries must change to re-balance trade relationships. This affects the purchases of our debt by foreigners, the value of foreigner’s assets held in US dollars, etc. All currencies cannot simultaneously increase and decrease. Amoungst the developed currencies, the US dollar has been the loser.
Over the last decade, emerging economies have grown faster relative to the US (to be expected), inflation rates have been steady or declining, and their spread borrow rates in US dollars have dropped dramatically. The first and second tier emerging countries have independent central banks with inflation targets. International trade will evolve to include emerging country currencies (e.g. China/Brazil swap trade transactions). Politically emerging countries are becoming more stable as their middle class grows.
US dollar weakness has limits. Countries with bulging US dollar reserves do not want those assets to depreciate too quickly. The US is running a risky strategy of twin deficits to offset the effects of the financial crisis on it’s economy. As a reserve currency, the US dollar does keep the cost of global transactions low. These are stabilizers for the US dollar.
Bottom line: The US dollar will weaken. The bond and currency markets will provide guidance when investors believe the twin deficits have reached a tipping point. As politicians re-regulate and partly diffuse globalization, the movements of this long-term trend are murky. The current popular ABD trade (Anything but the Dollar) is crowded and expensive. Thinking as a European, whereby over time, investors methodically build-up diversified non-US dollar assets, is a prudent course of action.
Always Asking, Never Assuming™
Christopher Holtby
Tags: depreciation, fx, medium of exchange, PPP, us dollar trade