5 November 2008

Whither the US dollar?

This dramatic growth in the monetary base has not yet been inflationary since the velocity of money may have recently fallen due to the rise of deflationary expectations. Some will argue that liquidity being injected into the bank system will be drained subsequently by the Fed via open market operations. In principle, this could abate the ultimate inflationary impact of the bailout operations. However, currently this liquidity cannot be removed without collapsing the banks and worsening the recession. Since bringing bank balance sheets back to health is probably a multi-year process, this argument does not seem to stand.

We currently stand on Occam’s razor, staring into a deflationary abyss on one side and incipient inflation on the other. The Fed and US Treasury have shown their policy hand, revealing a strong preference to avert deflation. No doubt this reflects a broad political consensus that prospects of inflation are to be preferred to deflation, if those are the two choices. Claims that these massive debt levels can be financed and ultimately retired by future economic growth, taxation and lower government spending ring hollow.

Whilst the velocity of money has been quite stable in the past several years and perhaps even fallen most recently, this will not always be the case. As spring surely follows winter, it can be relied upon that velocity will accelerate in the future. Once it does, it will combine with this huge increase in the monetary base to boost liquidity and elevate price inflation.

There also remains an open question whether foreign investors will continue to be willing to accumulate additional US dollar assets. A strong argument could be made that foreign investors are already sated with US dollar debt. Foreign holdings of US Treasury and Agency debt stands around $4.1 trillion, representing approximately 36% of publicly held issuance. The concept of Bretton Woods II -- wherein foreign investors were the lender of last resort extending vendor financing for their exports sold to the US (consumer) -- was predicated on the stability of sustained household consumption. With the US household suffering from declining home prices, falling real wages, job loss and collapsing confidence, the American consumer will take years to recover their former spendthrift ways. With this missing critical link in the global relationship, it is suspect whether foreign governments will be willing to significantly increase their holdings of US dollar debt, if there is not the quid pro quo of increased export receipts from further US consumer spending.

Any meaningful pushback from foreign investors on buying additional US Treasury debt or US dollar denominated assets will imply either a steeper yield curve or monetization of new Treasury debt issuance. Neither outcome is desirable. A steeper yield curve implies declining Treasury bond prices and, by raising interest rates, also creates a headwind for US equities. In this scenario, it is hard to imagine a strong US dollar in the face of weakness in both US stocks and bonds.

In the second scenario, if investor demand is inadequate to absorb new issuance, then the Federal Reserve will have to hold a portion of new debt issuance by the US Treasury on their balance sheet. This is sheer monetization of the debt and highly inflationary since it is equivalent to simply printing money. Such a scenario would quickly lead to higher inflation and a weaker US dollar.

The tsunami of oncoming US Treasury debt issuance holds the real potential to crowd-out private sector issuance both here and abroad, steepen the US Treasury yield curve, put downward pressure on the real economy, undermine the US’ AAA rating, weaken the US dollar, and if the Treasury is required to resort to monetizing new debt issuance by “selling” it to the Fed due to pushback from foreign investors, it could even threaten the Bretton Woods’ US dollar reserve status and the Greenback’s role of denomination currency for commodities: a very high price to pay for a decade-long party on Wall Street.

So it seems that, despite the violent rally in the US dollar over the past three months, it may not be long lived. Much will depend on the capacity of foreign investors to offer safe harbour for new Treasury issuance and/or the likelihood of a policy mix set in Washington, DC that runs tight money and a fiscal surplus. When was the last time that occurred?

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