Fed chairman Ben Bernanke talked up the dollar a couple of pips yesterday. But beware a false sense of security. The bullish crowd from Wall Street would have us believe the dollar’s fall is over and that stabilization at two per cent interest rates will spark a rally after eight months of falling rates. It would be nice to think this is true. But the dollar is going to $2 per euro over the next two years.
From a technical perspective a modest rally is to be expected after such a long fall. Yet if you look at falling charts they seldom move in a straight line and what in the past looked like a rally proves in fact to be a false or sucker’s rally.
For on fundamentals why should the US dollar stop falling now? Is not the money supply growing like a snowball – 16.7% annualised on synthetic M3 thanks to the Fed’s ultra loose policies. Does this not mean the value of the dollar diminishes against other currencies?
And what about the stop on interest rate falls? Why should interest rates stop at two per cent? We have not yet seen a big sell-off on Wall Street which is surely bound to come as the recession and inflation hit corporate profits, let alone when markets come to digest the full impact of a new US president, almost certainly Barrack Obama whose economic agenda is unknown.
Then the Fed will cut rates to one per cent, or lower if things seem really bad. And what will that do to the value of the US dollar? It will bring it hurtling down another step towards $2 to the euro.
Last summer my old friend Dr Marc Faber forecast a recovery in the US dollar and a correction in the gold price.
Unfortunately since last summer the euro:dollar rate has moved from $1.38 down to almost $1.60 and has bounced back a few cents since then. The gold price shifted from $650 an ounce to peak at $1,030 in March and is presently around $900 having briefly dipped below $850.
Now Dr Faber is again predicting a US dollar rally and telling his newsletter readers to go long on the US dollar and that gold could fall to $800. Dr Faber has been right on many more forecasts than he has been wrong, but it could be that the false optimism of last year is being repeated. And if there is a rally it will be short lived.
Eventually all markets hit bottom. But the bottom of the US dollar cycle will surely not be reached until interest rates hit rock bottom. Rates went to one per cent as recently as the dot-com crash. Expect a repeat of this recent historical performance. For whatever the concerns about the inflation outlook the Fed appears to have a bias to support economic growth.
Besides the Fed knows the true extent of the frightening debt and derivatives exposure that overhangs the US economy. In March the Fed moved very quickly to rescue Bear Stearns because it knew the risk of a meltdown of the counterparty obligations in its derivatives pool.
Mr. Bernanke is not going to risk anything that will put the banking sector at risk from multiple failures, which as a scholar of the Great Depression he knows is what turns a recession in to a depression. ‘Helicopter Bernanke’ is his nickname because he knows when to drop the cash into the system.
The doyen of the gold bugs, veteran trader Jim Sinclair, has the US dollar dropping to $2 to the euro over then next 18 months to two years. This he links to an inverse move in the gold price to at least $1,650 and presumably silver will follow and probably outperform as in past financial crises.
I can see plenty of reason to see further dollar weakness. The Wall Street correction is a given and the correct response will be a further cut in interest rates to one per cent, albeit the exit of money from equities and into cash and bonds would be a balancing dollar positive. But then you have to wonder how President Obama will be received by the financial markets and then whether his inexperienced administration will impress with its handling of whatever foreign and domestic challenges emerge.
Will he decide to stay in Iraq? How will he deal with Iran? Will the Middle East peace process work better or worse under his guidance? Will oil prices spike to $200? These are all uncertainties that at the very best the markets will dislike until they are no longer uncertainties. This uncertainty will be a drag on the dollar until it lifts, and it is uncertain how long this uncertainty might persist.
In this environment – and against the backdrop of what is already the worst financial crisis since the Second World War according to many commentators – I hardly think a US dollar rally can be sustained for long against the euro. For the European Central Bank’s mandate is to control inflation and it will raise interest rates to do so, regardless of the consequences, although the finances of Germany and France are in better shape to take the pain than the US.
Where the US dollar is likely to rally is against some smaller currencies like the British pound which is being pummelled by its own housing and banking crises. But I doubt anything but weakness against Asian currencies is probable, though if a recession dents commodity prices that might exclude the Australian dollar.
What the smarter holder of US dollars will do is to dump them for other currencies or precious metals over this summer. Indeed that is another reason to think the dollar will not recover much further. And for the Gulf countries holding on to a dollar peg in this scenario is a recipie for higher inflation levels, albeit with an inward investment and tourism boom alongside higher property prices.
Eventually the US economy will rebound and with it the US dollar. But not unless and until it has worked through its present crisis. Financial crises typically last three years and this is just not over yet. First we will have to see the squeeze on profits in US domestic companies, a round of business failures, higher unemployment, more banking provisions for bad loans and a consolidation in the financial and housing sectors. And US house prices will have to stop falling, something not expected before the middle of 2009.
It would clearly be far pleasanter for all concerned if none of the above had to happen. The dollar would rally. Wall Street would surge. A new President would mark the dawn of a new era. Global trade would surge. But even that scenario would be highly inflationary and undermine a recovery. There are times when economies contract after a borrowing binge, and that is what is happening in the US and it will be bad for the dollar.
As for the prediction of $2 to the euro, is that so staggering? It is after all only a 25 per cent fall from where the US dollar stood a couple of months ago. Buy gold and silver if you want to hedge against this fall.
