Why Am I (Controversially) Confident In The US Dollar?3 June, 2011, 17:25. Posted by Zarathustra
Tags: Dollar, Economy, Quantitative Easing, United States
Long US Dollar (against anything else) is probably one of the most contentious trades these days. The idea of US dollar is doomed is so popular. On the contrary, gold has been doing well for 10 years.
After Moody’s threatened to think about downgrading the United States, I once again threw confidence on the US Dollar just like when S&P threatened to cut the rating. Of course, common arguments will go that perhaps the Federal Reserve will have to perform quantitative easing sooner or later, and the public finances are just awful anyway, so there seems to be no reason to feel positive about the US dollar and US Treasury, especially if the debt ceiling negotiation ends in disaster.
The debt ceiling thing is indeed a big uncertainty, in my view. But a US default in such a way has never happened before, so we probably don’t have much historical instances to guide us what might have happened if the debt ceiling can’t be raised. The GOP which are using these to force the Democrats to accept more spending cuts, which is actually bad for the economy as the United States is facing a balance sheet which calls fore more government spending. Thus, to put it bluntly, the brinkmanship of GOP is simply appalling.
Perhaps at the end, the debt ceiling will be raised, and the politicians come up with a “credible plan to cut long-term deficits”. And let’s say this is a base case scenario. In this scenario, I am, controversially, somewhat confident about the US dollar for some not-quite-desirable reasons:
The future will be deflationary
In a balance sheet recession, the private sector is still deleveraging. We also see home prices falling in the United States. These are profoundly deflationary, and it calls for more government spending to offset the contraction in the private sector. Unfortunately, the politics of it will mean probably a premature deficits reduction, and it will make matters worse. The outcome will be a deflationary future.
Even More Quantitative Easing will not work
One has to realise that the idea of the doom of US dollar through quantitative easing is based on the assumption that quantitative easing will work, in a sense that quantitative easing can create inflation (or indeed, hyperinflation). Early on, I have already argued that quantitative easing will not work in this profoundly deflationary environment because more liquidity will not be translated into more demand for credit if the economy is undergoing a balance sheet recession. Cullen Roche has pointed out that QE2 has failed to achieve its objective, just as I expected. I can once again put these two charts showing that the Federal Reserve has only been successful in increasing monetary base but not broader money supply (M2).
Source: St. Louis Fed
Purchasing Power Parity
So the democratic process makes the United States unable to maintain high government spending to plug the hole left by the deleveraging of private sector, and quantitative easing does not really help to create broader money supply. Under relative purchasing power parity, if the future is deflationary (relative to other countries), the purchasing power of your currency increase over time as you can buy more stuff for the same amount of money. In that case, the US dollar should be strengthening in the long-run, not weakening.
This is exactly the case for Japan. After they started quantitative easing in early 2000s, on the whole the Japanese Yen has ben strengthening. The reason is simple: quantitative easing simply does not work. Growth remains anaemic, and general price level fails to rise in Japan. As things get cheaper in Japanese Yen term, that means Japanese Yen is getting more valuable over time, so its exchange rate strengthened.
Source: St. Louis Fed
The Weaker then US economy, the stronger the US dollar
James Mackintosh of FT observed that the stronger the US economy, the weaker the US dollar. In fact, this observation fits very well with the above arguments. If government spending gets cut, the economic growth will run out of steam. Quantitative easing will not work, which means the probability of a deflationary future is getting more likely. If the Japan’s outcome is a good guide, that means, oddly, the US dollar will strengthen.
Folks like Tim Geithner and Ben Bernanke say once in a while that they want strong dollar. Ben Bernanke went onto say that to have a strong dollar, the Federal Reserve will first have to create a right condition for economic growth, so that the US dollar will be strengthened in the long-run.
Well, there you have it, but not for the reasons he wants.
Finally, if the future is indeed deflationary, US Treasury yields will decline, instead of rising.