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A Message from Louis B. Mendelsohn - President and CEO of Market Technologies
Be Afraid, or Maybe Not
Be afraid. Be very afraid. This is the prevailing sentiment in all the market these days, which is unfortunate because the fundamentals of the economy are improving, and a sustained recovery is coming. Yes, big economic and fiscal issues remain on the table, and more than one of those hold the potential to impede our economic recovery, but nothing out there presents the same conditions that could send us in the near term to the economic precipice again. True, the broad market could easily retrace the downhill path it took throughout 2008, and, in particular, it could, once again, almost kill itself in its rapid flight from risk. This could happen, or all of this selling just might be the long-predicted correction the pundits and analysts have been saying is coming since March of last year. Truly, no one knows for sure where the markets will be at the end of 2010, but one thing I do know is that the U.S. dollar will play a key role.
The underlying question about the U.S. dollar is this – will it fundamentally regain the strength it has traditionally had against foreign currencies? The answer will determine what role it will play in market movement, as well as our economic and fiscal future, which by the way, are now one and the same.
Currently, the dollar is still considered the premiere safe haven, as we are seeing a flight to the U.S. dollar during these, once again, uncertain and fearful times. The U.S. dollar is pushing highs it has not seen for some time. Interestingly, gold, another traditional “safe haven” is not experiencing an in-flow of capital; actually it is the other way around. Gold, however, is the subject for another article. Today, the focus is on the dollar, and where it is likely to go in the near term and far future.
Clearly, a movement is afoot. For some time, now, foreign central banks (foreign governments) have been making noise about diversifying their FX reserves, meaning trading out U.S. dollars for other currencies. Seemingly, this diversification would be an attempt to lessen the dependence on the U.S. dollar in global trading. This “shift” has been going on for about a decade. In 2000, roughly 71% of all global FX reserves were in U.S. dollars. As of mid 2009, that percentage dropped to 62%. With global FX reserves estimated at $4.3 trillion, the 9% differential comes to just under $400 billion. This drop hardly seems like a big deal when you consider that the $4.3 trillion is roughly only 15% of global GDP. Well, a lot has happened since mid-2009, not the least of which is the fact that the U.S. has piled up more debt trying to extricate itself from the near economic collapse, while continuing to fight two wars, and sustaining various entitlement programs, which comprise over 60% of the U.S. annual budget. As well, the Fed has pumped trillions of “theoretical” dollars into the economy to push interest rates down to near zero, while increasing liquidity to help the ailing economy. How does all of this factor into the future of the U.S. dollar?
Here is one plausible answer. We are not alone. As our economy, fiscal policies, and markets go, so does the rest of the world. It is true that in 2009 Russia “diversified” a chunk of its FX reserves from U.S. dollars to Canadian dollars. This begs a question. If the U.S. is Canada’s largest trading partner, can the Canadian dollar outperform the U.S. dollar in the long run? As well, does anyone really think that in the short term, the euro will continue to push the dollar to new lows? What about the sovereign debt issues of Portugal, Italy, Ireland, Greece and Spain, otherwise known as the PIIGS. What about the massive deficit spending of Great Britain and France which has exacerbated their own problems with entitlement programs? It appears that much of the talk about diversifying from the U.S. dollar is geo-political, and that what has happened over the last ten years makes sense as wise and prudent investment practice. The global economy is changing, as is our percentage of it.
This brings us to China (representing all emerging economies) and the Middle East. We don’t know how many U.S. dollars China has in its FX reserves, as this information is not public, but we do know that China has bought and continues buying our debt to the tune of almost a trillion dollars. We do know, like Canada, that we are China’s largest trading partner. And we do know, because of their dependence on us and the European Union China can ill afford to continue manipulating its currency in the global market. Eventually, the yuan will have to come more in line with other foreign currencies, if China wants to continue its surging growth and developing global trade. As for the Middle East, one fact that the world currencies cannot escape from is that oil, the most prized commodity on the planet today, is traded in U.S. dollars, despite periodic rumblings that I can remember as far back as the 1970s following the Arab oil embargo about all sorts of currency baskets, with the latest round coming in late 2009 purportedly involving secret talks between the Arab states and China, Russia, Japan and France.
Today, we see the U.S. dollar’s affect on the broad market – as it goes up, markets go down, and as it retreats, markets rebound. This is a simple reflection of the fear and uncertainty that is gripping the global financial markets. Looking down the road just a bit, however, as fear and uncertainty abate and confidence with a touch of greed fills the void, the U.S. dollar might exert a different influence on the broad market. The correlation trade of today will probably morph into a trade premised on the notion that a healthier U.S. economy in the coming years will precipitate the return of the inflation monster, which everyone knows is the harbinger of higher interest rates. The question then becomes: will inflation and higher interest rates mean a stronger U.S. dollar. Or, will it mean just the opposite? Time will tell, but one thing is certain – the demise of the U.S. dollar is overblown. It is not about to leave the world stage just yet, and, certainly, won’t leave without putting up a big fight which means that there will continue to be a lot of trading opportunities for currency and Forex traders to ponder.
Best Wishes,
Lou Mendelsohn
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