A bearish frenzy has developed in the US dollar, and is probably the strongest consensus I’ve seen since the bullish stampede in oil futures crashed last Summer. With publicity hungry commentators from historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories weighing in with their economic insights, and hedge funds leveraging up aggressively again on the global carry trade using the dollar as a ‘free’ funding currency, it’s time for a reality check. There is no alternative to the dollar as the global reserve currency for the foreseeable future; while the dollar’s share of CB reserves has declined from 72% to just over 62% this decade, this is the result of the Euro’s emergence, with the Yen still a paltry 3% of global forex holdings.
Total dollar holdings have steadily risen, and even this year, China has continued to accumulate dollar assets, while grumbling about US economic policy. It will be at least a decade before Yuan convertibility is a real prospect, and only then if China can radically overhaul its financial markets in the meantime, developing deep capital markets and hedging mechanisms and gradually opening its capital account. At the moment, even in Hong Kong, less than 2% of trade is conducted in Yuan. As for that complex proposed IMF basket currency, which dollar bears offer as a real alternative, call me when a Colombian drug smuggler is caught with a suitcase full of the things.
The structural nature of America’s trade deficit has been demonstrated this year by the fact it still remained at 3% of GDP in Q2, in the depths of the recession (from 7% at the peak of the boom in 2007, when its funding was soaking up 70% of global excess reserves). In fact, the US hasn’t run a trade surplus since the early 1990’s recession, and that constant funding requirement places ongoing pressure on the dollar. I’ve commented at length on the dangers of current Fed policy, which does little to alleviate deflation in real assets while stoking hyperinflation in financial ones, and to the extent it is spiking commodity prices, undermining a real recovery. If it was down to me, I’d immediately place the $870bn in excess commercial bank reserves at the Fed at a negative interest rate (ie charge them for the privilege of parking their cash, as the Swedes have already done) and simultaneously hike rates by 50bps. This would correct the current dangerous distortion of the monetary base.
Those reserves, applying the typical 7-8x deposit to loan multiplier over the last couple of decades, would translate into a credit surge equivalent to 40-50% of US GDP, underwriting a cyclical recovery, and closing the divergence between the Fed’s $1.2trn of quantitative easing and the $110bn rise in M2 money supply as stymied by commercial bank capital hoarding. By hiking rates now, you offset the inflationary implications on expectations, while underpinning the dollar and supporting foreign capital flows while the US economy rebalances after a decade of excess consumption and underinvestment. Ben Bernanke and Tim Geithner may talk the talk on the need for higher US household savings, but a zero interest rate policy is punishing thrift. The Fed’s emergency response to last year’s financial panic was appropriate and decisive in tackling a deflationary threat, but it now needs urgent adjustment, before the law of unintended consequences results in a new bout of economic turbulence and a fatal loss of credibility. Even without a radical rethink, such is the bearish extreme we have now reached (reflected in the sense of panic at central banks from Europe to Brazil) that a snapback rally of 15-20% is likely imminent, leaving the consensus confounded.