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The relative value of the U.S. dollar is certainly a newsworthy piece of financial data reported consistently on the business news channels. The implications of its relative strength or weakness not only affects the level of trade between the United States and the rest of the globe but also affects bond yields, commodity prices, and inflation.
The present theory is that the increased spending from the stimulus programs initiated by the United States will eventually lead to rising inflation, increasing interest rates, and a sharply lower dollar. Assuming the stimulus works, global investors will be left to wonder whether the dollar is worth holding.
The United States has a debt ceiling in place. The debt ceiling puts a limit on the amount of debt the U.S. Treasury can auction off to investors. In September 2007, that ceiling stood at $9.815 trillion. In February 2009, that ceiling was raised to $12.104 trillion. This represents a 23.3% increase in a relatively short period (17 months). To put the increase in perspective, the deficit only grew by 20% during the 34-month period previous to September 2007. Not only is the deficit growing by a larger amount, but it is also growing at a pace twice as fast.
With more debt to auction off, the demand from overseas has become more of an integral part of the funding equation, and in turn, the value of the U.S. dollar. Of the total U.S. Treasury securities auctioned off, $3.265 trillion (29%) is owned by foreign and international accounts, according to data as of December 2008. This is up from 18% in 2001. Of that total, China and Japan account for 44.5% of the foreign holdings. China alone owns $768 billion of U.S. Treasury securities, or 23.5% of foreign holdings.
Recently, there have been conflicting signals from China (and other central banks, including Brazil, Russia, and India) with regard to their commitment to the U.S. debt, and this has led to a sharp rise in U.S. interest rates and a decline in the U.S. dollar.
Since April 1, 2008, the 10-year U.S. government bond has risen by 114 basis points, while comparable debt in the United Kingdom and Eurozone have risen by 84 and 64 basis points, respectively. Meanwhile, the value of the dollar has fallen from a high of 89.00 on March 9 to the recent low of 78.40 on June 2—all of which smells of more dollar bashing to come.
The fall of the dollar has likewise brought back the memories of the first half of 2008, where the oil/dollar spiral took its lethal toll on the global economy. During that time, dollar selling led to oil buying, which led to more dollar selling and more oil buying. The speculative spiral, which saw the dollar move to a low of 71.80 and the price of crude oil to $145 per barrel, ended in July and was a contributing catalyst to the sharpest global slowdown since the Great Depression. Since February 2009, crude oil has more than doubled, rising from $34 per barrel to a high of nearly $73.
Higher crude oil has also raised gasoline prices, and the dollar selling has also contributed to a flight back into commodities. On June 11, the Commodity Research Bureau Index reached the highest level since November 2008, indicating inflation and a lower dollar. Will the trend continue?
It is difficult to predict the future with so many balls still up in the air. Not only are economies still experiencing employment layoffs, housing woes, and hangovers from over-leveraged balance sheets, but there also is the implications of the global exit strategy, which when enacted will bring about its own set of uncertainties. These implications will be felt around the world, not just in the United States. I believe that the markets will need assurance that high-debt nations like the United States are making all efforts to control deficits because the stimulus spigots cannot stay open forever.
And while the likes of China, Brazil, and Russia may like to diversify their dollar holdings, outright selling also has negative implications for the debt they already hold. But over time, they may indeed find the means through alternative blended debt offerings from the likes of the International Monetary Fund. In addition, China still relies on the United States for their exports. Higher bond yields, higher commodities, and a lower dollar threaten U.S. stabilization, which will affect demand for goods from abroad, including those from China.
So, although it is easy to see dollar pressure from the stimulus surge, maybe it’s not the best time for the market to get too out of hand. Finding the equilibrium level will likely err on the side of dollar selling and higher rates, but I would not expect a total collapse. The knife’s edge that the world continues to sit on is just too sharp to ignore.