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May 16th 2010

When Will Attention Shift to the Dollar?

The fiscal crisis ravaging the Euro and the Pound has sent the Dollar skyward. On the one hand, the prospect of continued uncertainty and dissolution of the Euro would seem to be an excellent harbinger for continued appreciation in the Dollar. On the other hand, it should only be a matter of time before investors recognize that the Dollar’s fiscal fundamentals are also quite weak.

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Unlike during the last few years, analysts are no longer talking about (forex reserve) diversification. It was once widely predicted that the Euro would rival the Dollar for a place in the portfolios of foreign Central Banks. As expected, preferences are now shifting back in favor of the Dollar and to a lesser extent, the Yen. The Pound and Swiss Franc may have a small role, as will the “New” Euro. Over the short-term, however, Central Banks (and investors) will continue to eschew the Euro, if only due to sheer uncertainty.

Given that everything is relative in forex, investors and Central Banks only have so many options when it comes to choosing which currencies in which to denominate their portfolios. Thus, it’s understandable that a sudden crisis in the EU would buoy the Dollar. At the same time, it’s not exactly a good bet that the US isn’t destined to suffer a similar fate.

Due to extremely low short-term interest rates, most investors have been willing to accept low returns when lending to the US (by buying Treasury Securities, and indirectly by simply holding Dollars). At some point, both short-term interest rates and the rate of inflation will rise, and investors will have to re-examine their risk/reward schemes. My suspicion is that investors will demand higher yields in exchange for lending to the US.

Just like with Greece, a US fiscal crisis would probably emerge suddenly. While the US government pays lip service to the notion of balancing its budget and reducing its sovereign debt, even the most optimistic projections show a budget deficit for the next 10 years. Beyond that, the retirement of the baby boom generation and their “entitlement” payment will make it nearly impossible for the US to operate a budget surplus.

In short, the only hope is for the US economy to grow faster than the national debt. If the US economy grows at 4% per year, for example, it will have to run a budget deficit less than 4% of GDP in order to reduce its relative level of debt. On the surface, this seems like a reasonable possibility, but given trends over the last three decades (covering periods of both recession and economic boom), it doesn’t seem likely.

This is not new information. Doomsday theorists have been predicting the bankruptcy of the US for two centuries. Don’t mistake me for doing the same. Rather, I only wish to point out how ironic it is that the Dollar’s fiscal conditions are comparable (and in some ways worse) than some of the problem countries that investors are currently focusing on.

Then again, forex is relative. Some analysts have suggested that the new reserve currency will be gold, oil, and other commodities. Unfortunately, there isn’t nearly enough (liquid) supply of these materials to occupy more than a small portion of reserves. Under the current system, then, investors are pretty much stuck with the Dollar. At this point, betting to the contrary is tantamount to betting on the complete collapse of the modern financial system. A reasonable bet, perhaps, but you can forgive investors for being hesitant to embrace it.

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Posted by Adam Kritzer | in Commentary, Euro, News, US Dollar | 5 Comments »

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5 Comments of “When Will Attention Shift to the Dollar?”

  1. Dean Bonkovich Says:

    Excellent article. I too have been wondering when the interest rate of the Federal Reserve was going to reflect a 17 trillion deficit. In any other country this sort of debt would classify you as third world with the appropriate central bank interest rate, but not in the US.

  2. circross Says:

    Forex is indeed an »illegal« cross/circular reference game. There is a very good reason for not nearly enough (liquid) supply of, say, phyzz gold. @ these (virtual) prices.

    Should the existing “market structure” producing these “virtual” prices somehow change in its nature, that change could easily effect the liquidity required / for “stability” to resume. `twould also boost reserves v outstanding debt. Of course, the required level of these prices stands so high, the sign says: “epic epic change”.

    Hesitant yes, but someone is persistent for (at least) the 10th year in a row today. (each of those bought by brown s butt).

  3. Forextc Says:

    I think you are right. Focus in the markets at present is not on ‘who is the healthy guy’ but rather who is the ‘least sick’. It’s a bit like a hopsital ward where a cough or splutter from a patient suddenly focuses attention.

    The big benefit to the US as I see it is that it can apply a unilateral policy to try to stabilise itself. The Euro Zone, despite it’s perceived unity struggles to achieve this. The French and German pockets only run so deep.

    Despite its run up so far Gold is stil historically cheap by most measurements. But then again the average Joe does still not seem to be in touch with the severity of the current situation. Once he grasps it, Gold could well become the only ‘currency’ worth holding.

  4. price action Says:

    Interesting read, I also feel it’sironic that the Dollar’s fiscal conditions are comparable (and as you say ‘in some ways worse’) than some of the problem countries that investors are currently focusing on. I feel the US Dollar will remain the reserve currency for some time though. Just my 2 cents.

  5. FX Says:

    Thanks for the article. Interesteing information here. I think that the US is going to be in for another financial crisis here soon. Could be start effecting the T Bills and could potential crush the dollar.

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