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RS

FRONT PAGE CONTRIBUTOR

Emerging Theme in Financial Markets: The US Dollar is Getting Stronger

Capitulation and Decoupling

A vast movement involving enormous amounts of capital is now underway. Investors around the world are buying dollars again. And they’re selling the oil, gold and other commodities that have been serving as a hedge against dollar weakness since the Federal Reserve started aggressively cutting interest rates eleven months ago.

As I write, the US dollar is trading above $1.50 to the euro. The dollar’s low point was below $1.59 earlier this year. This morning’s additional strength follows a very sharp gain on Friday. Crude oil is up slightly after a stunning drop on Friday, and gold is little changed.

What set off the stampede, and what happens next?


It’s probably not true that the dollar is getting stronger (but more on that in a moment). The euro, however, is definitely getting weaker. On Thursday, Jean-Claude Trichet (the governor of the European Central Bank, or ECB) reiterated his prior statements that economic conditions in the Eurozone are worsening rapidly. Meanwhile, the US economy continues very weak, but still growing perceptibly as the export sector remains hot as a firecracker.

So expectations are for lower interest rates in Europe, and continued steady rates in the US. The problem with all this is that Trichet and his surrogates have been saying throughout the year-long credit crisis that their top priority is to control inflation, even at the expense of growth.

At this moment, however, inflation is roaring in Europe (Germany reported a nearly 10% annual rate of increase in producer prices for July, a shockingly large number and far above expectations), but output is slowing rapidly.

Trichet also tried to say something like “Don’t you know that evewy move we make is cawefully planned?” But the markets didn’t bite this time. Hence the decline of the euro relative to the dollar.

News reports are indicating this morning that expectations have turned in favor of a rapid economic recovery in the US, which (all else equal) would put upward pressure on interest rates and thus strengthen the dollar.

But I’m not buying it.

There is another very strong structural factor which is propping up the dollar, and is usually overlooked. That is the insatiable appetite of “official” investors (generally central banks and sovereign wealth funds) for US Treasury debt. The extremely large issuances of long-dated notes and bonds by the Treasury last week were received very well overall (overlooking the to-be-expected raggedness and localized disturbances caused to such a large issue). And short-dated bills and notes continue to receive strong bids.

Meanwhile, the spread between dollar-denominated risk-free debt and risk-bearing debt is extremely high right now. It’s always high during recessions (that’s how banks rebuild their balance sheets), but this is across the board and being sustained for a long period of time, even in the absence of an “official” recession.

In short, the world would rather park capital with the US Treasury than invest it nearly anywhere else. Extreme risk aversion continues to be the order of the day. And you can’t have sustained growth without taking risk.

So the fact that the dollar is the world’s safest and most trusted money by far, will ultimately serve to support its value. The dollar rally appears to have legs.

COMMENTS

  • janis

    diaries. I’m a dunce about the financial world and find it hard to argue with some libs I know about the economy. Your diaries have often given me the ammo I need to combat their “We’re All DOOOOOOMED!!’ attitude, and “America is Dying!!”

    I’m still a dunce about it all, but I’m now bright enough to know when I can feel reassured. Thanks!

  • BrianH

    I’m an amateur investor and know enough about finance and economics to be dangerous. The knowledge you have passed on over the years has made me considerably less dangerous.

  • streetwise

    on work.

    In addition to the technical trends described by blackhedd, there is an intangible strength of the dollar whenever international turbulence is afoot, as with the recent Russia-Georgia conflict.

    As delightful as the continent can be, Europe is a dysfunctional, bureaucratic, low growth mess with depressing demographics, a weak military and irresolute leadership. In troubled times, this matters.

    BTW, the stronger dollar will help to counteract upward pressure on oil prices due to international unrest. Which is a good thing. Let’s keep our fingers crossed.

    • streetwise

      So far, so good!

      • Alberta

        Im an accountant student who plays investor, and when you say enough knowledge to be dangerous, aignt that the truth!

        I thought, like blackhedd said, that the Euros had been talking junk about raising interest rates, but I guess they displayed that courage the Euros are known for!

        I hope whoever wins the general here will have the guts to raise interest rates. Lets ring the bad actors outa the system and start the recovery in earnest.

        • blackhedd

          It won’t be done by whoever wins the election. It will be done by the Federal Reserve Open Market Committee, which is chaired by Ben Bernanke, and theoretically independent of the government.

          Of course, that’s the headline. There have been many attempts (mostly by Congress in recent decades, and by the Treasury in the more-distant past) to compromise the Fed’s independence, generally by way of over-issuing money. I’d rate the chances of another attempt at that to be very good indeed in case the Dems do well this fall.

          • blackhedd

            …that the crude price is headed below $100. I’m hearing some people talk about $80. As I’ve said here many times, the commodity-price run was a bubble, and bubbles always pop.

            The oil-price picture farther out, of course, is pretty opaque because no one really knows what supply is going to look like. The OCS and ANWR resources, if they ever materialize, don’t look very important in my crystal ball, campaign hyperbole notwithstanding. Indirect clues suggest that the Saudis did indeed manage to step up production a bit over the last several months.

            But remember, markets will always surprise you. The very fact that everyone (including yours truly) is focusing on long-term supply is enough to make a contrarian look at the demand side for the real key to the long-term market. And there’s a significant risk that long-term demand will be less than everyone thinks.

          • pilgrim

            There is only one oil pipeline from the oil in the Caspian Sea westward to Europe that is not Russian, and it passes through Georgia. If this pipeline is disrupted I can imagine the price of oil going up.

          • Alberta

            Although Bernake is independent, is he really? What I mean is will he, or would he, raise interest rates, which would bring some short term pain, without the tactic approval of whoever is President?

            I only ask because, although Im very fuzzy on this, when the rates where raised in the early 80′s under the Reagan Presidency, Reagan, I thought, its entirely possible Im wrong, gave approval for the Fed to do so.

          • JKH1232

            It looks like there’s going to be some resolution there in the near term. Plus, oil’s down a great deal in spite of two attacks on that very pipeline. The Structure of the commodity bubble has been fundamentally altered.

          • streetwise
          • streetwise

            blew up the pipeline on the southern end. Crude rose over a dollar in response.

            Then the next day, news came out that the oil was rerouted. Plus, traders began focusing on a strengthening dollar. IIRC, output in Nigeria has been climbing after a period of disruption. And blackhedd has noted that the Saudis, cryptic though they may be, have kept oil flowing.

            So today we have even lower oil.

          • pilgrim

            I’m kinda like Janis at being a financial world dunce, and I gladly accept good news when folks like you and Blackhedd can provide it.

          • streetwise

            nt

          • jonlester
          • streetwise

            Thanks for the compliment, though.

          • jonlester
          • blackhedd

            They didn’t start publishing anything like a “Fed funds target rate” until 1995. The Fed Chairman generally credited with increasing interest rates to stratospheric levels in order to choke off the inflation of the Seventies was Paul Volcker, appointed by Jimmy Carter.

            I’ve been trying to figure out exactly when he started raising rates (I guess I could just ask him), but I think it happened before Reagan became President. You see a sharp spike in the historical series for long-term interest rates around the time Volcker became Fed Chairman in August 1979, and they rose steadily until they peaked in September 1981. We had a recession in 1980 (before Reagan was elected) and another one in 1982.

            No disrespect to Saint Ronald, but if you had asked him at the time what monetary policy should be in respect of the prevailing inflation, I suspect he would have looked at you like you were speaking some foreign language.

            For what it’s worth, Paul Volcker is today an adviser to the Obama campaign.

          • blackhedd

            As streewise says, it’s not material to the crude-oil markets in the near term because that market is in the process of adjusting downward anyway.

            The fact that the Russians explicitly targeted a supply line that connects the Caspian Basin with Turkey (and from there by sea routes to Western Europe) is exceptionally important. To my mind there’s no question what they’re trying to do.

            Additionally, there was another Caspian pipeline project in addition to the one in prroduction (which is one-third owned by British Petroleum). That second line was supposed to be for gas, and it mysteriously got cancelled a few months back, if memory serves. I remember pricking up my ears at that news but I don’t remember any more about it now.

          • streetwise

            were saying that the true economic value of oil was in the $80-$90 per bbl range.

            OPEC knows from past experience that extremely high prices suppress demand and spur production. They don’t want to kill the goose* that lays the golden eggs.

            *On the Obama team, this is known as what’s for dinner. *

  • FWGuy

    The $$ lost almost half its value in 7 years against the Euro.

    From its low of 84 cents in July 2001 to the amount $1.598 is terrible and any gain is needed.

    You can truely blame $4.50+ a gallon for gas on a weak dollar policy in the USA.

    Finally it is nice to see below $4 a gallon but it is still three times as high as we saw in 2001.

    • streetwise

      and had a rocky road after that.

      Markets go up, and they go down. Always have, always will.

      • Neil_Stevens

        See Econbrowser for one debunking. Oil prices are just up, inflation or no.

        • Wubbies_World

          I love reading your stuff Blackhedd. It helps me understand what is going on in the word. – Thank You.

          • aardpig

            …given that it transports only 1% of global oil supplies (can’t recall where I saw this, but I’m sure its not difficult to track down)? I’d imagine that Russian interference with the pipeline would have more of a psychological than physical effect — in that it would demonstrate their willingness to play hardball with energy supplies.

            However, the pipeline could just as easily be a red herring. Arguably, just having a presence in S. Ossetia — or more importantly, controlling the Roki (sp?) tunnel under the Caucasus Mts — has far greater geopolitical importance than messing around with the BTC pipeline.

          • JKH1232

            It’s not the Straits of Malacca or anything, but it’s still noticeable. But, the psychology is part of what matters. If people panic about these things, there’s a premium added to prices for panic.