Dollar Dilemma       August  2001 - Issue 12

In an earlier newsletter issue entitled Don't Fight the Fed, we commented that whilst logic might suggest an aggressive easing of interest rates, as witnessed by the Federal Reserve, would lead to a stronger economy and rising asset prices, this is unlikely to be the case after the kind of debt induced asset bubble seen in the US and to a lesser extent in the other major global economies.

After this weeks quarter point cut we have had seven in number US interest rate cuts this year to date, yet the main equity indices of the United States, the Dow, S&P 500 and Nasdaq have returned -5.2%, -12% and -25.4% respectively, year to date as of business close last night.

Although the majority of investors have been 'surprised' by the magnitude of the equity market falls over the past year or so, foreign investors have taken heart from the currency gains seen by their US investments into both equity and treasuries which have at least offered some protection from the volatility witnessed. That may be about to change.

As can be seen from the chart, the US Dollar trade weighted index has started to correct of late. In fact over the past six weeks, it has lost 6.7% of its value or put another way, foreigners with an investment exposure to the United States have lost approximately 1% per week on currency grounds. This obviously compounds any losses incurred from the equity markets and even within the so called 'safe haven' status of 30 year Treasury Bonds, foreigners have seen the current annual yield of some 5½% wiped away by currency loss. Patently, should this recent correction be a trend reversal then foreigners will be reviewing their fairly large holdings of US assets estimated to be some 11% of the total US equity market and a frightening 25-30% of the total US treasury market.

Before outlining a couple of important impending events, perhaps we should look at the 'make up' of the $US trade weighted index. The major components of the index are as follows:-

As can be seen the fortunes, or otherwise, of the Euro and Yen in particular have a bearing on the $US 'value'. With a decade long economic stagnation in Japan and concerns over the politically inspired new Euro land currency, we should not be surprised to have seen the dollar strength of the past few years, particularly when it has been assisted by an unprecedented flood of investment money into equity and bonds during the latter 1990's. The so called new paradigm of ever increasing productivity and profits within an inflation free environment sucked in huge amounts of investment, all of which required the conversion of currency to dollar. Coincidentally one crisis after another, be it from Asia to Russia or Latin America, not to mention the LTCM debacle of course, ensured that 'safe haven' refuge was sought in Uncle Sam's sovereign bonds. Such has been the extent of faith given to the mighty dollar that central banks around the world, who's job it is to be prudent with their nations reserves currently hold in excess of 70% of their reserves in the US dollar!  Some prudence.

In summary, it could be contrived that the dollar is both overvalued and over owned.

In early September 2001, two events transpire in the all important Euro land and Japan, which will have a bearing on the dollar. The 12 member Euro land states start sending out even larger amounts of Euro coins and notes to banks and retailers ahead of the January 2002 launch date. On September 1st 2001, all Japanese banks and businesses will be forced by law to 'mark to market' their investments. This means that the book value of these investments must be shown, NOT the acquisition value currently used by the majority, at prices not seen for many years. This is likely to ensure a repatriation of trillions of Yen as banks and other corporates endeavour to shore up their balance sheets as the true losses are bared to all.

Both the Euro and the Yen are likely to gain in value by these events and which currency do you think is likely to be the casualty ...?

The dilemma for the US administration of course is that whilst they may actually prefer a weaker dollar to alleviate the howls of pain from their exporters, any weakness should be gradual and controlled as should the floodgates open, interest rates would have to rise, choking off any chance of recovery hoped for. The foreign money sunk into real, physical investment inside the US is stuck and therefore likely to remain long term. All or most of the paper investments made by foreigners into the US can make a dash for the exit at any time .... will they and when?