While the Federal Reserve left US interest rates unchanged last night, the market has recently started to expect that a rate hike will come sooner than initially anticipated, leading to expectations of a near-term rebound in the US dollar exchange rate. If memory serves me correctly, a similar shift in interest rate expectations in 2004 heralded the dollar rally in 2005. However, we are facing a totally different situation today than in 2004/05. In my view, the dollar may have entered a cyclical downtrend from a medium-term perspective and its weakness may last through 2010, if not longer.
Crucially, the dollar's expected depreciation may follow a rotational pattern instead of a simple straight line depreciation against the major currencies. Such an alternating depreciation process is a key way for the developed world to expand their monetary base to fight deflation. However, even though a dollar crisis will not materialise, the expectation of such an outcome will present profitable opportunities for currency trading and the Greater China stock markets.
A different world today
The dollar appreciation in 2005 took place in the fourth year of the US economic recovery after the 2001 recession. Today, the US economy may be bottoming out, but it is still mired in a deep recession, with post-bubble deflationary forces not completely spent yet. In the past, the Fed has not tightened policy before a sustained decline in the jobless rate. At this point, the US jobless rate is still projected to rise until late this year, if not longer.
Depending on the severity of the post-bubble deflationary forces, the Fed has also pledged to expand its quantitative easing effort, if needed. Currently, the US money multiplier (the ratio of M2 to base money) still has not shown any signs of recovery after falling off a cliff since the collapse of Lehman Brothers last September. This suggests that the monetary transmission mechanism is still broken and as a result, the odds are high that the Fed may even expand its asset purchase programme and keep its key interest rate at zero for a while longer. With the US economy only showing tentative signs of stabilisation, Fed rate hikes (a boosting factor for the dollar) are unlikely in the coming year, in my view.
Shifting out of the dollar
The leaders of Brazil, Russia, India and China, or the so-called Bric economies, are sending out signals about shifting away from dollar assets. If they decide to "work together" to diversify their foreign reserves out of the dollar, it could spell disaster for the US currency, with the potential of unsettling the global system. The Bric countries together hold 42% of the world's currency reserves and 33% of US Treasury debt. The US debt value in their foreign reserves has fallen sharply so far this year as bond yields have risen and the dollar has fallen and China has complained about the US monetising part of its debt. Together with Russia and Brazil, Chinese officials have been vocal about diversifying out of the dollar into SDR-denominated bonds issued by the International Monetary Fund and other assets.
A shift away from the dollar would also have huge implications for the global financial markets. Foreign investors (including the Brics) are estimated to hold 50% (or $3.2 trillion) of the US Treasury bond market, suggesting this market could crash if sovereign holders started to desert it. That would force a sharp rise in US interest rates, strangling America's corporate bond and mortgage markets. All this would crush the US economy and asset markets, sending negative shock waves around the world.
Fortunately, such a disastrous outcome is unlikely because the world is still a very long way from finding a credible replacement for the dollar's global reserve currency status. No other debt market has the size or liquidity to accommodate the reserve needs of the surplus countries of the Brics, Japan, Korea, and the oil exporters. In a sense, global investors are being forced to stick with dollar assets because they do not have a choice. Despite the recent noise about diversifying out of the dollar, the latest data from the Fed show that its custody holdings of Treasuries and agency debt on behalf of foreign official and international accounts hit new record highs in early June, rising $10.5 billion to $2.75 trillion.
Dollar on cyclical downtrend, but no crash
But while the dollar's reserve currency status may not be challenged seriously, the direction of the dollar exchange rate is a different matter. From a cyclical perspective, the dollar may have entered a downtrend which could last beyond 2010. In the coming year, the dollar may be used as a carry trade currency. There is also a risk that the US's AAA credit rating may be cut. All this will add downward pressure to the dollar.
Several key fundamental factors are also turning increasingly negative against the dollar. They include a soaring US fiscal deficit (which leads to a rising public debt-to-GDP ratio), uncertainty about the Fed's exit strategy from quantitative easing (which leads to concern about future inflation), and rising unemployment. While the vulnerability caused by a current account deficit is falling, thanks to a rise in household savings, this improvement is swamped by the above factors. This is also why there is a concern about a potential lowering of the US sovereign credit rating.
But the dollar depreciation may not necessarily happen in a straight line. It is likely that the major currencies, especially the euro and the dollar, may go into rotational depreciation in the coming months. The Fed's aggressive quantitative easing policy will weaken the dollar momentarily, while the European Central Bank's less aggressive policy will keep the euro strong at times. But a worse European growth outlook relative to the US will weaken the euro periodically when market sentiment changes.
The expected strength of the euro against the dollar is more a result of dollar weakness than a fundamental improvement of the euro. The Euro zone recession is severe. While there have been some tentative signs of stabilisation in the Euro zone recently, they are coming from a very low base and are mainly due to re-stocking. The demand side is still contracting. Even the ECB is not projecting an economic recovery until mid-2010.
The same goes for the Japanese yen, whose expected strength against the dollar is more a reflection of weakening dollar fundamentals than of strengthening yen fundamentals. In fact, the Japanese economy remains stagnant. Moody's Investor Services downgraded Japan's foreign currency debt rating in mid May. Meanwhile, the Japanese government has announced additional fiscal stimulus, which will bring the public debt- to-GDP ratio close to 200% next year. This is much higher than the US's estimated ratio of 70%. However, Japan is a net creditor nation so investors have confidence in its ability to absorb the debt domestically and service it.
Without alternatives to the dollar's global reserve currency status, a dollar crash is not likely. Asset managers may hold less dollar assets, but the bulk of their portfolios will remain in dollars. From an economic angle, most other countries face the same headwinds as the US. Thus, other currencies may not look much more attractive than the dollar. This should limit expectations of a dollar crash. Finally, no one will want to see a crash of the US currency as it would create more financial stress in the global system. Other governments will act to limit their currencies' appreciation against the dollar on the back of a feeble global economic environment.
A weak dollar is good for Greater China
Back in Asia, expectations of a sharp and/or sustained dollar depreciation will lead investors to question the sustainability of dollar pegs, including the Chinese renminbi and the Hong Kong dollar (HKD). The forward markets will probably start pricing in a large renminbi and HKD appreciation again in the coming months. These currency pegs do not have to break for market players to profit from trading. The markets only need to price in the risk of a dollar crisis and, hence, a potential breakdown of the currency pegs to create profit opportunities for currency trading.
Beijing will unlikely let the renminbi rise more than 3% against the dollar this year under a negative external economic environment. The HKD/USD peg is also unlikely to go in the medium-term. Thus, the spill-over effect of the renminbi's and HKD's appreciation pressure on domestic liquidity will be positive for Chinese and Hong Kong stocks.
Last but not least, a weaker US currency is bullish for gold. This is not only because of the potential inflationary implications stemming from a weak dollar, but also because gold is a quasi monetary standard. Hence, even under a post-bubble disinflationary/deflationary environment, the gold price will still rise (just like in the post Great Depression years of 1931-1934 and more recently in the years since 2000) as every country is trying to reflate its economy by devaluing its currency.
Chi Lo is a research director at Ping An of China Asset Management (HK).