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  • The Rise of the Dollar

    Posted by Carl from Chicago on February 10th, 2015 (All posts by )

    When I was growing up as a kid I remember they had TV commercials against Jimmy Carter explaining how the dollar declined vs. other currencies over the decades. In the late 1980s the Japanese Yen soared in value until their market crashed in 1989. The Euro was originally near parity with the dollar, then fell to 70 cents on the dollar (I happened to be in Europe at the time, it was great), then rose to over $1.30 against the dollar.

    In general if you keep your portfolio all in US assets you are essentially “100% long” against the dollar. A few years ago the dollar effectively fell almost 40% vs. many of the world’s major currencies – this is the time when the Canadian and Australian dollar almost reached parity with the US dollar. For US citizens who traveled frequently across the border into Canada, it seemed strange to think of the Loonie as being just the same as a US dollar, since for years it was worth substantially less. Thus if your portfolio was all in US dollar denominated assets, your value fell 40% that year vs. the worlds’s currencies, even though you couldn’t “feel” it unless you traveled abroad or tried to buy imported goods.

    Recently, however, this has all turned around. The dollar is soaring vs. most of the world’s currencies, which is good news for travelers and makes imports cheaper. However, those who own foreign stocks are looking at losses regardless of how the underlying stock performs (often many of the underlying foreign businesses IMPROVE when the US dollar rises; for instance Indian outsourcing firms who are paid in US dollars find that this money stretches further when paying their Indian based staff in rupees), just because of the rising dollar.

    Rise_of_dollar

    It is controversial but many central banks are taking steps to effectively debase or reduce the value of their currency in order to keep their export economies competitive. This is essentially the strategy of Japan. On the other hand, some countries are faced with dire circumstances due to the fall in their currencies, which causes inflation locally and can crush banks and those who take out home loans and bank loans denominated in foreign currencies (a surprisingly common overseas practice, although the down side is clearly on display in countries like Russia where a 50% fall in the ruble means that your mortgage just doubled). Some countries like Venezuela and Argentina are in extreme shape and basic goods are not available on the shelves and local manufacturing has mostly seized up; this happens when you stop the flow of dollars outside the country and try to prop up your local currency regime (and lack credibility).

    Finally, while everyone thinks the Fed is going to raise interest rates at some point, now we need to think of the impact on the dollar. All else being equal, raising interest rates is going to make the dollar even stronger against its peers, especially as those countries remain in a zero interest rate environment (ZIRP). Given the huge rise that the dollar has already seen, further increases will make exporters even less competitive on the world stage.

    I am reading a few books on currency wars and I didn’t realize that the US and Saudi Arabia had an explicit deal where the US provided security as long as the Saudis invested their excess in US Treasury bonds and denominated the world price of oil in dollars and not any other currencies. This gave rise to the term “petro dollars”. While I had heard the term many times I did not realize that this was an explicit not implicit relationship. Even today oil is denominated in dollars, although Putin and the Chinese are working to change that over time with their own bi-lateral relationship (which is running into a rough patch with the fall in the ruble recently, but obviously has long term potential given Russia’s huge resource pool and China’s voracious demand for commodities).

    Cross posted at Trust Funds for Kids

     

    16 Responses to “The Rise of the Dollar”

    1. Grurray Says:

      “In the late 1980’s the Japanese Yen soared in value until their market crashed in 1989”

      The dollar has seen some big fluctuations over the years, but the 80s was big roller coaster. It lost half its value in four years, after doubling the previous five years when Volker wrestled inflation to the ground.
      The drop occurred after the 1985 Plaza Accords when everyone agreed to devalue the dollar. It probably caused the ’87 market crash because of the interest rate mismatch. Europe had agreed to increase the value of their currencies but forgot to raise their interest rates along with it. The damn broke when they couldn’t keep up the charade anymore.

      You know how everyone now likes to read and talk about the Black Swan. Back in 1987, they all thought Taleb was crazy for sitting around waiting for the (now recognized as inevitable) day of reckoning. When the market crashed, he turned a $15,000 position into $30 million in a few hours betting on interest rates rising. Of course, he was probably waiting at least a year for it to happen. The market stays irrational longer then you stay solvent, they say.

      Something similar just happened on a smaller scale in reverse in Switzerland last month, when the Swiss National Bank was keeping their rates too high. After telling everyone they were in complete control and would keep rates at their elevated levels no matter what, out of the blue they had to decrease them. They now amazingly have negative rates. People have to pay a premium to put their money in Swiss banks.

      After a long period of relative stability, we’re probably going back to roller coasters.
      To put it in perspective how much more sensitive things are now, back in the early 80s the dollar went up 50% in a couple years.
      Last month the Swiss Franc went up 50% in a few minutes.

    2. Trent Telenko Says:

      Carl, Grurray,

      The markets are betting energy prices.

      Historically the American economy rises on lower energy prices.

      The Saudi’s said we are looking at two year of low energy prices and that fracking has put a defacto cap of $50 a barrel on oil.

      There are a lot of other negative factors at work out there in the American economy — primarily Government regulatory uncertainty — that may derail that.

      But since the election of a Republican Senate to match the House, the Dollar traders are betting on American economic energy history.

    3. TMLutas Says:

      Every dollar deposited as reserves at the Fed creates 9 dollars out in the economy. When banks deposit at the fed but do not loan those 9 dollars out for every dollar, the reserves are called “excess reserves”. We have over $2.5T in excess reserves at present which means if we normalize our economy that money is going to get lent. In essence we have $22.5T in baked in monetary growth that has not hit the economy. Excess reserves dwarf required reserves.

      This is not safe and the roller coaster could start up at any time.

    4. Robert Schwartz Says:

      “raising interest rates is going to make the dollar even stronger against its peers”

      Actually. Dollar denominated debt is already paying high returns. Here are the rates for government issued 10 year bonds in various countries, taken from Bloomberg.com a few minutes ago:

      United States 2.00%
      Canada 1.42%
      Germany 0.37%
      Britain 1.66%
      Greece 9.91%
      Switzerland -0.04%
      Japan 0.38%

      If you are an international investor, 2% looks pretty good. Greece is included for humorous effect. The minus sign on Swiss Francs is not a typo. You have to pay them to hold on to your money. You really have to give up credit quality to get high returns. Further, carry trades almost jump at you. I am not a currency trader, but I do listen to Rick Santelli every day.

    5. Carl from Chicago Says:

      Yes the dollar is the “least dirty shirt”

      Agreed that 2% might be the best rates out there among major countries. This is apparently the “new normal”

    6. Robert Schwartz Says:

      TMLutas. The Fed has alternative strategies. They could sell their securities portfolio, which is mostly short Treasuries to the banks and extinguish the reserves. Of course that could go wrong. The sale of the securities might crash the bond market.

      However, I think your basic point — the current Fed balance sheet is not stable and unwinding it without causing massive damage to the real economy will be very tricky — is bang on. As I never tire of pointing out, when considered as a bank, the Fed is severely undercapitalized. The Fed would put a bank they regulate, that had that kind of leverage, into receivership.

    7. Mike K Says:

      ” They now amazingly have negative rates. People have to pay a premium to put their money in Swiss banks.

      They did so in the late 1970s. I don’t consider that bullish. I am a poor businessman (as Rick told Captain Reynaud in Casablanca) but I have a long memory. I remember buying a new 1968 Mustang for $3050. And a Ford Country Squire wagon for $4800 in 1969. And a nice house in South Pasadena for $35,000 in 1969. I wish I had them all now.

    8. TMLutas Says:

      Robert Schwartz – That would be an uncomfortable week for anyone else to look to sell treasuries. Given the bond market average volume, How much of a bath would the FED likely take on the face value of the securities? Wouldn’t they have to sell virtually their entire portfolio in order to extinguish the excess reserves and make that sale without taking a loss on the securities. Is that even realistic?

    9. Robert Schwartz Says:

      TMLutas. It would depend on the maturity structure.

    10. Robert Schwartz Says:

      Mike K: Those Fords would be rust by now. The cars I owned back then were not well built. 100,000 mi. was more than you could hope for.

    11. Grurray Says:

      “And a nice house in South Pasadena for $35,000 in 1969.
      I wish I had them all now.”

      That house is probably, worth, what 20 times that now? A nice investment. Although there were fluctuations there too. Wasn’t it about when the Japan bubble burst in ’89-’90 that S. California real estate tanked?

      Robert’s comment about the carry trade is interesting. A lot of people like John Mauldin think the carry trade won’t return because of the combination of deflation in the US and Japanese quantitative easing. Ever since their tsunami a few years back, the Bank of Japan has been going hog wild devaluing and pumping up the economy. They even admitted that they’re buying ETFs to keep their stock market elevated. However, even though the currency has dropped, rates are still low. One wonders if they may be the next central bank to capitulate.

    12. Grurray Says:

      ” The Fed has alternative strategies. ”

      Jim Grant had some thoughts on whether their limited options would be effective

      Once upon a time, the funds rate alone did the policymaking trick. Now the Fed fixes, or administers, three money-market policy rates. Interest paid on excess reserves (IOER) is the first. The reverse repo rate (RRP) is the second. The good, old-fashioned funds rate, or interest on borrowings in the federal funds market, is the third.

      Readers who have been away for a while will hardly believe how much things have changed. To tighten monetary policy was once a snap. In receipt of the appropriate instructions, the Federal Reserve Bank of New York sold Treasury bills to its chosen network of primary dealers. The sales drained cash from the banking system, thereby reducing the volume of excess reserves. By reducing the marginal supply of liquidity, the Fed increased the marginal cost of liquidity. Up went the funds rate.

      QE has steamrolled the funds rate and marginalized the funds market. Excess reserves stood at $1.8 billion when the Fed started to crank up its emergency purchases of Treasuries, mortgages, and kitchen sinks in the waning days of 2007; now such balances weigh in at $2.7 trillion. Not only is the federal funds rate low, but it also is increasingly irrelevant.

      “Bills only” was the name of the doctrine by which the Fed operated exclusively at the short end of the yield curve — the idea was to minimize disruption in the pricing of longer-term securities. “Bonds only” is virtually the Fed’s modus operandi today. Out of a $4.2 trillion securities portfolio, the Fed owns just $9.8 billion of T-bills; 56% of its holdings are locked up in issues maturing in 10 years or more. The very purpose of the Fed’s immense post-crisis intervention has been to disrupt the normal pricing of longer dated securities — to promote higher house prices through lower interest rates.

      Question: Without T-bills to sell, how could the Fed lift the funds rate, assuming it ever wanted to? The techniques under consideration are still in beta testing. The Fed might raise the IOER, now fixed at 25 bps. But the IOER does not by itself set the floor in rates. We know that for a fact because the funds rate is quoted at just 9 bps. Federal funds are trading at a discount to the IOER for reasons that you certainly would not care to explore in detail. The short of it is that Fannie Mae and Freddie Mac are heavy lenders of federal funds. Foreign-chartered banks (regulatory advantaged in ways that you may also not care to explore in full) are heavy borrowers. The foreign banks deposit these balances at the Fed to earn the 25 bp IOER. The risk-free arbitrage gift comes courtesy of the taxpayers; of the $2.6 trillion in total reserves in existence on 30 June, $1.1 trillion, or 40% of the total, was credited to the US branches of foreign banks. Wait till the Tea Party finds out.

      The aforementioned RRP pays 5 bps, but neither does it constitute a dependable lever for rate-raising. Where the RRP came from, what it does, what it means, and what risks it poses are subjects covered in the 2 May issue of Grant’s. Suffice it to say that QE has brought about a redistribution of cash and securities. The Fed, buying everything in sight, has accumulated securities. The banks and the money funds, selling to the Fed, have reciprocally accumulated cash. From time to time, the money funds especially seek to borrow securities; accommodating them, the Fed lends collateral for cash. In this exchange of paper, the funds earn their 5 bps, lest they actually starve to death.

      A friend of mine reads Jim Grant’s Interest Rate Observer and is always trying to get me to read it. While recognizing the immense insight and uselessness of his observations, I can’t get myself to get jazzed enough about rates to pay the steep price of his letter. Apparently, he predicted the Swiss National Bank debacle last fall, so maybe I’ll have to rethink it.

      I know his new book, The Forgotten Depression: 1921: The Crash That Cured Itself, is definitely in the on deck circle.

    13. TMLutas Says:

      Grurray – Is it right that we’re giving US subsidiaries of foreign banks $7.5M taxpayer money every day and $10.2M to domestic banks so that they deposit excess reserves at the Fed instead of loaning 22.5 trillions of dollars out into the real economy?

    14. Grurray Says:

      TMLutas,

      Maybe the capital markets are telling us something here, and it’s that they control the Fed not the other way around.
      My friend the interest rate observer who knows much more about the subject than I do explained it to me this way – capital is like water, always trying to find the way of least resistance, and it always finds a way.

      Back in the old days of the Gold Standard, there was a problem you probably heard of called the Triffin dilemmae.

      In order to maintain the Bretton Woods system, the U.S. had to run a balance of payments current account deficit to provide liquidity for the conversion of gold into U.S. dollars. With more U.S. dollars in the system the citizens began to speculate, thinking that the U.S. dollar was overvalued. This meant that the U.S. had less gold as people started converting U.S. dollars to gold and taking it offshore. With less gold in the country there was even more speculation that the U.S. dollar was overvalued. Furthermore, the US had to run a balance of payments current account surplus to maintain confidence in the U.S. dollar.

      As a result, the U.S. was faced with a dilemma because it is not possible to run a balance of payments current account deficit and surplus at the same time.

      It’s the reserve currency problem, but it was really a problem of imbalances caused by mistaken belief that a committee of official elites can control the markets. In that case they were trying to force gold too low.
      The markets knew that the dollar was overvalued. Everybody likes to put the blame on Nixon, but he didn’t have much of a choice. Deficits were the long lasting result.

      It seems we never learn because now there’s another dilemma this time with trying to force interest rates too low.
      The opposite result may be the case because the markets think that the dollar is undervalued. Another arbitrage is arising that’s forcing us to act, this time to surpluses.

    15. TMLutas Says:

      Robert Schwartz – These days the maturity structure of Fed held Treasuries is unusually long though they seem to be trying to slightly shorten them, specifics here:
      http://www.federalreserve.gov/releases/h41/current/

      Grurray – Thanks for the primer. It was useful.

    16. Gringo Says:

      Grurray Says:

      “And a nice house in South Pasadena for $35,000 in 1969.
      I wish I had them all now.”

      That house is probably, worth, what 20 times that now?

      My aunt and uncle bought an ordinary 3 bedroom tract house in LA in the Mar Vista neighborhood in the early 1950s for $8,000. My aunt sold it in 1975 for $45,000. A year or so ago I looked it up in the LA Appraisal website. It is now appraised at just short a million dollars. A little ticky tacky 3 bedroom for a million.