The mainstream media is full of stories about the Federal Reserve cutting rates, but the bigger story is the fall of the dollar below the accepted index standard of 80 , which was barely mentioned!
It’s critical to understand the ramifications of the U.S. Dollar value in our global economy, since it affects your ability to carry on business transactions; much of the problem is tied to the credit crisis and trade crisis I discussed in a previous blog.
The dollar has taken a pounding since the Fed slashed its benchmark rates on Tuesday by half a percentage point to 4.75 percent.
The deep US rate cut has raised concerns about whether it can ease the credit squeeze.
According to one analyst at Sumitomo Mitsui Bank: “Appetite for the dollar is weakening due to receding hopes that rate cuts can resolve the credit crunch”.
I watched the Fed chairman Ben Bernanke makes his testimony at a Congressional hearing on the Fed decision. I noticed a distinct sense of fear and anxiety while he was discussing the Economy. He said that the US economy and markets had reacted to a wave of foreclosures in the US sub prime, or high-risk, mortgage sector in a manner that has “far exceeded even the most pessimistic estimates.”
As I pointed out last week, more homeowners face difficulties making payments on adjustable rate mortgages that are being reset with higher interest rates.
The expectation of bigger interest rates cuts in the US is now having a huge affect on
global currencies.
The US Dollar is weakening relative to other currencies in the world.
Why is this important?
Because there is a delicate balance of currency values which determines the global trade in the world. To illustrate, China’s booming economy is based on its export of manufactured goods - mainly to the U.S. So, U.S. dollars are spent on Chinese goods in places like Wal-Mart. The Chinese are paid in U.S. Dollars. Because so much money changes hands internationally, the U.S. and Chinese agreed to set (’peg’) their currency, the YUAN, to the U.S. dollar’s value. Without this, their exports would become more expensive to buy! In addition, they have to invest in our currency to keep the machine going.
The Chinese have bought $800 billion of our treasuries!
The Japanese have bought over $3 Trillion!!!
Why would a foreign government buy so much of our currency?
TO KEEP THE VALUE OF OUR DOLLAR HIGH SO WE CAN CONTINUE TO BUY THEIR EXPORTS!!
This setup can only work if the dollar stays high relative to the economy. What we see now is a credit crisis (also trade deficits) that is touching the ability of the dollar to stay above an established index (over 80, relative to other currencies).This has been a sort of benchmark for the economic order of things since 2002, a low. With the current credit crisis, China has an ongoing conflict with the US regarding the Yuan, which is now trading higher relative to the dollar. The Chinese have threatened to dump USD reserves if the US pressures China further on trade issues. If that were to happen, we would be obligated to repay this debt, our dollar value would fall perhaps 40%!
What does it matter if the index stays below 80. If you were the Chinese, Japanese, Korean or other central banks, would you buy an asset in dollars if you fear the dollar will lose 40% of its value in a few months? In reality, there is nothing “safe” about a Treasury in which you can lose that much of your principal - it’s a lousy investment!
We are increasingly seeing the weakness of the dollar now relative to other currencies.
Yesterday, for the first time in many years, the Canadian Dollar is on a par with the U.S. Dollar.
Russia is in the process of building the strength of the Ruble into a super resource currency, and is getting rich selling resources and oil with record prices in these.
And take a look at this comment on the strengthening Euro:
“It is all about dollar weakness and Euro strength this morning again, with Euro/dollar touching a new record high of 1.4120,” said Audrey Childe-Freeman, economist with the Canadian Imperial Bank of Commerce in London.
The Euro is gaining status as an “alternative Reserve Currency” for the world banks - as there is concern the USD is losing its advantages. The OPEC oil exporters threaten to use Euro as a standard, sidestepping the U.S. Dollar. Again, as I spoke about, this is due to the weakening US economy and huge trade and fiscal deficits and record debt. Also included is declining US interest rates which will reduce the interest rate premium US bonds have enjoyed, and supported the USD.
And probably the most impact on global trade is now the increasing strength of the YEN, Japan’s currency. Most of us have never heard of the “Yen Carry Trade”. Why should we be concerned? The yen carry trade has supported U.S. equity and lending markets for over 15 years on a large scale. The interest rates in Japan have been about 1% forever; investors and the like borrow money in Yen to finance purchases of bonds, treasuries, and derivatives in other currencies. For instance, borrow large amounts of cash in Japan at 1% interest rates; then invest the borrowed funds in U.S. Treasuries paying 4.5%, or leverage the money into derivatives or equities purchased on margin. This only works if the index ratio to the dollar stays at about 115. When the interest rates and value of the Yen go up (and dollar is going down such as now), this affects the ability for all those debts to be repaid. The index ration is heading south of 113. This requires selling of equities, derivatives and bonds from what was originally borrowed in yen. So the Japanese bank is intervening to keep the ratio of the U.S. Dollar to the Yen steady, no small feat.
WHAT DOES ALL THIS MEAN TO US?
A major change may for the world economy, trade balances, and just about everything economic. The whole system has been based on a relatively strong USD. If this were a human body in critical care, I would liken these events to taking off the life supports. The Fed cut was nothing more than a pain killer to delaying the inevitable.
I will discuss proactive strategies to investing in GOLD and alternative currencies (i.e., Euro) to protect your portfolio, which we will investigate in future posts…
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on Saturday, September 22nd, 2007 at 4:14 pm and is filed under Economy.
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