Why Dollar Collapse may not be coming

A lot of nonsense is written about many financial markets. It is difficult to think of any area in finance where more nonsense is written about than that of the US dollar. On April 2, 1792, the United States Congress created the United States dollar as the country's standard unit of money. At the time of creation the dollar was equivalent to about 5 pounds British sterling.

Dollar Collapse ‘1’
The sterling dollar rate is the oldest trading pair as we discussed before and is affectionately called ‘cable’. During the civil war the dollar ‘collapsed’ to 16 to the pound. Perhaps we should call this ‘dollar collapse 1’. If arbitrage opportunities had been available at the time this would have been a good time to buy gold cheaply for dollars as it was fixed and sell it in sterling. The dollar recovered to the 4-5 area and stayed there until WW2. At this point the pound began to slide as it lost its reserve currency status to the dollar.

At the time of creation of the dollar the cost to buy an ounce of gold was $19.39. It stayed at this level until 1833, was revalued at $35 in 1934 and moved slowly to $35.50 in 1967. The gold price began to go up dramatically after August, 15 1971 when the US came off of the gold standard and gold no longer had a fixed monetary value and began to trade as a commodity, with the concurrent volatility.

This was end of the 1944 Bretton-Woods agreement where the US, Western Europe and Japan and Australia agreed to adopt a monetary policy that maintained each country’s external exchange rates within 1 percent by tying its currency to gold and the ability of the International Monetary Fund (IMF) to bridge temporary imbalances of payments.

Dollar Collapse ‘2’
From 1972 the US became a net importer, rather than exporter of goods and services, a situation which remains in effect today. The US dollar was by now the de facto world’s reserve currency and dollars (more correctly dollar credits) began to accumulate outside the US, mainly in Europe. These were known as ‘Eurodollars’.

One of the favorite tricks of European bankers back then was to ask a novice who joined the bank to go and get them a ‘Eurodollar’. They would return empty handed and confused until the joke was explained.

These dollars when earned by oil exporting countries were called ‘petrodollars’. They were deposited with European (mainly in Switzerland and Luxembourg) banks as the oil country banks were not that sophisticated at the time.

Always ready to make a profit, these dollars were used by the banks to lure investors to buy “Eurodollar” bonds, usually in bearer form, which was of great assistance to tax evaders and money launderers. This was the forerunner of the now “Global” bond market to which US persons still do not have access because US citizens and residents were forbidden to buy these bonds.

It is important to remember that foreign banks do not hold dollars. They hold them in their own treasury account with a US bank. The only dollars not in the US system are physical currency dollars again largely in the possession of those engaged in criminal activity.

This excess of dollars looking for a home found their way into commodities and helped cause the inflation of the seventies. Excess dollars and low global debt and the expenses of the Vietnam war lead to inflation and stagflation. The dollar fell from nearly 4 to around 2 to the Swiss Franc and similarly the German mark and German mark linked currencies (Dutch Guilder, Belgian Franc, Luxembourg Franc and the Scandinavian Kronors) and even weakened against some of the weaker Southern European currencies(Italian lire and Greek Drachma), but not sterling. The dollar went from around 400 Japanese Yen to 250.

All this took place over about 7-8 years until 1980. Gold went from $63 in 1972 to $800 by 1980. We shall call this ‘dollar collapse 2’.

For some reason this situation has become the mantra of ‘normality’ perhaps because it was a time to make money with little effort and no risk as stocks were not performing like they are now and bonds were collapsing because of inflation and higher interest rates. It is not really possible to compare interest and bond rates in different countries because of widely differing standards that were used. In 1980 the late Paul Volker was chairman of the Federal Reserve and he raised interest rates to 20% which sent the dollar soaring against all the major currencies and gold. This was not a situation which all those who had borrowed in dollars and were struggling to get enough of them could tolerate. The financial world was truly shocked. I was long the dollar at the time and enjoyed it immensely.

Major central bankers met at the Plaza Hotel in New York in 1985 and agreed on the ‘Plaza Accord” to devalue the dollar. Lower interest rates and lower lending standards did the trick. The dollar came down and exchange rates have fluctuated in a much narrower range than before. The US trade deficit has steadily increased leaving an excess of dollars which is getting readily mopped up by developing countries and Chinese domestic companies at a very rapid rate.

Erroneous call for Dollar Collapse ‘3’
The dollar is going to remain the world’s reserve currency for the foreseeable future. Gary Shilling gives the following reasons:

1) The US is a relatively rapid growth economy in usual times

2) The US has a large economy

3) The US has deep and broad financial markets, especially the global bond market

4) The US has free and open financial markets

5) Credibility in the value of the currency-don’t believe me, then why is it the currency of choice for international drug dealers, they know a thing or two

6) no real substitute at present.

China only satisfies criteria 1 and 2. The Euro region satisfies only 4 and 5. From the foregoing you will see that both dollar collapse 1 and dollar collapse 2 were partial collapses. Let’s examine the prospects for ‘dollar collapse 3’ that Peter Schiff and Stephen Roach, formerlly of Morgan Stanley, go on about.

We will also come to a conclusion as to what are the primary determinants of a currency’s value remembering that in the short term sentiment always plays a role and that this is difficult to measure.

Currently we also have an excess of dollars in world due to the continuing and increasing US trade deficit and the Federal Reserve QE efforts. So why are we so confident that this will not be inflationary, and will not lead to ‘dollar collapse 3’?

The reason is the global market for US dollar denominated debt. We never tire about talking about it since it is so key to understanding all financial markets. That Eurodollar bond market which issued bearer bonds which could be clipped and paid at major banks has died a long time ago. In its place there is a behemoth, a multi-trillion global market for US dollar debt. In fact China herself and Chinese domestic companies are busy issuing trillions of dollar bonds in addition to their Renminbi bonds. Focusing on China’s holding of 1 trillion or so of US Treasuries alone shows that you have not really examined the complete picture.

Middle eastern and developing countries do the same. Everyone in the world wants to live the ‘American dream’ even if they are not in America thanks to the internet and their governments ‘ borrowing to give it to them if the can'.

This is the biggest vacuum-cleaner for excess dollars ever created and they are ready and willing to vacuum up anything falling from the Fed dinner table. In fact if like sparrows under the table they cannot get enough crumbs the dollar will soar (which is why we saw Fed currency swaps with other central banks).

Let’s examine the currencies against which the dollar could collapse. Is the dollar going to collapse against the Argentine and Mexican pesos, the Botswana Pula, the Egyptian pound or many other ne’er do wells? of course not. What about the Hong Kong dollar, the Jordanian and Kuwati Dinars? These are normally strong currencies but guess what, they are pegged to the dollar so they are also going to collapse in tandem and unless they break the peg. You can see where I am going with this. I am analyzing the nonsense utterings these commentators have made whose words are totally un-deflected by thought. Let’s look at the major currencies. The British pound has been in a long term downtrend against the dollar since 1861. ‘Cable’ is unlikely to strengthen against the US dollar especially given the state of the British economy. What about the Eurozone? We now have the Euro in place of about 20 European currencies which has made analysis a lot easier. Their economies are still moribund and interest rates are lower than those in the US and even negative. So we need another candidate for the dollar to collapse against. The Japanese Yen is around 105. They panic when the yen strengthens above 95. That leaves the Swiss Franc which has come from about 4 to the dollar to now just 92cents. The Swiss economy is tiny, 30 year bonds are negative and a dollar collapse against the Swiss Franc is unlikely.

With the exception of gold and silver (which are highly speculative) the dollar is not collapsing against commodities either.

Perhaps a dollar collapse is not coming but in fact a soaring dollar as the recession re-intensifies and the scramble for offshore dollars intensifies. ‘Plaza Accord 2’ anyone?

The main determinants of a currency are real interest rates. If they are negative in the US, then they are even more negative elsewhere. The second determinant is true Purchasing Power Parity over the longer term and properly measured. We discount the ‘Big Mac Index’ as amusing but not really useful. If you want to trade the dollar the best read on the subject is “The Way of the Dollar” by John Percival.