Saturday, September 7, 2013

Is The U.S. Dollar Set To Spike?

by James Gruber

Does America’s energy boom change everything?
Possible impact on Asia & beyond
Potential problems with thesis

So markets wait with bated breath on the words of a bearded academic-turned-central-banker on September 18. Bond king, Bill Gross of Pimco, probably has it right suggesting Ben Bernanke and his Fed have already agreed on a small cut to QE even though economic data out of the U.S. has shown only marginal improvement. I’d add that that Bernanke and his minions would remain concerned with rising bond yields and interest rates and if both head higher in the months ahead, all bets on further QE tapering are likely to be off. Perhaps the word “re-tapering” may soon enter the financial lexicon?

Today I’d like to step back from the “will he or won’t he taper” debate and look at an interesting, and still minority, view developing that there are structural factors beyond QE tapering which may drive both the U.S. dollar and U.S. bond yields higher in coming years. The argument goes that an energy boom in America will result in a further decline in the U.S. trade deficit, reducing the number of U.S. dollars being supplied to the global economy and thereby creating a scarcity of U.S. dollars which will inevitably push the currency higher. A reduced U.S. trade deficit will also result in contracting foreign exchange reserves for overseas countries, reducing foreign demand for U.S. Treasuries and pushing up government bond prices which will help the dollar further.

Don’t worry if you didn’t get the full thread of the argument as I’ll lay it all out for you below. Suffice to say though that if the view is correct, it’ll have enormous ramifications, including for our neighbourhood of Asia. For instance, it may mean the recent currency turmoil in Asia is only a taste of things to come (higher U.S. yields leading to reduced flows into Asia ie. tighter liquidity).

I don’t happen to agree with much of the argument and will outline why. But it seems like a debate worth having as it goes to the heart of some of the key issues which will drive economies and markets going forward.

Does America’s energy boom change everything?
Here’s a theory: the majority who read my newsletter on a regular basis agree with most of what I have to say. Don’t worry, I’m not trying to be arrogant or belittle but just to point out that science suggests that people primarily read things which confirm their pre-existing biases and views. It’s called confirmation bias and everyone does it to an extent.

Today is my attempt to shake things up. To offer a well thought-out view which is contrary to my own and perhaps yours. This particular view has made me question and re-examine some of my beliefs and perhaps it can have the same effect on you.

The view is that there are structural trends which will lead to a higher U.S. dollar and higher U.S. interest rates. It’s a line that’s been pushed by some stock brokers over the past year. But financial blogger, Charles Hugh Smith is perhaps its most thoughtful proponent.

In his most recent article, “America’s Energy Boom and the Rising U.S. Dollar”, Smith puts forward a strong case. He argues that to understand the trends which will lead to a higher dollar, you need to appreciate why the U.S. currency is the world’s reserve currency. And he suggests that it’s because the U.S. is willing to provide the world with an extra supply of the dollar to fulfill global demand for the reserve currency and thereby cause a trade deficit (where imports exceed exports). Put another way, the U.S. must export U.S. dollars by running a trade deficit to supply the world with dollars to hold as reserves and to pay debt denominated in dollars.

Of late though, the U.S. trade deficit has been falling. In June, the deficit hit four-year lows, before increasing again in July. The fall is primarily attributed to America’s energy boom. The U.S. has been able to provide more of its own energy. That’s significant because oil imports account for 40% of America’s US$750 billion annual trade deficit. And the importing of oil has been the main reason why the U.S. has been running trade deficits for decades. Remember too, trade deficits negatively impact GDP.


Anyhow, Smith argues that the American energy boom will lead to further falls in the U.S. trade deficit. A lower deficit will mean fewer U.S. dollars being exported to the global economy. Basic supply and demand suggests fewer U.S. dollars in circulation will push the value of those dollars up.

Smith goes on to say that the uptrend in the U.S. dollar over the past 18 months has aligned with a rise in U.S. energy production. He suggests that’s not coincidence, but causation: the latter is causing the former.

Possible impact on Asia and beyond
If that’s right, it will turn the trend of recent decades, featuring growing U.S. trade deficits and a lower U.S. dollar, on its head. For America, it will be positive for the economy, as Smith explains:

“As the dollar strengthens, the U.S. will pay less for imported energy and earn more for exported energy. This decline in energy costs will ripple through the real economy, offsetting any decline in exports. A strengthening dollars lowers the cost basis for all goods and services originating in the U.S.”

Smith acknowledges though that a strong U.S. dollar won’t be good for listed U.S. companies. That’s because more than 50% of their earnings come from overseas. In other words, their profits will be negatively impacted with the higher dollar reducing earnings from overseas operations.

When it comes to the effect of a higher U.S. dollar on the rest of the world, Smith loses me. He argues other countries will also benefit from an increasing dollar as it will increase the value of their existing foreign exchange (forex) dollar reserves, enlarging the base for their own credit. But he acknowledges future forex reserves will start to contract with a higher dollar.

Won’t the latter more than offset the former? If so, as I suspect, it’d be negative for the likes of Asia. Contracting forex reserves mean Asian countries, particularly China, would start selling local currencies to maintain currency pegs against the U.S. dollar. Previously China has been printing yuan to maintain the peg which has created inflation at home and supported local asset prices (think real estate, for instance). Contracting forex reserves will result in the opposite occurring.

Declining forex reserves though mean there’ll be reduced demand for U.S. treasuries and potentially higher U.S. bond yields, which could well feed back into a higher U.S. dollar.

The other issue is the impact of a rising U.S. dollar on commodities. Traditionally, an increasing dollar has been seen as commodity-negative. But Smith thinks for gold least, there’s no evidence of a correlation between the dollar and gold prices. He seems to have a point here, but for other commodities, less so. Broadly falling commodity prices would be another deflationary force for the likes of Asia.

Potential problems with thesis
It seems to me that there are a couple of other, broader potential issues with the view, namely:

1) Whether the boom in unconventional oil and gas in the U.S. is overstated, particularly in terms of the probable economic gains in the short-term. It should be noted that a recent study by IHS Global Insight found that the increased energy production had lifted disposable income in the US by US$1,200 in 2012. IHS suggests that figure will rise to more than US$2,000 by 2015. Call me a sceptic, but any forecasts are likely highly dependent on oil prices. Lower oil prices would substantially lower the gains.

2) More importantly, the view largely discounts the role of QE in money creation and lowering the dollar as well as bond yields. Smith counters the influence of QE on the dollar by suggesting that base money isn’t rising in the U.S. because banks are holding onto the printed cash and not lending it out. But QE is playing a role in demand for bonds and keeping yields low. Any rise in yields would surely have a dampening effect on the U.S. economy (it’s already impacting the housing sector). And a further yield rise would therefore likely be met with more QE. Suppressed bond yields would cap the value of the dollar.

In sum, I remain unconvinced that an energy boom will drive a U.S. economic recovery. And though I see a case for a modestly higher dollar on slower global economic growth, it seems that lower rather than higher U.S. bond yields are likely, for the following reasons:

1) Reduced U.S. inflation expectations. Inflation plays a central role in long-term interest rates. All current signs point to low inflation (disinflation in economic parlance) given a higher dollar and lower commodity prices.

2) GDP in the U.S. has seen the slowest growth of any economic expansion since 1948. Post-war growth has averaged 3.5%, compared with current GDP growth of 2.5%. Nominal GDP growth (real GDP growth plus inflation) drives bond yields and therefore growth has to quicken from here to justify higher yields.

3) U.S. consumers are still paying down debt and will need to do so for many more years. As economist David Levy of the Jerome Levy Forecasting Center has demonstrated, private sector leverage in the U.S. remains very high, despite what the bull market propagandists tell you. Given consumption accounts for 70% of GDP, stronger economic growth from here seems a stretch. An oil boom won’t mitigate this headwind.

US household debt

4) The history of U.S. and Japanese balance sheet recessions suggests that bond yields bottom around 13 years following a crisis, meaning we should expect lower bond yields for several years to come.

US bonds vs previous panic yrs

And that’s a wrap for this week.

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