Many factors that contributed to the falling dollar over the past still exist, like excessive public debt, trade imbalances, and easy liquidity from the Fed. Even after the recent budget debate and the Fed’s first taper announced last week, we still have a lot of debt and a lot of dependency on the Fed to keep short and long-term rates low. Despite some of the fundamental reasons that still remain why the U.S. dollar should stay weak, perceptions and expectations are beginning to change. It may be time to patch up investor relations with the forsaken U.S. dollar.
The Balance Is Shifting
One of the changes you may notice on the chart below is that the U.S. trade imbalance is narrowing. The trend has changed from a persistent 10-year negative trend to a rising one since our dependency on foreign oil has dropped significantly.
The energy renaissance is not just a short-term seasonal fluke; it’s a real and tangible theme that has far-reaching implications. It has not only helped with the trade imbalance (imports of oil have dropped), but has encouraged companies to increase production or even relocate here in the U.S., close to consumers and close to cheap energy. Yet another case of companies shifting production to the U.S. is with the German chemical company, BASF, who is building plants along the U.S. Gulf Coast and may do more in the coming years, with billion expected through 2017 according to a WSJ article last week:
“At this point in time, the overall framework—if you consider all the factors including economic growth, the cost of raw materials and the cost of energy—is more favorable in the U.S. than in some European countries," said Hans-Ulrich Engel, BASF's group finance officer and chief executive of its North American division.
Cheaper gas is not only encouraging companies to open factories here in the U.S., it’s also increasing consumer discretionary spending by taking less from the consumer’s pocket. As Francois Trahan of Cornerstone Macro Research put it in his 5-minute Portfolio Strategy update Nov 13, 2013, “U.S. consumers get a tax cut when the USD appreciates, leaving more money to spend.” That’s because commodities priced in U.S. dollars fall when the dollar rises.
So we’ve established that for the most part, a smaller dependency on foreign oil has narrowed the trade imbalance and therefore, strengthened the U.S. dollar. In 1973, President Nixon said it would take 10 years to reach U.S. energy independence. While it might have taken 40+ years, it really appears that we are on the right track according to the World Energy Outlook Report from the International Energy Agency (IEA). With production increasing in 2013 based on denser fracturing methods closer to the wellbore, the idea of energy independence by 2035 doesn’t sound as farfetched as it did in 2012. Whether or not we reach that point, any increases in domestic production do help strengthen the U.S. dollar.
Safe Haven vs. Reflation: A Historical Look
Taking a look at how the U.S. dollar has traded over the last several years, there is a pattern of strength found when the dollar was needed as a safe haven; while it weakened near periods the Federal Reserve announced asset purchase plans or when risk appetites returned. Let’s review those periods to anticipate what might happen in the current environment.
When the credit bubble burst in 2008, it was a major financial crisis that not only affected the U.S. but also the global financial markets. Bank lending dried up, commodity prices crashed, and global equities tanked. Paradoxically, investors stopped chasing returns in non-U.S. markets and sought protection from the crisis in none other than U.S. dollars—which rose nearly 17% from August to November 2008 against a basket of currencies. One of the explanations was the unwinding of the carry trade. The carry trade was the borrowing of funds in a low interest rate environment to leverage up and buy assets in another financial market with better expected returns. At that time, the trade was to borrow from the U.S. and Japan, sell those currencies in exchange for currencies in China, Europe, Brazil, Canada, and other commodity-driven economies to buy assets there. The carry trade unwound, and investments flowed back into U.S. dollars and U.S. Treasuries as investors sought a safe haven.
The safe haven trade in the dollar began to unwind again when risk appetites returned, March of 2009. Positioning shifted and investors began to re-enter equities, commodities, and what came to be known as the “risk on” trade. However, later that year in December of 2009, Greece’s credit rating was downgraded from A- to BBB+ by Fitch after another credit rating agency, Standard & Poor’s, placed Greece under negative watch. The euro weakened sharply and we went through another safe haven play in the dollar as concerns grew over Eurozone sovereign debt through the summer of 2010.
Right as worries began to ease on sovereign debt, the euro began to rally that summer (2010), just before the U.S. began debating quantitative easing with the purchase of U.S. Treasuries. Gold and the euro rallied strongly versus the U.S. dollar when we began our second bout with reflation, this time 0 billion of Treasury securities by the end of June 2011 – where the dollar found a new floor. Commodity prices peaked along with the Chinese stock market and the dollar had a nice one-year rally. Then, once again, concerns shifted to the spreading contagion of the Sovereign debt crisis – now to Spain and Italy.
Moving forward to 2012, the dollar began to weaken that summer as it was again debated whether the U.S. would begin another wave of quantitative easing. In the August fed minutes, it was discussed that “additional monetary accommodation would likely be warranted fairly soon” as well as that members looked at lowering the rate on excess reserves and funding for lending. It was clear the Fed was looking to reflate again and the dollar sold off in anticipation.
Since QE 3 was announced in September of 2012 as well as the removal of short-term sales to the Fed’s “twist” program (buying long-term and selling short-term Treasuries), much of 2013 has been a positioning game between dollar bears and dollar bulls as the full year was spent debating the removal of the open-ended quantitative easing program. As such, the dollar has gone nowhere but sideways. Now that a taper has officially been declared, what is the likely trajectory of the dollar? Have traders sufficiently discounted the Fed’s taper in the dollar? Is the dollar needed as a safe haven at this time? Are risk appetites returning to the markets?
It’s my belief that risk appetites are returning to the markets. I don’t believe the U.S. is needed as a safe haven at this time as we’ve seen risk measured in credit default swaps fall in Europe over the past two years. China is still growing at a respectable pace and hasn’t shown any signs of a hard landing that many have feared over the last couple of years. I believe that while the Fed is beginning the process of removing its purchases, which would normally raise interest rates and strengthen the dollar, the dollar may stay within a tight range as credit remains cheap in the U.S. Investors can borrow from the U.S., sell U.S. dollars, and invest in other assets and areas outside of the U.S. – as long as investors feel safe!
Despite a lower risk environment in the world markets currently, as perceptions have improved, it is still an unknown whether Europe can pull out of its zero-growth environment. The European Central Bank recently dropped rates a quarter point, but the policy makers have stopped there without any real forward guidance and plan. Europe is currently stuck in neutral, so it’s still unclear what direction the dollar may need to take if conditions weaken or if the ECB undertakes a reflationary strategy. When conditions become more apparent, I’ll be sure to focus on it in my weekly wrap up on the Financial Sense Newshour.
That concludes this week’s look at the dollar. I plan to discuss many more topics affecting the U.S. dollar such as financial market performance abroad, sentiment, Federal Reserve policy, and money supply next week.