The Dollar Riddle

“After two years of almost relentless decline,” begins a New York Times piece dated July 28, 2002, “the United States stock market has a new source of distress: a falling dollar.” This story, emblematic of the equity-fixation of the United States, managed to run close to a half-page of type without once mentioning the phrase “current account deficit” or “bond market”. (Its simplistic conclusions: buy American-based multinationals, sell foreign-based multinationals.) While rubberneckers in the market are wont to fixate on the newest accident by the side of the road-Enron, Global Crossing, Worldcom, JP Morgan Chase, Adelphia, Martha Stewart, the persistent weakness in equities-one of the most important developments of 2002, the breakdown of the US dollar, has gotten only a sideways glance.

While the collapse in stocks had been foretold-this chicken is now coming home to roost-the dollar's move has been significant but, due to its very nature, only recently taken on as a subject. Much ink has been spilled and many brain cells have been exhausted in recent weeks, trying to describe, explain and contextualize the dollar’s decline. Over the next 3,800 or so words, we will add our brain cells to the cause. For those impatient readers who can’t wait for the end, we will conclude that a) this dollar weakness will have a salutary effect on the US economy, but too much weakness will hurt it, b) continued and persistent declines in the US dollar would have a negative effect on the US economy and the value of dollar-based financial assets, c) foreign investors and economies have more to lose by a weak dollar than we do, and will ultimately take steps to support it, and d) it will take a lot of heavy lifting to stabilize the dollar. In short, expect more dollar weakness, and expect to see its ramifications-deflationary pressures leading to inflationary ones, weakness in financial assets, continued downward pressure on short-term rates and upward pressure on long-term rates.

The market facts are as follows: Despite sanguinity from virtually every quarter that the decline in the dollar has been controlled and gradual, we would call it anything but. From the beginning of March to the end of July, the yen has appreciated 11.3% versus the dollar, while the dollar has dropped 12.5% against the euro, passing the economically meaningless yet psychologically important parity level. The US Dollar Index, a tradeweighted value versus 6 major world currencies, has fallen 9.9%. (On the other hand, the dollar is doing quite nicely against the Brazilian real, the Venezuelan bolivar and the Mexican peso, thank you very much.) For perspective, over that period, the S&P 500 and the Nasdaq Composite have fallen 17.6% and 23.3%, respectively. The yield on the 10- year Treasury has fallen from 4.877% to 4.46%.

The five-month swoon in the dollar

Before we pick up on our thread, a brief review is in order. What is a dollar? As far as we have been able to determine through calling the Fed and the Treasury, there is actually no legal definition of what it is, no statement that begins, “The dollar is …” Instead, the dollar is defined by other things. When the Federal Reserve was created by the Federal Reserve Act of 1913, the dollar was basically defined by the amount of gold-35 cents on the dollar-that had to be kept in reserve to back the currency.

Now the definition is even more circumspect. The Federal Reserve Act simply requires that adequate backing be pledged for all Federal Reserve notes in circulation. U.S. Treasury securities, acquired through open market operations, are the most important form of collateral and provide backing for most of the value of the currency in circulation. In other words, a dollar, a fiat currency, is a piece of paper backed by nothing more than the promise of the Federal Reserve to pay you another dollar. [In fact, our calls to the relevant agencies for a definition of the dollar elicited the kind of bad directions you get from someone who doesn’t know the neighborhood. The Treasury flack sent us to the US Mint, where we learned about how a dollar is printed. In lieu of a definition, the Federal Reserve’s public affairs office emailed us the following section of the US Code: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.”]

This is not to say that our brand of currency is different from any other. Central banks around the world also keep currency reserves rather than gold to legally back their own currencies. And more often than not, fiat money around the world is backed by dollars. According to the Bank for International Settlements, dollars account for 75% of the $2 trillion in official foreign exchange reserves. The dollar’s position as the world’s premier monetary asset is commanding, yet fairly recent. Before World War II the British pound bestrode the world, but afterwards, the dollar was preeminent. However, by 1971 the Nixon administration suspended the free exchange of dollars into gold at the $35 per ounce statutory rate. Since then, despite intermittent inflation, deficits and market collapses, the dollar has still beaten the competition. Not even when Japan was waxing and the US was waning did the yen make a dent as a central bank’s choice for a store of value. Central banks voted with their feet on gold over the last few years, with coordinated and controlled dumping of gold reserves through either outright sales or massive forward selling. The euro (formerly known as the ecu), that historical watershed of floating currency, wasn’t even close, as it stumbled out of the gate after its introduction as a virtual currency in 1999.

So how to explain the dollar’s recent rapid decline? The best and simplest explanation we have read for the movement in exchange rates is by the former strategist of JP Morgan, Douglas Cliggott, who said that what drives the exchange rate is return on capital. As US asset prices appreciated, so did the dollar. “A powerful virtuous circle has been in place,” wrote the Bank Credit Analyst in the still-virtuous days of November 2000, “with inflows of foreign capital financing the capital spending boom that, in turn, has propelled productivity growth higher. The desire of foreigners to boost holdings of dollar assets has meant that a soaring current account deficit has not constrained the economic expansion. Meanwhile, the firm exchange rate has kept a lid on import prices, providing an offset to domestically-generated inflationary pressures.”

And, like the swallows returning to Capistrano, as US asset prices have fallen, the dollar-with some hesitation based on hope for recovery-has followed. We are now witnessing the cyclical flip side of the virtuous circle-a vicious one. The boom of the late 1990s would not have been possible had it not been for historic and unprecedentedly large inflows of foreign capital coming into the market. “Foreigners bought a net $522 billion of US long-term securities in 2001, compared with only a net $58 billion in 1991,” writes Christopher Wood of Credit Lyonnais. “The result of this buying frenzy is that foreigners will take massive losses on these investments, be they foreign direct investment, equity or corporate bonds.” As foreign investors decide against US assets, the dollar exchange rate falls, risk-based financial assets plunge, triggering further declines in the dollar. Another way to express this is that what we have been witnessing is a capital flight away from dollar denominated assets.

The demand by foreign investors for US dollars and dollar-based assets can be seen in the fact that the US current account deficit now stands at close to $400 billion. In other words, to finance this deficit, America needs foreigners to buy approximately $1.2 billion worth of assets every day. Anything short of that, and the deficit shrinks, but it also means that the assets that filled that bill-hard assets, financial assets-will lose value as the dollar weakens. For years, many have stood in awe at the continued strength of the current account deficit. Again, as long as there were high expected rates of return on US investments, coupled with relatively fast productivity growth, money would flow here rather than, say, Europe, where companies and economies couldn’t keep up. Initially, as the BIS has pointed out, these flows into the United States were initially in the form of foreign direct investment and equities, only to be replaced last year with inflows into the bond market, particularly Treasurys and agencies. And this year, even these flows have shrunk. Morgan Stanley pointed out that in the first four months of 2002, portfolio inflows were off about 30% from the comparable prior period; inflows from Euroland during the period were down a stunning 70% from the prior year. The rapidity of the decline in the dollar in the last quarter is troubling because it suggests that foreign investors are indeed, as Wood suggests, moving away from losing positions.

Feed me -- annual US Current Account deficit deepens

“[A]t the end of 2000,” writes Paul Kasriel, director of economic research at Northern Trust Corp. in Chicago, “the rest of the world owned US financial assets equal to almost 25% of the total US capital stock… In 1980, the rest of the world owned about 5% of us and in 1990, about 11% of us. So the 14-percentage point jump in foreigners’ stake in the US in the decade of the 90s was a pretty hefty increase in their bet. And how has this increased bet paid off? Lousy.”

Kasriel pointed out that return on capital for nonfinancial corporations in the 1990s was mostly around 7%, with a high of 11.7% in 1997-well below the almost 20% returns of the 1960s and about the same as was observed in the late 1970s. “Recognizing that past performance is no guarantee of future performance,” concluded Kasriel, “but with federal spending surging, tariffs being imposed on some of our imports, capital deepening slowing dramatically, and a Fed already trying to print our way out of difficulties, would you want to raise an already considerable bet on the US?”

While foreigners are watching the value of their investments fall, they are also worrying over the effect that a weak dollar is having on the other side of the global trade. A recent survey published by the European Commission shows that pessimism about the 12-nation economy grew among businesses and consumers in June. Reasons for the downturn in sentiment include the strengthening euro and uncertainty about the US economy, among others. In Japan, any chance that economy has of exporting or inflating its way out of troubles is being severely threatened by a strong yen and a weak economy in the big American export market.

In the US, on the other hand, American manufacturers, who have been bitterly complaining in the last year or two about the strong dollar, are beginning to see some benefits. US exports are rising, but we hesitate to declare that there will be any kind of export boom in the offing. “Equally important,” says William V. Sullivan, Jr., strategist at Morgan Stanley, “there was a sense that the dollar had moved down so fast that the extent of the cumulative erosion was of sufficient magnitude to apply some upward pressure on US inflation. The inflation fears that were engendered by the dollar’s drop had a clear influence on the shape of the yield curve, with the overall construct steepening significantly as the back end bore the brunt of the negative sentiment, which is understandable when dealing with an incipient inflation scare.”

Even while the classic first-order effect of a weakening currency would be deflationary-the flip side of our strong dollar through the second half of the 1990s has been Japan”s weak yen and deflationary undertow-the step after that would be reflationary. The recently published Fed study, “Preventing Deflation: Lesson from Japan’s Experience in the 1990s”, covers this ground. Its very publication seems to suggest that the Fed believes that a little inflation isn’t such a bad thing (or at least it’s better than deflation) and could provide cover for inflating. Creditors, on the other hand, will run. If the Fed does not increase rates, inflationary pressure builds. “With the Fed focused on the fragile equity market, any prospective tightening is continually pushed back,” writes Brian A. Wesbury, chief economist of Griffin, Kubik, Stephens & Thompson. “This causes the dollar to fall, the price of gold to rise, and puts an updraft under commodity prices. While inflation may be low today, under the surface, pressures are building.”

A short-term view of the dollar dilemma would be to focus solely on how its weakness helps the markets: It helps to lower the US current account deficit. It will make our products cheaper overseas, helping exports and profits. It will help fight deflation by making import prices higher. It will put a brake on tightening by foreign central banks and help our trading partners. Goldman Sachs published a well-received and lengthy think-piece on the dollar that stopped at this shorter time horizon. “We expect recent weakness in the dollar to extend, with the main source of uncertainty being the extent of the depreciation,” the authors contend. “Contrary to concerns in financial markets, with the appropriate shifts in domestic policies, we believe that the weaker dollar will provide a boost to the global economy over the medium term.”

Fred Bergsten, former assistant secretary of the US Treasury, argued recently in the FT that the global economy would benefit from a continued fall in the US dollar, and that a weaker dollar would, in fact, strengthen the US equity market by helping multinationals, by making US products price competitive and by making everything cheaper. We believe that a persistently weak dollar would hurt global economic growth, by stanching any incipient growth in Japan and Europe. Moreover, a weaker dollar lessens the appetite of the true engine of world growth, the purchasing power of the American consumer.

Our take on this laissez faire level of unconcern is that no dramatic change in value like we have seen in the dollar occurs in a vacuum. Thomas Sowanick of Merrill Lynch points out that during the two years of the bull run in the stock market, the S&P 500 outperformed the US Treasury market by 3,500 basis points. “While this 3,500 basis points of incremental return was indeed remarkable at that time, it has now been surpassed with Treasurys outperforming the S&P by 5,442 basis points during the period of 2000 to July 2002.”

One bubble, serially, follows another. As the popping of the equity bubble drives investors out of that market, it drives them into others, such as residential housing or Treasurys. Money is pouring into these higher quality assets, distorting values in those markets. Furthermore, we have already seen several attempts at interventions to prop up the dollar by the Bank of Japan, to little avail. Such intervention generally plays out by a recycling back into purchases of short-term Treasurys, a practice which helps to hold down money market yields even as the dollar weakens.

Alan Greenspan, in his Humphrey Hawkins testimony on July 16, addressed the precarious position of the dollar: “A considerable volume of market commentary in recent weeks has suggested that concerns about earnings prospects and the proliferating revelations of serious governance and accounting issues have contributed not only to lower equity prices but also to a decline in the foreign exchange value of the dollar. And some of that commentary has extrapolated the trend of dollar weakness. As you know, the Secretary of the Treasury speaks for our government on exchange rate policy. But, given the recent intense interest in the future course of the dollar, I would like to raise a technical issue and a flag of caution regarding those forecasts--or, for that matter, any forecast of exchange rates. There may be more forecasting of exchange rates, with less success, than almost any other economic variable.”

He continued: “The reason that it is so difficult is that an exchange rate is a very complex price that balances, on the one hand, the demand for, for example, dollars stemming from the demand for dollar investments and for U.S. exports against, on the other hand, the demand for foreign currencies by U.S. investors desiring to acquire foreign assets and by U.S. importers of foreign goods and services. Hence, exchange-rate movements depend on shifting perceptions of the relative returns from investing in different countries and on the myriad influences on relative tendencies to import and export. The net effect of these factors over any future time period is extraordinarily difficult to assess in advance. Although measures such as real interest rate differentials, differential rates of productivity gains, and chronic external deficits are often employed to explain exchange rate behavior, none has been found to be consistently useful in forecasting exchange rates even over substantial periods of one or two years.”

Judging by the first paragraph, Greenspan doesn’t seem to want to go out on a limb discussing whether a strong dollar is good or bad for the American economy and financial markets. (He’ll leave that to Treasury Secretary O’Neill.) But in the second paragraph above, Greenspan seems to believe that any change in the US dollar exchange rate is a by-product of other variables, rather than a causative agent on those variables. For example, in this construct, weak demand for US assets leads to a weak dollar, or a change in perceived interest rate differentials cause a change in the dollar price.

For us, we don’t agree with Chairman Greenspan when he says that forecasting exchange rates is next to impossible. We do know, however, that anyone who ventures to make a forecast is bound to be wrong so if one insists on making a prediction one should neglect to give a date upon which said prediction will occur. With that qualification, we will now hazard our guess, but give no timetable as to its eventual outcome. We believe that the dollar will continue to move lower. The strong dollar, whose exit is now bemoaned by equity holders throughout the land, was the reflection of a world in which the Nasdaq topped 5,000, attracting foreign and domestic capital alike in unprecedented volumes, this easy access to capital leading to a pumped-up capital investment in telecom and other capacity, which in turn led to stunning productivity gains and the wonder of stellar GDP growth without inflation. It now turns out that much of that plot line was fictional, based on misleading financial statements and, in some cases, outright fraud.

Those days are gone, those capital flows have slowed and shifted, and that dollar is gone. Treasury Secretary O’Neill and other officials don’t seem to be doing or saying very much to try to change the situation. Secretary O’Neill, burned by his foot-in-mouth candor in the past, seems to be going to great lengths to avoid being tricked into saying anything that might stake out a position on the dollar. It may turn out that over time the benign neglect of the dollar by the Secretary O’Neill and the Treasury Department, and the resulting strength of other currencies, particularly the euro, gives credibility to it as a reserve currency. Asian central banks, China in particular, are said to be interested in diversifying their foreign-exchange holdings away from dollars and, at the same time, deepen trade relationships with the European Union. George Soros, who knows a thing or two about currency trends, said recently that with the reversal of trend in the dollar, he wouldn’t be surprised for its value to fall by a third from where it is now.

Such a decline would, we believe, lead to a secular change in the value of the dollar rather than a cyclical one. The BIS, ever the diplomat, in its annual report put it this way: “Even given the recent weakness of the dollar, it would be naïve to simply extrapolate this trend into the future. However, it is a matter of simple arithmetic that for every year the United States runs a large current account deficit, its external debt mounts. Should the United States also experience the most robust recovery among the major industrial nations, as many now expect, this arithmetic will apply with increasing force. The fact that so many investment portfolios, both public and private, seem weighted heavily towards dollars could also provide some scope for rebalancing should the period of dollar strength seem definitely over. Europe now has financial markets in euros that match those in the United States in many key respects.”

If this is the case, then the Federal Reserve and the US fiscal policy potentates are going to have to be prepared to fight. Continued weakness by the dollar will put significant pressure on the Fed to step in to defend. But with its hand stayed by a still-weak economy, fragile equity markets and credit markets, a general crisis of confidence in Corporate America, a critical mid-year election looming and growing budget deficits, the only way out might be to grow. In that case, we would expect to see continuing easy policy; low short-term rates-with but token raises in Fed Funds, if any-aided by currency interventions from abroad and demand for money market instruments from the homeland; and higher long-term rates as inflationary pressures rise.

Through the first week in August, the equity market has continued its volatile ways, and yields on the long end of the yield curve have come down as Treasurys have firmed. The dollar has retraced some of its losses. Recently-released economic data has revealed a stall in the US economic recovery-weaker-than-expected GDP growth for the second quarter of 1.1%, continued low industrial production and capacity utilization data and virtually no job growth-and gave the financial markets hope for future Fed rate cuts. Fed rate cuts may stimulate the economy, which would help the dollar if the American economy were perceived to be relatively strong; ineffectual rate cuts and continued weak financial markets, combined with comparatively low rates will do little to defend the dollar’s value in the global marketplace.

In the final analysis, the decline of the dollar does not constitute a “currency crisis” in which the dollar falls sharply and the current account goes through a rapid adjustment. However, a grinding down of the exchange rate and a shift in the current account will be a drag on the economy and therefore have a negative effect on the effort to get the government budget out of deficit. It will also erode consumer confidence and the price levels of risk-based financial assets. But most troublingly, a persistently weak and declining dollar will play a role in the reversal of the dollar’s hegemony. And then we watch as the world adjusts to a dollar that stores less value, loses market share and reflects an economy that struggles to overcome a punctured financial asset bubble.

August 7, 2002
By Jeremy Diamond, Executive Vice President
Annaly Capital Management