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Friday March 20, 2009 - 17:31:29 GMT
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Forex Blog - End of the Dollar as we know it?

What the Fed did this week is no doubt consistent with a lower dollar.  But is it the beginning of the end for the USD as the world’s reserve currency?  Or as one bank currency strategist said Rome is burning only this time it is the city on the Potomac


To set the record straight, I am not including gold, yuan, yen or real as alternative reserve currencies.  Nope, this is a race between the almighty buck and the euroschadenfreude. 


I would say all else being equal the dollar might be ready for its final act – Wylie Coyote off the edge of a mountain road and nothing but granite boulders to land on 1,000 feet below. 


The problem is not all else is equal, not even close.  The Fed is trying to ring-fence deflation.  The ECB does not see any reasonable chance of deflation ahead, even when forecasting a significant risk of declining CPI y/y for several quarters. 


The Fed is engaging in a rapid expansion of its balance sheet buying agency and government debt to near $2trln (and likely to get even bigger) and going BOJ with quantitative easing (Bernanke can’t tell Congress again this is not Japan).   The Fed is very clear about why it has rates at zero and why it is buying assets by adding zeroes to its balance sheet (checkbook)…the banking system is broken and is not functioning effectively as a transmission mechanism for monetary policy.  


The ECB is ruling out expanding its balance sheet by buying assets from the market directly as it asserts the banking system is not broken and the transmission mechanism is working.  The ECB cuts rates and banks pass this on to customers and the demand for money goes up.  So cutting rates works – we heard this from Weber today.  For the benefit of the doubters, there is some case to be made that ECB fears going to zero bound and QE because it marks the move from monetary to fiscal policy and there is no central fiscal policy in the EZ…only way QE could be carried out is by farming out unconventional monetary policy to the national central banks (reverse problem the Fed has where Board is empowered and FOMC Presidents are window dressing in unconventional monetary policy. 


Regardless why the ECB is not embracing ZIRP and QE as a response to ring fence deflation (risk in its own inflation forecasts), the important point in examining the prospects for the euro emerging as the world’s preeminent reserve currency is that it is not responding appropriately to the prevailing economic risk. 


I don’t want to completely give the thumbs down to the ECB on its policy response to the crisis.  It gets an A for providing liquidity to the European banking system and accepting all sorts of financial waste as collateral for funds whether in EUR or USD.  But this has never been a banking liquidity crisis.  It has always been a banking solvency crisis (capital market failure – say that over and over again and remember it when idiots call for letting capital markets sort out a 100-year massive capital market failure) and liquidity shortages reflect insolvency risks.


Bank America/Merrill’s David Rosenberg said in a note this week that the Fed announced it is buying bonds not stocks.  He noted that in March 2001 when Japan’s BOJ embarked on quantitative easing after several years of massive fiscal spending packages were not working (banking system was broken, but there was no global capital market failure and all else was not equal) the Nikkei rallied about 20% into May and by July had reversed all of the gains to around 12,000 (got under 7,000 on recent downturn…this month).   The yen weakened apart from a bounce on 9-11 through early 2002 and then began to rally to new high versus the USD culminating in an orgy of unprecedented currency intervention (yen selling) ending in March of 2004.   Japan’s official rate was effectively zero and JGB yields fell to record lows…admittedly with negative inflation producing positive real return.


Yes I still hate stocks.  Yes I think financials will lead the way down again.  Yes I think the government will continue to put new capital into banks and avoid the much feared (and underrated) nationalization (this crisis has funny ways of bringing neo-Keynesians together with neo-classicists).  And yes I think the US is facing a lost half decade at least. 


Europe is a basket case short of celestial intervention and God sends a messenger down to recreate the pre-2007 financial world in a restore system reboot.  The US is not going to provide the updraft for JC Trichet to be saved from his own religious dogma – doctrine of one-sided price stability.  China won’t do it either.  Russia could at $100 oil and it might be with tanks. 


Gold, as much as I think it is its own fiat fantasy (it’s just metal, and not good for fashioning tools for hunting and gathering), is the alternative reserve currency in the race to the bottom of the USD and EUR and represents the hedge of last resort to deflation and hyperinflation and at this period of the cycle that is not such a bad bet (I fully think deflation is unavoidable and hyperinflation will not present a serious risk for years – after Wednesday the Fed clearly thinks so too).


Euro/dollar should put in a top in the next few months and I have no clue where that will be – maybe 1.45-1.50.  But if the yen and QE is any guide and Europe’s inherently vulnerable organization (monetary union without political union) prevents an appropriate policy response in Europe, I think euro/dollar has new lows on it by year end.


Lastly, Japan’s lesson holds…when banks, firms and households discover they have too much debt and deleverage, it is nearly impossible to prevent.  For all the credit Bernanke is due for taking bold step after bold step in a world of still narrow minded thinking in the halls of government and in the public, there is no evidence that an economy in deleverage mode will respond to unconventional monetary policy.  Maybe the lesson of the Great Recession will be just that…policy can only preserve social order, help the most vulnerable and punish the most successful.  Capitalism is mortally not fatally wounded and it will take years to recover.


David Gilmore 


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