Friday, March 5, 2010

US Dollar Strength: Is this the recovery of confidence?

I have just returned from a reunion dinner (after over two decades) with some of my former colleagues at what was then India’s largest IT Company. The occasion was the visit of one such colleague who has been living in the US (Washington DC, to be more precise) for the past thirteen years. A few shots of Johnny Walker Swing down, brought the discussion to the IT industry, economy and the future of the world. My eyes popped open in disbelief at my dear friend’s belief in the US Government and the US economy. According to him “all is well” as the US dollar has been gaining strength (and hence is secure) and that the US has a future that India will take years to reach. I assured him that India would certainly not be either that debt-ridden nor that over-leveraged ever. We ended up making a bet – in the true “3 Idiots” way – to see who was correct exactly 5 years from now.

The US Dollar Index (also called USDX or Dollex) has been exhibiting unusual strength over the past couple of months, having risen from a level of 74.5 to almost 81.4 and thereafter refusing to budge below 80 for any reasonable period of time. I get to meet several people who have started believing that the recent strengthening of the US$ is due to the recession in the US having ended and a harbinger of good days that lie ahead. Unfortunately, few people (and even fewer Americans) really understand what is responsible for the US Dollar’s current strength.

To understand the reason’s for its recent strength, one must first realize what the US Dollar Index actually is. The US Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. It is a weighted geometric mean of the dollar's value compared only with:
• Euro (EUR), 57.6% weight
• Japanese Yen (JPY), 13.6% weight
• Pound Sterling (GBP), 11.9% weight
• Canadian Dollar (CAD), 9.1% weight
• Swedish Krona (SEK), 4.2% weight and
• Swiss Franc (CHF) 3.6% weight.

USDX started in March 1973, soon after the dismantling of the Bretton Woods system (in 1971) wherein, the United States unilaterally terminated convertibility of the dollar to gold, thereby making the US Dollar the reserve currency of the world. At its start, the value of the US Dollar Index was 100.00. It has since traded as high as the mid-160s and as low as 70.698 on March 16, 2008, the lowest since its inception in 1973. The makeup of the "basket" has been altered only once, when several European currencies were subsumed by the Euro at the start of 1999.

The recent strength of the USDX is more because of the massive erosion in the value of the Euro on account of the infamous sovereign defaults of the PIGS (Portugal, Ireland, Greece & Spain) and the recession in the UK and the consequent fall in the Pound Sterling. Also most traders who had earlier shorted the US$, have covered their positions and gone long, while creating shorts in the Euro - to add to the woes of the European Union. These longs would give way to fresh shorts, once the traders realize that there is more to lose than gain in carrying forward these positions.

The Western world is still in a state of disarray and it is highly unlikely that it will come out of this mess by printing more fiat currencies and creating further debt. The basket of currencies that determined the USDX in the seventies, itself is today more representative of financial turmoil that these so called developed nations have created for other nations. I don’t see much hope of any sustainable long term financial order coming from most of the countries that form either the basket of currencies or the reserve currency. The answer will have to come from Asia, whose demographic & GDP growth coupled with internal consumption and high savings rates will have to provide the world with an alternate to dying Western economies with high deficits.

There are some fundamental reasons as to why the US dollar is in trouble long term and why the precious metals sector and the commodities sector stands to benefit from these dollar woes.

1. The US has a massive current account deficit since 1990s, which only seems to be getting bigger. Economists may play with the numbers by stating that one month is less than the other and so forth, but the trend is visibly up. It now comes close to 6% of the total economic activity in the US.
2. The US needs to attract a whopping 1.8 billion dollars a day to compensate for the current account gap. A trend that is simply unsustainable.
3. The US has a national debt of $12.4 trillion and increasing. However, this does not take into consideration several unfunded liabilities such as Social Security and Medicare. If these are combined, the debt levels soar to well unimaginable levels and clearly present a picture that the ablest (most corrupt) of men in the Treasury or the Fed would not be in a position to defend.
4. 44 states out of the 50 in the US are facing budget shortfalls. California is leading the way as it is expected to spend 50% more than it will generate this year. Since 2007, US states have collectively spent 300 billion more than they have generated. These deficits mean higher taxes and so far 33 states have raised taxes, but collections have plummeted to their worst levels in 46 years; as you cannot squeeze water out of a rock! No jobs means no revenues but states are selling new bonds at record rates to raise funds. If this is not a sure recipe for long term disaster, what is?
5. Eventually the Fed is going to have to raise rates to continue attracting the huge amounts of money it needs to function. Overseas investors are going to start demanding higher rates. Higher rates will kill any fragile economic recovery that the US may be beginning to see. Precious metals thrive in a high interest rate environment. From a long term perspective the bull market in precious metals has only just begun.
6. While Government officials talk big about a strong dollar policy, they actually favour a weak dollar. This serves two purposes, it helps increase exports and it allows the government to pay its debt with lower valued dollars. As long as the Government continues to borrow at these mind boggling rates, it is going to unofficially favour a weak dollar.
7. By inflating the money supply, the government is imposing a nefarious silent killer tax on the masses. The only way to hedge against this outright theft is to hedge yourself by getting into hard assets (meaning precious metals, oil, agri-products etc).

Watch your step & de-risk your investments. If you have to play stocks, move into markets that have local consumption along with high savings & GDP growth rates. If it is paper currencies, stay away from the Euro, the US$ & the Dhiram – You may want to look at the Swiss Franc or the Australian $ or even the Singapore $. If it is precious metals & commodities that you favour, do look closely at whether your EFTs actually hold physical bullion or they are relying on paper trades through COMEX etc. You may just be safer holding physical Gold & Silver.

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