How Does The US Dollar Defy The Law Of Gravity?
Global Money Trends Magazine
Gary Dorsch, Editor
Trading in foreign exchange is akin to judging a reverse beauty contest. The trick is to buy the "least ugly" currency at the right time. Nearly every central bank is engaging in some sort of manipulation of its currency, from outright intervention in the marketplace, such as in Brazil and China, to pumping up the money supply to inflate local stock markets, such as in Australia, China, England, the Euro zone, and India. Other central banks engage in "verbal jawboning" to keep traders in check.
Central banks are key players in the $2 trillion-a-day currency market, and traders are always on the lookout for signals that central banks are diversifying their FX reserves away from the US dollar. Global central bank reserves have more than doubled to $4.9 trillion in just three years, with particular focus on the massive US dollar stockpiles built up by Asian central banks, which could be switched into other currencies such as the Euro, Japanese yen, British pound, or Gold.
The US dollar accounted for 66% of foreign currency reserves held by global central banks in 2005, with 25% stashed in the Euro, 5% in the British pound, and 4% in the Japanese yen. In London, the world's largest FX market, the Euro accounts for 35% of its average daily trading volume of $942 billion. Traders often look to the Euro, yen, and pound to gauge the mood of the global currency markets.
For the past six months, the Euro, Japanese yen, and British pound have been remarkably stable against the US dollar, locked into a 4% to 5% trading ranges. So the big question is: How did the big-4 central banks and their finance officials pull off such remarkable currency stability, at a time of enormous global trade imbalances, and 10% to 25% swings in global commodity and stock markets?
As if by magic, the Euro obeyed the whims of the Group of Seven, stabilizing within a tight range between $1.25 and $1.30. The Euro did attempt a break-out rally towards $1.30, after the Federal Reserve paused in its 2-year rate hike campaign at 5.25% on August 8th. With the Fed on the sidelines, the European Central Bank lifted its repo rate twice to 3.25%, and telegraphed a third hike to 3.50% in December, which in theory, should make the Euro more attractive.
Instead, the Euro did a U-turn, tumbling from a high of $1.2939 on August 21st to as low as $1.2480 on October 13th. The reason for the Euro's slide didn't become apparent until October 17th, when the US Treasury said foreign demand for US bonds and stocks had soared to $116.8 billion in August from $32.9 billion in July, far higher than the monthly US trade deficit of $69.9 billion.
Against the Japanese yen, the US dollar bottomed out at 114-yen on August 8th, within minutes of the Fed's announcement of a pause in its rate hike campaign. The US$ climbed 5-yen in a see-saw pattern to as high as 119.88-yen on October 13th. Japanese investors were net buyers of $7.6 billion of US Treasuries in August, their largest purchase in 14-months, anxious to lock in 5% yields on US long bonds.
But the dollar received its biggest boost against the yen from Tokyo's sleight of hand on August 25th, when Japanese apparatchniks re-jigged the consumer price index, and revised the inflation rate lower by two-thirds from the previous calculation. That handcuffed the Bank of Japan (BoJ), and ignited a rally in Japanese yen Libor futures to 99.50 from 99.34, which effectively ruled out a BOJ rate hike in Q'4.
The US dollar hit resistance at the psychological 120-yen level on Oct 13th, when BoJ chief Toshiro Fukui hinted at a rate hike, despite Tokyo's re-jig of the inflation data. "If you ask me whether there's a possibility of another rise in interest rates within this year, I cannot deny that possibility," he warned. Then on October 16th, Russia's central bank said it planned to convert some of its $267 billion of foreign currency reserves into Japanese yen, triggering dollar sales below120-yen.
Russia's finance chief Alexei Kudrin ignited a big rally for the volatile British pound in late April, when he questioned the US$'s status as the world's reserve currency. Speculators jolted the British pound from $1.74 to the $1.90 psychological level on May 14th, where the currency has been capped for the past six months. The Bank of Italy announced on August 3rd, that it had boosted sterling to 25% of its $79 billion in FX reserves, briefly lifting the pound to $1.91, where it ran into a brick wall.
The British pound is a favorite among currency speculators, because of the Bank of England's "hands-off" policy. Last week, the BoE received the green light to hike its base rate by 0.25% to 5.00% on November 9th. UK Treasury minister Edward Balls signaled on October 20th. "With the economy growing more strongly than expected and with upward pressure on global commodity prices we must all remain vigilant. We need continued discipline in wage-setting and pay-bargaining across the private and public sectors," he said.
How the US$ defies the Law of Gravity
The giant US trade deficit has generated a huge outflow of dollars, and behind-the-scenes strategies to bring the money back home. For the first eight months of 2006, the US trade deficit rose to $522.9 billion, and is likely to exceed the 2005 shortfall of $726 billion. Such a sea of red ink suggests the US dollar is still overvalued on a trade weighted and prone to a further devaluation.
Nearly a third of the US trade deficit in August was with China, widening to a record $22 billion, and twice the $11-billion deficit posted with the European Union, and three times the $7.5-billion US deficit with Japan. By the end of September, China's global trade surplus was at $110.9-billion this year, surpassing the annual record of $102-billion set in 2005, and on course to reach $150 billion in 2006.
China's trade surpluses with the European Union of $127 billion and with the US of $202 billion in 2005, enabled it to become the world's third largest trading nation, exporting and importing about $1.4 trillion worth of goods and services a year. Robust exports and bank loan growth of 15.2% have defied planners' efforts to rein in economic growth, projected at 10.5% for this year.
Under the Bush administration, the US trade deficit mushroomed from about $26 billion per month in 2002, to as high as $70 billion in August 2006. The US dollar's 30% devaluation against a basket of currencies since 2002, including the Euro, British pound, Canadian dollar, and Japanese yen, did catapult US exports to a record high of $122.4 billion in August '06, but import growth was still stronger at $192.3 billion, and generating record US trade deficits.
The US trade deficit remains stubbornly high, partly because the undervalued Chinese yuan (Renminbi) pushes up imports of Chinese goods and handicaps US exporters of durable goods and high-end services. Also, record high oil prices boosted US oil imports to $27.2 billion in August, and the world's biggest economy was on course for a whopping $320 billion oil bill this year, until the latest plunge in oil prices.
Financing the US external deficit requires increasing agility. Every business day requires $3.5 billion of net new money to enter the US markets, to prevent the US dollar from falling under its own weight. Most of that money comes from Asian central banks and Arab oil producers, which own large amounts of dollars.
Japan is the largest holder of $644.2 billion of US Treasuries, and China is the second-largest holder with $339 billion. London based brokers added $11.1 billion of US Treasuries to their clients' portfolios in August, including members of OPEC, to a record $210.4 billion. Overall, foreigners now own $2.14 trillion, or 46% of the $4.5 trillion of marketable US Treasuries.
The US Treasury's Secret agreement with Beijing
The Bush administration's dealings with Beijing are simple, free Chinese access to US consumer markets, and acceptance of the undervalued yuan, in return for massive Chinese purchases of US bonds. China is loath to increase the yuan enough to dampen growth in its coastal factories. Exports are a key source of jobs in a country that must employ tens of millions of poor farmers and workers laid off by bankrupt state factories, in the continued transition from communism to capitalism.
The Chinese central bank prints yuan in exchange for the foreign currency flowing into the country, and in the process, has increased its M2 money supply by 18% for the past few years. Beijing added $169-billion to its foreign currency reserves in the first nine months of this year, which will soon top $1 trillion, the world's largest. Beijing's satellite, the Hong Kong Monetary Authority said its foreign currency reserve assets rose $1.4 billion to $130.3 billion in September.
China purchased more than $200 billion in US and other foreign debt last year, equal to 9% of its economic output and about 25% of its exports. China has recycled about 70% of its $988 billion foreign currency reserves into US Treasury and other government agency debt, helping to keep US mortgage rates artificially low. In return, the Bush administration killed the Schumer-Graham bill that would have slapped a 27.5% tariff on Chinese imports into the US.
Beijing has limited the yuan's gains to 2.1% since it ended the rigid dollar peg in July 2005, and is expected to limit the dollar's decline to 3% this year, to minimize losses to its massive US bond portfolio. Yu Yongding, an adviser to the central bank has warned, "China's economy would take a big hit if the US dollar weakened sharply due to such factors as a bursting of the US property bubble. The loss for China's foreign exchange reserves would be extremely serious."
Subsidizing its exports with an undervalued yuan has allowed China's cargo trade to reach about 56% of the level of the United States and 82% of Germany's. But Beijing is paying a heavy price in its trade dealings with the Bush administration. The purchasing power of US Treasury notes in relation to gold has dropped in half from four years ago, making it much more expensive for Beijing to switch its reserves from US debt to gold. Beijing holds only 1.5% of its FX reserves in gold.
And the million dollar question in the foreign exchange and gold markets is how will Beijing manage its bloating reserves in the years ahead? China's FX reserves are on track to hit the $1.5 trillion mark in the second quarter of 2008, and might hit $2 trillion by the end of 2010. Last month, China tapped into its reserves, importing a record 13.2 tons of crude oil, up 24% from a year earlier, and not including 3 million barrels of Russian crude that was pumped into storage tanks south of Shanghai.
After the Bush economic team departs, China might find a tougher US president or a Democratic Congress, that aims to reverse the massive transfer of wealth from the US to China, but could steer Beijing away from the US dollar. However, such a scenario is at least 2-years away, and no change is expected in the gentleman's agreement between the US Treasury and the People's Bank of China until then.
Japan Targets US dollar for Nikkei Exporters
Japanese investors have $14 trillion in savings, and earn more from interest and dividends on investments held overseas, than from foreign trade. Japan's current account surplus rose 22.2% in August from a year earlier to 1.48 trillion yen ($12.3 billion) earning 1.16 trillion yen from overseas investments, dwarfing a trade surplus 312.4 billion yen. Japanese investors were net buyers of 16 trillion yen ($140 billion) of foreign bonds in 2005, but avoided the US Treasury market.
The Bank of Japan affixed its reputation as the world's second leading interventionist bank, when it sold 35 trillion yen in exchange for $315 billion US dollars, mostly between 105-yen and 112-yen, in late 2003 thru March 2004. The BoJ plowed the US dollars into US Treasuries until August 2004, when its holdings peaked at a record high of $699.4 billion. Thus, Tokyo is the world's biggest "yen carry" trader.
Tokyo skillfully unwound $50 billion of its "yen carry" trade over the past two years, without disturbing the US dollar's uptrend to 120-yen. Tokyo depends on the US dollar's 5% interest rate advantage over Japanese Libor rates, to enable the dollar to bounce back from periodic sales of US Treasuries. Still, Tokyo holds onto the bulk of its US Treasuries, to maintain cordial relations with its military protector, especially while under nuclear threat from North Korea's Kim Jong-il.
Japan's ministry of finance and the US Treasury might have a secret target zone for the dollar /yen, and when the US$ approached 120-yen on October 23rd, Japan's top financial diplomat, Hiroshi Watanabe told reporters in New York, "I see no reason for a further deterioration in the yen given the strength in the Japanese economy."
Arab Oil producers Recycle Petro-dollars thru London
The Institute of International Finance, an umbrella group for 340 of the world's private-sector banks, predicted in August that high oil prices would lift the current account surpluses of six Gulf Arab states to $230 billion this year, or 30% of their gross domestic product. The bulk of the surpluses in Saudi Arabia, the United Arab Emirates, Kuwait, Oman, Qatar and Bahrain, are re-cycled into their already large private and official foreign assets, such as in British gilts and US Treasuries.
The six Gulf countries, all with currencies pegged to the dollar, are working towards monetary union by 2010, but will initially peg their future common currency to the US dollar. "It makes sense for the Gulf States to peg its currencies to the dollar since the oil market is priced in dollars," said Sheikh Ahmed bin Mohammed Al Khalifa, the Bahraini Minister of Finance on October 19th.
Amid soaring oil prices, holdings of US Treasuries through London based brokers quadrupled in just fourteen months to a record $210.4 billion in August '06, probably on behalf of Middle Eastern investors. Only the UAE's central bank has signaled a desire to convert 10% of its largely dollar-denominated foreign exchange reserves into Euros and gold, but is waiting for a dip in the Euro before making the switch.
Russia is an Outspoken Bear on the US dollar
Record oil prices combined with record Russian oil exports, have boosted the Kremlin's foreign exchange reserves to a record $267 billion this year, outstripped only by those of China and Japan. In August, Russia paid back $22.5 billion debt to the Paris Club of creditor nations, and with its foreign debt standing at just $108 billion, S&P raised Moscow's foreign bond rating to BBB+.
It represents a spectacular transformation from the financial meltdown in 1998 when Russia defaulted on its debt and the rouble crashed. Booming crude oil, base metal and other commodity prices lifted Russia's foreign trade surplus to $86.2 billion in the first half of 2006 from $66.3 billion in the same period a year ago.
With its reserves swelling from petrodollar inflows, strong current account surplus and booming economy, Russian kingpin Vladimir Putin ordered the full convertibility of the rouble in July, and launched trading of Russian oil, refined products and commodities on local bourses in roubles. Russia was accumulating $10 billion of foreign exchange a month until July, and the central bank bought more than $100 billion from the currency markets this year to slow the appreciation of the rouble.
But Moscow remains a vocal bear on the US dollar, bucking the strategy of other central banks in China, Japan, or Brazil. Instead, Moscow has steadily reduced its dollar holdings from three years ago. Sergei Ignatyev, the central bank chief, said that about half of bank's reserves were held in US dollars, with the bulk of the rest in Euros. He indicated the yen would be increased as a proportion of the total reserves, and Russia would build positions in the Australian and Canadian dollars.
Federal Reserve Underpins US$ with high Fed Funds Rate
In order to attract $3.5 billion each working day from Asia, Europe, and the Persian Gulf, the Federal Reserve lifted the fed funds rate to 5.25% to discourage dumping of the dollar. The fed funds rate is pegged 5% above Japan's overnight loan rate, 2% above the ECB's repo rate, and a half-percent above the Bank of England's base rate, even at the risk of sinking the US housing market.
The Federal Reserve understands that it cannot afford to ease its grip on interest rates in the fourth quarter, without triggering a speculative attack against the US dollar. On October 4th, Federal Reserve Vice Chairman Donald Kohn challenged expectations that Fed rate cuts will occur anytime soon. "I am surprised at how little market participants seem to share my sense that the uncertainties around inflation and their implications for the stance of policy are fairly sizeable at this point."
Philly Fed chief Charles Plosser was more hawkish, "The housing sector is going through a painful, but necessary adjustment. But the expansion is still on firm footing and growth is likely to accelerate in 2007. We need to remain vigilant and maintain the current policy, or even firming further, in the best interests of the economy's long-run performance. The predominant risks facing the economy now are on the inflation side," he warned on October 6th, ruling out Fed rate cuts in Q'4.
But at some point however, the Fed may have to confront the unenviable choice of defending the US dollar or US home prices. Now that the fed funds rate has settled at 5.25%, US dollars bears such as the Russian central bank, are acting before the earliest clue that the Fed is about to lower the fed funds rate.
"The world economy is doing miraculously well," commented former Fed chief Paul Volcker on October 17th, because "there are some big imbalances underneath all of this, especially the flow of capital into the US. If the music stopped or slowed down a bit in terms of the foreign money coming into the US, you've got a potential problem for the US dollar and inflation," Volcker warned.
Central Banks Fear a Revival of Crude Oil and Gold Rally
The Federal Reserve gained a reprieve from its 2-year rate hike campaign, when crude oil unexpectedly plunged by a whopping $20 per barrel, or 25% below its all-time highs set on July 14th. The gold market tumbled from as high as $675 per ounce at the onset of the Hizbollah-Israeli war to as low as $560 /oz, lessening inflation expectations in the bond market. The collapse of crude oil and gold prices knocked the US Treasury's 10-year yield from 5.25% to as low as 4.55% on Sept 25th.
The sudden plunge in gold prices below $600 per ounce that stunned investors was linked to sales by European central banks, which sold an extra 100 tons from reserves in a rush to meet a quota deadline on September 26th, but had done so by selling through forward contracts that disguised the effect. The European central banks had previously reported sales of just 393 tons of gold in the spot market for the year, far below the 500 annual limit agreed under the Washington Accord.
Still, gold remains hostage to the crude oil market, which is the kingpin of the global commodity markets, and has the greatest single impact on headline inflation figures, published by government apparatchniks. Several reasons were offered for crude oil's sudden demise, including the complete dis-integration of the Iranian "war premium" worth about $15 per barrel, to Big-Oil's determination to help Republicans hold onto their Congressional seats, by dumping excess oil supplies onto the market.
The dis-integration of the Iranian "war premium" is most strange, considering that Iran is moving closer to its goal of obtaining the nuclear bomb to wipe out Israel and rule the Persian Gulf. Iran will start feeding uranium gas into a second network of centrifuges within days that can enrich uranium for making nuclear bombs. One has to wonder if US oil companies might begin hoarding oil supplies again after the November 7th elections, and restoring a good chunk of the Iranian "war premium."
Bundesbank chief Axel Weber doesn't believe the latest drop in crude oil prices is sustainable, especially after OPEC decided to cut its oil output by a larger-than-expected 1.2 million bpd to 26.3 mil bpd starting November 1st. "The possibility that energy prices can climb again, and strong credit growth to business are among several risks that the Euro inflation rate will certainly lie above 2% again", he said.
25 October 2006
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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.
As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.
He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.
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