One of the contributing factors in our call for a financial crash is a collapse in the U.S. dollar. Recent pronouncements by world policymakers suggest they are willing to let the dollar fall in an attempt to cure large global imbalances. By asking for a devaluation of the dollar, policymakers are unwittingly sowing the seeds of the forthcoming financial crash.
We now believe the medium-term and long-term direction for the dollar is down. Further dollar weakness from here will cause a continued loss of confidence in the dollar and ultimately dollar-based assets. The spillover effects of the dollar collapse will create upward pressure on interest rates that will cause the U.S. bond market to crash. The final spillover effect will be an extended crash of the U.S. stock market.
Last month's issue of The View detailed how the U.S. government is pressuring China to revalue their currency upwards, which in effect will weaken the U.S. dollar. 1 This month, The View extends our currency analysis to include key pronouncements from world policymakers. Collectively, policymakers now agree the dollar must fall…
U.S. Dollar Index is Near its Lows
The chart below is the trade-weighted index of the U.S. dollar from 1973 to today. The index computes the international or foreign exchange value of the U.S. dollar versus major currencies. It shows the dollar's worth compared to other currencies since 1973 when the dollar began to float freely against most major currencies. While there have been periods of U.S. dollar strength, the long-term direction has been down.
Notice how the dollar is trading just about 6% above its long-term lows. The chart also shows that the U.S. dollar bull market that began in 1995 peaked in 2002. We believe the dollar peak occurred due to former Fed Chairman Alan Greenspan's unprecedented campaign to slash short-term interest rates starting in January 2001.
The IMF is an organization of 184 countries whose purpose is to work together to promote financial stability, trade, employment, economic growth and a reduction of poverty. Unfortunately, the track record of the IMF has been mixed and the organization has frequently recommended currency devaluation as a solution for struggling countries.
Now the IMF is calling for the U.S. to devalue the dollar. Here is a recent quote came from IMF chief economist Raghuram Rajan:
"the dollar will have to depreciate over the medium-term to facilitate adjustments. That's simple economics." 2
Here is what the IMF recently had to say about the state of the global monetary system in their just-released 2006 World Economic Outlook:
…an orderly resolution of global imbalances will require measures to facilitate…a realignment of exchange rates over the medium term, with the U.S. dollar needing to depreciate significantly from current levels, and currencies in surplus countries--including in parts of Asia and among oil producers-to appreciate." 3
There are two main problems with the currency devaluation policy. First, markets rarely proceed to an "orderly resolution" when the shock of the currency reverberates through the financial system. The devaluation can lead to a risk of overshooting-where the dollar collapse becomes self-reinforcing and reaches levels that many call "unbelievable". The second problem is that the devaluation can lead to many unintended (negative) consequences like inflation, slower economic growth (or recession), lower worker incomes and increased unemployment. 4
World Policymakers want the Dollar to Devalue
Policymakers' worry over global imbalances has finally reached a crescendo. At a meeting ten days ago in Washington, D.C. the finance ministers and central bankers from seven large countries (the Group of Seven or G7) hammered out an agreement to "fix" the global imbalances. 5
Here is an excerpt from the G7 communiqué released after the meeting:
"In emerging Asia, particularly China, greater flexibility in exchange rates is critical to allow necessary appreciations…" 6
So one of the G7 solutions is to engineer an appreciation of the Chinese currency. Since the Chinese currency is pegged to the U.S. dollar, the G7 is essentially asking for to devalue the U.S. dollar. And who represents the United States at G7 meetings? The Secretary of the U.S. Treasury, John Snow and the Chairman of the U.S. Federal Reserve, Ben Bernanke.
When governments seek to devalue the purchasing power of a currency, every citizen suffers a loss. Historically, emerging countries like Thailand, Argentina and Mexico have struggled mightily after the devaluation of their currencies. Now, the largest developed market in the world, the United States, is asking for its currency to decline.
Following the release of the communiqué last week, the U.S. dollar fell 2.3% against the euro currency and the Japanese yen. We believe this is only the tip of the iceberg. Years from now, when financial commentators look back, we believe the G7's April 21, 2006 communiqué will be regarded as historic. The request for non-dollar appreciations (U.S. dollar weakness) will be seen as unleashing a torrent of market forces that eventually cause the global monetary system to break apart.
Remember the last time the developed countries got together and announced their wish for an appreciation of non-dollar currencies (a dollar devaluation)? It was the G5's (the predecessor to the G7) September 1985 meeting at the Plaza Hotel in New York, dubbed the Plaza Accord. Fifteen months later the dollar collapsed, a few months after that the U.S. bond market collapsed and then stock markets around the world collapsed in October 1987.
How to Hedge your Dollar Investments
Dollar holders can use short-term strength in the dollar to reduce or eliminate their exposure. If you have a currency trading account you can sell dollars and purchase foreign currencies to profit from any future U.S. dollar weakness.
You may also consider the Euro Currency Trust. The trust is an exchange-traded fund managed by Rydex Investments. The ticker symbol is FXE, traded on the New York Stock Exchange. The fund is priced so that 1 share = 100 euros. So the share price change mirrors the rise and fall of the 100 euros relative to the U.S. dollar. If the dollar falls by 5% against the euro, a long position in FXE will gain approximately 5% from the appreciation of the euros held in the trust.
Previously in The View, we wrote about the growing imbalances in the global financial system:
"We believe the U.S. financial markets will bear the brunt of the adjustment forces required to bring the world's economies back into balance. As confidence disappears, a large fall in the U.S. dollar and a large rise in interest rates will occur. Eventually the pressure will spill over to the U.S. stock market where prices will crash." 7
Currency pronouncements from world policymakers over the last two months reinforce our view that the medium-term direction for the dollar is down. With the U.S. Administration, the U.S. Congress, The U.S. Federal Reserve, the IMF and the G7 all advocating a weak dollar policy, it is only a matter of time before U.S. dollar declines unfold. A spillover effect of the U.S. dollar collapse will cause the second crash factor to occur: the collapse of the U.S. bond market. The final spillover effect (caused by the bond market collapse) will be when the U.S. stock market eventually peaks and crashes.
Stay tuned, as future issues of The View will analyze political, monetary, economic and market conditions leading up to the crash. In addition, we will present potential investment techniques that you can employ to protect your assets and increase your financial success.
Thanks for reading and have a great month!
John Wibbelsman, CFA
GlobalMarkets Investment Advisors, L.L.C.