The U.S. dollar’s strength in the face of adversity flatters to deceive. America appears to be “ground zero” for the collapse in global economic activity; its troubled housing market and banking sector are at the heart of faltering confidence in financial markets worldwide. Since the credit crunch really started to bite in July, however, the U.S. dollar rallied. It’s risen about 25% against a basket of its major currency peers. The bulk of these gains occurred since mid-September, a period in which the federal government took mortgage giants Fannie Mae and Freddie Mac into conservatorship, and Wall Street giant Lehman Bros. collapsed. It feels like investors are running toward the burning building instead of away from it.
One might interpret this performance as a vote of confidence in the ability of U.S. authorities. And since the 1970s, bullish and bearish trends in the U.S. dollar have typically lasted seven or eight years; given that the last major turning point in the dollar index occurred in July 2000, we might suspect it has reached the tail end of a secular decline. At TD Bank Financial Group, however, we don’t think the dollar’s rebound can be sustained.
The greenback’s gains likely reflect short-term, temporary issues. Many U.S. investors are repatriating foreign investments; data show that they’ve been consistent sellers of foreign equities and bonds since the summer. Others who sold the U.S. dollar short are now covering their positions. And many are de-levering and moving assets into temporary safe havens, such as Treasury bonds. Finally, the credit crunch has made it difficult for banks and institutions to secure U.S. dollar funding by borrowing in the wholesale money markets; the resulting scarcity has helped drive up the value of the U.S. dollar in the foreign exchange markets. All of these factors drove the U.S. dollar up significantly: in broad terms, we estimate it’s now 10% above its fundamental fair value. But none of this will continue indefinitely.
The challenges facing the U.S. economy will pull America’s currency lower again through 2009. According to the National Bureau of Economic Research, the economy has been in recession since December 2007. The Federal Reserve’s key interest rate is nearing zero. U.S. authorities are committing trillions to rescue the financial sector and revive the other sectors of the economy. These policies will require a surge in borrowing. TD Economics expects a U.S. budget deficit of 8% of GDP in 2009, or a little more than US$1 trillion. Total government borrowing may be around twice that, given that accounting interpretations will keep some of the funding (equity stakes and other asset purchases) requirements off balance sheet. This is a huge amount of debt for investors to absorb, and the situation is unlikely to improve much in the coming years; if investors balk at buying U.S. IOUs, the dollar may fall and/or U.S. yields may rise.
Over the next year or so at least, we think the dollar is most at risk from the increase in debt supply. Even if policy-makers quickly rein in deficits once the economy stabilizes, the medium-term impact on the dollar will likely be significant. America’s fiscal performance — whether looked at in terms of absolute levels of public debt or the relative change in the level of debt — had a momentous impact on the dollar’s overall trend over the past 15 years or so. And the rash of bailout funding, liquidity provisions and aggressive easing of monetary policy will soon encourage global investors to become a lot pickier about where they put their money.
Despite these challenges, the U.S. dollar should remain the world’s medium of transaction. That’s because it remains deeply embedded in the global financial system — in commodity markets, for example. And there is little risk — for the moment — of it losing its reserve currency hegemony completely. U.S. financial markets are deep and liquid, and the United States appears to be in little danger of losing its top credit rating despite the challenges it faces.
The U.S. cannot afford to be complacent, as potential rivals, such as the euro, continue to gain prominence among global asset and central bank reserve managers’ portfolios. An abrupt and destabilizing shift away from the U.S. dollar and U.S. dollar-denominated assets is unlikely. However, if we are correct in our view that the greenback will fall over the coming year (we expect the Canadian dollar to rise toward 87¢US and the euro to rally back toward US$1.40–$1.50), we may see renewed pressure on currency peg regimes (for example, the Saudi riyal) that are tied to the dollar to abandon or modify these regimes; this may ultimately put additional downward pressure on the dollar.
Shaun Osborne is chief currency strategist at TD Securities.