Stocks sold off in the final hour of trading Friday, turning what had been tidy gains in all the major indexes into losses and almost wiping out all the gains achieved by the markets during the week. The Dow Jones Industrial Average finished the day down 14.81, while the S&P 500 lost 1.33. For the week, the Dow managed to eke out an 8.68-point gain (after having started out Monday gaining 235 points) and the S&P rose 4.12 points (up 26.83 on Monday.
The primary concern among investors was the possible problems the US government was likely to have in funding its debt. Some observers feared a downgrade in the US’ credit rating.
The Dollar touched a new low for 2009 this week (on a trade-weighted basis), dropping three and a half percent against the Euro and four and a half percent vs. the British Pound. Since March 9, when stock markets around the world began their current rally, the Dollar has lost almost 12 percent against the Euro and over 15 percent vs. the British pound.


Background

Since the middle of September, when the US Treasury allowed the bankruptcy of Lehman Brothers and which date serves as the starting point for the current financial crisis, the Dollar has had two significant rallies (from mid-September to mid-November and from the end of December to March 9) and two major sell-offs (November to December and March 9 to the present date).
In attempt to find reasons for these major moves, analysts have resorted to the "safe-haven" theory: In times of uncertainty, investors and traders bought Dollars (and Japanese Yen, as well), despite the United States and Japan having the lowest interest rates among the developed nations, and sold European currencies. When the economic outlook appeared to be gaining some clarity, investors turned around and sold Dollars and Yen, having developed an "appetite for uncertainty", according to the pundits.
Thus, during the period from September to November, when things looked most bleak, the Yen and Dollar both appreciated. From November to late-December, the euphoria over Obama’s election victory and the hopes he carried regarding economic recovery led to strength in the European currencies. Then, just before Christmas, new pessimism set in and back came the Dollar. Finally, in March, when Treasury Secretary Geithner revealed his "bank bail-out package, with stress test details and toxic asset solutions, the Dollar started on its latest (and current) slide.
On Friday, an article in the Financial Times again cited the current aura of economic optimism as the reason the Dollar’s "prognosis is far from good" (implying, of course, that a reversal of this optimism could lead once more to a Dollar rebound). We agree that the Dollar’s prognosis "is far from good", however, we believe there are more deep-seated reasons for the negative outlook for the Dollar other than simply an "increased appetite for uncertainty".


Analysis

During times of "normal" currency trading, investors, taking a long-term view, tend to buy currencies whose countries’ governments are expected to maintain a strong anti-inflationary stance. Inflation is probably the single most important factor that can lead to erosion of the values of one’s assets (or, at least it was until the current financial meltdown). It was this anti-inflationary bias that led the Deutschemark to dominate all other currencies in the period leading up to the establishment of the Euro. The Bundesbank’s main goal, year in and year out, was to keep a lid on inflation.
On a short-term basis, traders tend to buy currencies whose countries offer the highest short-term interest rates. Short-term currency trading involves rapid in-and-out movements. So, in the short run, the currencies offering the highest interest rates tend to be the strongest currencies.

In conjunction with this attraction for higher short-term interest rates, investors also tend move their funds into investments in countries that promise solid economic growth. Higher growth rates usually mean higher interest rates.
Until about 2001, the Dollar benefited from all three of these factors: Historically, dating from the appointment of Paul Volcker as Federal Reserve Chairman in 1979 and continuing with Alan Greenspan, the Fed has produced a solid anti-inflationary record.
In order to retain control over inflation, the Fed, during this period, ensured that real interest rates (nominal interest rates adjusted for inflation) remained positive. Diversified investors prefer high real rates.
Finally, the US economy for most of this period was among the strongest in the world, especially among the developed nations.
There was one other factor that, we believe, contributed to the Dollar’s strength during this period. This was confidence in the US’ political and financial leadership. I remember sitting in a Swiss banker’s office in 1981, shortly after Ronald Reagan’s election as President, and listening while the banker told me how happy he and his colleagues were about Reagan’s leadership. The Dollar began to appreciate shortly after Reagan’s victory. (Margaret Thatcher’s election produced similar results for the British Pound.)
During the nineties, the combination of Fed Chairman Greenspan and Treasury Secretary Robert Rubin elicited similar confidence among investors (although Rubin’s star has since become tarnished in connection with Citigroup’s problems).
Consequently, the Dollar, especially during the 1990s, remained strong.


After 2001, however, the Dollar began to depreciate. There were a number of reasons behind this decline.
First, many economists at the time cited the large US current account deficit. Normally, countries that run large deficits of this nature ultimately have to resort to currency devaluations because they can’t attract the foreign capital necessary to finance the deficit. The US, on the other hand, was in a different sort of boat. We have since come to realize (most of us, that is) that the US needed to run a structural deficit in its current account to counterbalance the current account surpluses run up by export-dependent countries like Japan and, especially, China. Because the US economy was so strong, US consumers were really supporting the rest of the world. The US economy was the only economy big enough to absorb the exports from these countries.
In our opinion, another, and perhaps more important, reason for the Dollar weakness after 2001, was the increasing loss of confidence in the leadership exhibited by the Bush administration after 2001. Midway through this period we also saw a change in the reins of control at the Fed, with Ben Bernanke replacing Greenspan. Although Bernanke may turn out to be an effective chairman (and, in our opinion is doing an extremely creditable job), at the time, his newness sparked concern.


Outlook

We believe the Dollar’s current outlook is related to factors similar to those that led to its decline beginning in 2001.
First, on a short-term basis, because of both the economic and financial crisis, the Fed has been forced to lower short-term interest rates to virtually zero. And because nominal rates cannot go below zero, the Fed has also had to resort to "quantitative easing" - increasing the money supply by buying up all sorts of securities. To do this, the Fed has in effect been creating money. The Fed’s balance sheet has swollen to more than $2,000 billion and could grow larger. Goldman, Sachs has forecast that that the Obama Administration will sell a record $3,250 billion worth of debt in the fiscal year ending September 30.
In normal times, money creation of this magnitude would be extremely inflationary. However, right now, deflation is a more immediate concern. Nevertheless, should the economy turn around, inflation could quickly become the real problem. And many analysts believe the Fed will be hard-pressed to soak up these excess funds. In perhaps an omen of times to come, this week the Fed offered to buy $7.4 billion in bonds and was flooded with $45.7 billion in offers.
This week, Bill Gross, managing director at Pimco warned that the US could be in danger of losing it AAA credit rating. Now, the US has never defaulted on its debt and a downgrade of this nature is probably not an imminent threat. But earlier in the week, Standard and Poor lowered its outlook for the UK’s AAA credit rating to "negative" from "stable", and investors were concerned enough to sell the Pound at the time. The Dollar fell sharply on Gross’s comments.
Treasury Secretary Tim Geithner (more on Geithner below) tried to calm investors’ fears by saying the Obama Administration was committed to minimizing the nation’s budget deficit to 3 percent of GDP by 2015 (this year it is expected to reach 12.9 percent of GDP). The Congressional Budget Office believes the Administration will only be able to reduce the deficit to 5 percent of GDP by 2015 and that it will then remain at that level for some time after that.
There are rumblings of trouble among the developing countries. China has already called for expansion of the SDR as a reserve currency and has established swap facilities (where China will swap its currencies for those of other nations) with a number of countries, especially in South America. And this week, China and Brazil announced they will begin denominating trade between their two countries in Chinese renminbi and Brazilian reals. None of these steps will have much of a short-term impact on the Dollar, especially since the value of global trade is such a small percentage of total currency movements. But, they could be harbingers of the future.
Our main concern about the Dollar, however, centers on the question of confidence in the US leadership at this critical juncture. Geithner’s performance to date has certainly been less than reassuring. His initial announcement of the bank bail-out program in February was a disaster for the markets. His subsequent clarification in March was an improvement in that he provided more details in what was to come. But, subsequent performance hasn’t borne out this promise. The stress tests, in the eyes of many observers, were less than stressful. No banks have been either nationalized or allowed to fail. All will apparently muddle through.
Nothing to date has been done about the toxic assets on the books of the banks and many observers question whether his plan can work.
There are a number of observers who believe that Geithner is in over his head. Unfortunately, many of these control the purse strings of the world’s money managers.
The bright spot, among the American leadership to date, has been Barack Obama. His approval ratings remain well above 60 percent. His speeches have been fantastic. Yet so far he has failed to accomplish anything. He has let Congress have its way on most of the projects he has championed, to the detriment of those plans. His honeymoon with international investors may not last much longer (and may already be nearing an end).
This lack of confidence in America’s leaders, on top of the other tangible factors, could be the factor that sends the Dollar plummeting. Unless, of course, Obama starts getting things done.
But where does one invest? The Euro is one likely candidate, but Eurozone GDP fell 2.5 percent in the first quarter, and is expected to show a 4 percent decline for the full year. Germany’s GDP alone is expected to fall 6 percent this year. The aforementioned UK has its own problems. Japan’s GDP fell 4 percent, quarter-to-quarter, in the first three months of the year, after dropping 3.8 percent, the preceding quarter. That foreshadows a double-digit decline in GDP for the entire year.
Dollar weakness will put upward pressure on the Chinese currency and it will be interesting to see whether the Chinese can continue to keep a lid on the renminbi.