Is The U.S. Dollar Set To Spike?

September 8, 2013

NEW YORK (Sept 9)  So markets wait with bated breath on the words of a bearded academic-turned-central-banker on September 18. Bond king, Bill Gross of Pimco, probably has it right suggesting Ben Bernanke and his Fed have already agreed on a small cut to QE even though economic data out of the U.S. has shown only marginal improvement. I’d add that that Bernanke and his minions would remain concerned with rising bond yields and interest rates and if both head higher in the months ahead, all bets on further QE tapering are likely to be off. Perhaps the word “re-tapering” may soon enter the financial lexicon?

Today I’d like to step back from the “will he or won’t he taper” debate and look at an interesting, and still minority, view developing that there are structural factors beyond QE tapering which may drive both the U.S. dollar and U.S. bond yields higher in coming years. The argument goes that an energy boom in America will result in a further decline in the U.S. trade deficit, reducing the number of U.S. dollars being supplied to the global economy and thereby creating a scarcity of U.S. dollars which will inevitably push the currency higher. A reduced U.S. trade deficit will also result in contracting foreign exchange reserves for overseas countries, reducing foreign demand for U.S. Treasuries and pushing up government bond yields which will help the dollar further. 

Don’t worry if you didn’t get the full thread of the argument as I’ll lay it all out for you below. Suffice to say though that if the view is correct, it’ll have enormous ramifications, including for our neighbourhood of Asia. For instance, it may mean the recent currency turmoil in Asia is only a taste of things to come (higher U.S. yields leading to reduced flows into Asia ie. tighter liquidity).

I don’t happen to agree with much of the argument and will outline why. But it seems like a debate worth having as it goes to the heart of some of the key issues which will drive economies and markets going forward. 

Does America’s energy boom change everything?

Here’s a theory: the majority who read my newsletter on a regular basis agree with most of what I have to say. Don’t worry, I’m not trying to be arrogant or belittle but just to point out that science suggests that people primarily read things which confirm their pre-existing biases and views. It’s called confirmation bias and everyone does it to an extent.

Today is my attempt to shake things up. To offer a well thought-out view which is contrary to my own and perhaps yours. This particular view has made me question and re-examine some of my beliefs and perhaps it can have the same effect on you.

The view is that there are structural trends which will lead to a higher U.S. dollar and higher U.S. interest rates. It’s a line that’s been pushed by some stock brokers over the past year. But financial blogger, Charles Hugh Smith is perhaps its most thoughtful proponent.

In his most recent article, “America’s Energy Boom and the Rising U.S. Dollar”,  Smith puts forward a strong case. He argues that to understand the trends which will lead to a higher dollar, you need to appreciate why the U.S. currency is the world’s reserve currency. And he suggests that it’s because the U.S. is willing to provide the world with an extra supply of the dollar to fulfill global demand for the reserve currency and thereby cause a trade deficit (where imports exceed exports). Put another way, the U.S. must export U.S. dollars by running a trade deficit to supply the world with dollars to hold as reserves and to pay debt denominated in dollars.

Of late though, the U.S. trade deficit has been falling. In June, the deficit hit four-year lows, before increasing again in July. The fall is primarily attributed to America’s energy boom. The U.S. has been able to provide more of its own energy. That’s significant because oil imports account for 40% of America’s US$750 billion annual trade deficit. And the importing of oil has been the main reason why the U.S. has been running trade deficits for decades. Remember too, trade deficits negatively impact GDP.

(Source:   James Gruber...FORBES)

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