How Dangerous Is A Dollar Crash?
A falling dollar isn’t necessarily bad, if it falls gradually. The severity of the decline and the span of time over which the decline occurs will determine how much havoc it leaves in its wake. Havoc could come in the form of steeply increased interest rates, a falling or even a crashing stock market, increased import prices, higher inflation, larger federal budget deficits and soaring energy prices. If that’s not enough excitement, remember 1985 to 1987. During that period, the dollar fell 50% (a crash) against the other major currencies, inflation and bond yields rose and in October, 1987 the stock market crashed.
Here is how such a scenario could develop. Foreign traders, governments and investors sell the dollar on foreign exchange markets. The dollar declines in relation to the Euro, Pound, Yen and other currencies. As a result, the value of foreigners’ investments in U.S. stocks and bonds decline due to the currency loss in their home currencies. In conjunction with the currency decline, foreign investors stop buying U.S. stocks and bonds and start selling these holdings. Interest rates rise and bond prices drop. Stock prices decline sharply. That’s stage one. Then, a global recession begins. The steep decline in stock prices causes American consumers to lose confidence and in turn spending weakens. Foreign investors and governments stop buying U.S. Treasury securities, causing interest rates to rise, resulting in larger U.S. government budget deficits and higher interest rates for corporate America and all U.S. citizens. Higher interest rates mean higher servicing costs of total U.S. debt [total U.S. debt is already more than three times that of Gross Domestic Product (GDP)]. If the dollar falls, the Euro, Yen and Pound rise, making those countries’ exports more expensive and their industries slow down and stagnate. As a result, since Asia, Latin America and Africa export most of their goods to the major economies, those countries will end up in a recession as well. Since we are all interconnected globally, we end up in a dire economic situation – a full-fledged global recession.
At first glance, the above scenario seems improbable, but consider the following. Of all new government debt issued, 40% is purchased by foreigners. In fact, foreigners own 13% of U.S. stocks, 24% of domestic corporate bonds and 43% of Treasury securities. In short, foreigners can significantly influence the U.S.’s financial markets. Hopefully, much of the damage has been done. The dollar has fallen versus the Euro since its high of $0.82 back in October, 2000 to a $1.31 at the time of this writing a 59.7% loss in value. Bill Gross has been quoted that he believes another 50% loss is unlikely, but 20% could be in the cards. Numerous others, such as Robert Arnott, Warren Buffett, Stephen Roach (Morgan Stanley economist), Alan Greenspan, as well as other domestic and foreign portfolio managers and economists, believe the dollar has room to fall, if not crash. Some of these folks believe the U.S. is in a perfect storm scenario: a crashing dollar, soaring energy prices and rising interest rates, which bring back the stagflation memories of the Gerald Ford administration. While the most dismal forecasts likely won’t materialize, it is the factors that are driving the dollar down that are the most worrisome. These factors include:
- U.S. imports are 16% of GDP. Exports are only 11%.
- Trade deficits since 1990 have been largely caused by a U.S. growth rate of 3.0%, while Europe has grown by only 2.0% and Japan by 1.7%. The slower growth rates in Europe and Japan and a higher U.S. dollar have hurt U.S. exports.
- In 1990, the current account deficit (the imbalance in trade and investment flows) was $79 billion and 1.4% of GDP. In 2004, the current account deficit is $665 billion and 5.7% of GDP. It is expected to be between 6.5% and 7.0% by the end of 2005.
- Net cross border claims (the U.S.’s external liabilities) are currently 25% of GDP.
- At the current trend, UBS economists forecast that the current account deficit will reach 8% of GDP by 2010, at which point external liabilities would be 90% of GDP. If that occurs, the U.S. is in a non-recoverable situation. The same economists also believe that the dollar would need to drop to $1.70 versus the Euro in order to stabilize its external liabilities so that they don’t get any worse than they are now.
- China, Japan and other Asian countries own more than $1.2 billion in reserves. China alone has $523 billion in foreign reserves (most of it in U.S. dollars) and spends 9% of GDP on currency intervention, according to one report. This is partly an attempt to keep the Yuan (Chinese currency) in lockstep with the dollar.
- Private overseas investors are cutting back on their purchases of U.S. government debt, according to a recent Treasury Department report. Private foreign investors are now buying only 65% of the foreign purchased equities, down from 85% in 2003.
- The U.S. federal government budget deficit now exceeds $400 billion and the trade deficit is in excess of $500 billion.
- The U.S. now requires $2.6 billion every business day from overseas to fund the current account gap.
The latest slide (approximately 9.2%) of the dollar against the Euro since September from all reports seems to be the fact that most other nations lack confidence in the Bush administration’s economic policies, particularly its large budge deficits. That, coupled with the Republican’s plan to make some of the Bush tax cuts permanent and the plan to partially privatize Social Security cause Europeans to believe that the $413 billion budget deficit will become a permanent fixture and, if anything, grow dramatically worse. In fact, the German newspapers during a recent visit by U.S. Treasury Secretary John Snow have been calling him “Der Dollar-Killer” according to a recent article in Fortune magazine.
Actually, a weaker dollar, although the decline needs to be gradual, would be a boost for U.S. exports to Europe and Japan and would stem the flow of imports from both. However, it would not affect the amount of goods coming in from China because the Yuan is tied to the dollar. In fact, Europe and Japan would be hurt worse because China’s goods would be even cheaper.
To minimize this possibility, Japan is quite active in the currency markets by buying U.S. dollars, attempting to keep the dollar higher versus its own currency. European central banks since the early 1990s have decided not to intervene in the currency markets to date. As the dollar declines, they may begin to reconsider. In fact, most economists and currency experts believe that while currency intervention may work in the short run, it is ultimately doomed for failure in the long run.
As the dollar falls, probably causing U.S. interest rates to rise, ultimately the dollar will come back into equilibrium. While the dollar, as mentioned earlier, has fallen against the Euro almost 60% since October of 2000, it has fallen only about 15% against a basket of currencies since the 2002 peak. Also, since the beginning of 2004, the dollar has dropped about 11% against the Euro, 6% against the Yen and 10% against the Pound with the majority of the decline occurring since September. The speed of the decline is what has caused the recent uproar.
The fall of the dollar is a double-edged sword. While this is good for the U.S. economy in the short run, a rapid decline will cause severe financial difficulties for the world’s economy. However, because of the large U.S. trade deficit, many foreign economies benefit from our taste for imported goods, yet these are many of the same countries that complain about the U.S.’s need for their cash to fund our current account deficit. In all likelihood, if the dollar falls too rapidly, it will eventually correct itself. However, there will be a great deal of pain in the interim.
The best way to prepare for this type of pain would be to strongly de-emphasize U.S. intermediate and long term bonds as well as U.S. equities in portfolios. Instead, acquiring interest rate insensitive fixed income investments such as bank loan funds, money markets, adjustable rate mortgage funds, bond arbitrage funds, and probably Treasury Inflation Protection Securities (TIPS) – (watch next month for Risk-Controlled Investing’s article on TIPS) are better ways to play a falling dollar. If one is looking strictly at a currency play, unhedged foreign bond funds and emerging market bonds are other fixed income plays that will probably work well in a declining dollar market. On the equity side, foreign equities – both developed and emerging market – will provide protection. Commodities and hedge funds will probably provide the best equity-type returns. Portfolio managers that have broad mandates with regard to their potential universe of investments are desirable. These type investments and hedge funds may prove to provide the most optimal returns.
In any event, the picture is not very rosy. A prudent, non-traditional, risk-avoidance investment approach to avoid a crashing U.S. dollar, a severely overvalued U.S. equity market and the rising interest rate environment problems may be the only way to succeed from an investing standpoint over the next ten years.