The global financial system is in a state of bedlam – just ask anyone whose 401k had WM, BSC, LEH, AIG, GM, or Citi in it. And then there is the US, which has run historically large current account, trade and budget deficits over the last decade. One would think that the US with an est. 2007 current account deficit of 731 billion, a trade deficit this year of about 700 billion and perhaps the first ever 1 trillion dollar government deficit next year, should be facing a run on its currency in the wake of this credit crunch. But in reality, quite the opposite is happening.
Why?
Despite all of the fundamental problems with the US dollar, people around the world still want to hold greenbacks. Why? Firstly, and in my opinion most importantly, the US has an unbeatable military. I don’t think this factor can be underestimated when considering why a group of people chooses the currency it denominates their assets in. Secondly, the dollar has been seen historically as a reserve currency with the best liquidity on the planet. That is, the fact that so many people are trading the dollar makes it a more attractive investment as high liquidity, you guessed it, reduces liquidity risk. Moreover, the recent run-up in the dollar can be largely attributed to an international flight to quality. In And I think this flight should be able to silence any economists out there who are still trying to argue that the rest of the world has decoupled from the US.
In short, the US economy is bad, but it is still seen as one of the safer places to park one’s wealth.
Is the Rally sustainable?
In my opinion- highly unlikely. The fundamentals for the dollar are too bad for it to stay at these unsustainably high levels. Once the world panic subsides, which could be in 6 months, 2 years, or 10 years, then the dollar is going to resume its slump towards a reasonable valuation. In my opinion, after this crisis is over, the rest of the world is going to think twice about holding dollars as their primary reserve currency and diversify into holding a basket of currencies. Right now there are too many dollars out there – the Asian appetite for dollar denominated debt will have to be satiated at some point, it’s an eventuality. What is that point and when will it happen? I don’t know I assume I will see a “run on the dollar” or several decades of dollar positions unwinding, at some point in my lifetime.
The current system is not sustainable. Don’t get me wrong it was great while it lasted – Chinese appetite for debt kept interest rates low and their cheap source of labor kept inflation low. But the day will come when the US debts come due. My advice - keep a short biased on the dollar long term, and make sure you diversify your assets (especially your retirement funds) globally. The home biased is tempting, but it is also very dangerous. I would suggest looking at globally diversified ETF’s from iShares. Also, I would recommend taking advantage of this dollar strength to diversify outside the US if you have not already done so.
Conclusion
In the past the mantra has been “America sneezes and the world catches the flu.” I think today it is more appropriate to say “America catches the flu, and the rest of the world panics (who is going to buy our stuff?) and decides to pay the medical bills.”
Disclosures- None
