The dollar declines in response to the drop in the target Fed Funds rate. What next?
The dollar has declined in value to record lows against the euro. It’s declined to a record low against a basket of currencies in the Fed’s basket of major currencies.
Figure 1: USD per EUR; up is dollar weakening. Source: St. Louis Fed FRED II.
Figure 2: Trade Weighted Dollar Value; up is dollar strengthening. Source: St. Louis Fed FRED II.
It’s important to recognize that the drop in the dollar’s value in response to the Fed’s action is only latest in a trend decline. From Bloomberg:
Dollar Near Record Low Versus Euro Before Bernanke’s Testimony
By Stanley White and David McIntyre
Sept. 20 (Bloomberg) — The dollar traded within a half- cent of its record low versus the euro before Federal Reserve Chairman Ben S. Bernanke’s congressional testimony on the mortgage market and economic growth.
Traders are betting the central bank may reduce borrowing costs further this year as the worst housing slump in 16 years threatens economic growth. The first U.S. interest-rate cut since June 2003 on Sept. 18 has pushed the dollar to a 15-year low against an index of six major currencies.
“We’re going to see a continuation of U.S. dollar weakness against the euro,” said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. “Bernanke will talk about the housing market and how that could flow through to the rest of the economy. The possibility of more U.S. rate cuts is completely open.”
The dollar traded at $1.3975 per euro at 9:18 a.m. in Tokyo from $1.3957 late in New York yesterday. It reached a record low of $1.3988 on Sept. 18 after the Fed’s rate decision and will finish the year around $1.42 per euro, Gibbs forecast. The U.S. currency was at 115.97 yen from 116.10 yen yesterday.
The U.S. currency has lost 5.7 percent this year versus the euro as traders bet the Fed would cut interest rates while the U.S. economy slowed. The European Central Bank’s benchmark interest rate is 4 percent.
The dollar’s losses may be limited against the euro on speculation investors will buy the U.S. currency to protect options that would become worthless should it weaken beyond triggers at $1.40. Investors use triggers to reduce the premium paid for currency options that grant the right to buy or sell a currency at a specific level on a predetermined date.
“Defensive dollar buying is picking up in intensity,” said Shinichi Hayashi, foreign exchange trader at Shinkin Central Bank in Tokyo. “I don’t think the dollar can fall very far against the euro.” The dollar may rise to $1.39 against the euro today, he said.
U.S. reports yesterday showed consumer prices unexpectedly declined 0.1 percent last month while housing starts fell to an annualized 1.331 million during August, the lowest in 12 years.
“The data validated the Fed’s view to take growth before inflation and to cut interest rates,” said Kathy Lien, chief currency strategist at DailyFX.com in New York. “The market is taking a break. The dollar is losing interest-rate support, and I think $1.40 against the euro is within reach this week.”
The New York Board of Trade’s Dollar Index comparing the U.S. currency against six primary peers, including the euro and yen, touched 79.091 yesterday, the lowest since September 1992.
The analysis laid out in this article is quite straightforward and makes sense. Weakening output growth in the US, combined with a Taylor-rule monetary policy, implies a weakening currency.
But, as I’ve discussed before, the dollar, like the euro and the yen, is a reserve currency. Indeed, it’s the pre-eminent reserve currency, and so the valuation of the dollar depends upon factors in addition to the standard macro ones (see here and here, and this paper). These include:
- Desired holdings by central banks.
- Relatedly, pegging to the dollar.
- Desirability of dollar assets, aside from rate or return (i.e., liquidity motivations).
- Invoicing of trade in dollars.
While the last point is unlikely to change rapidly, the second to last point is one where, clearly, conditions have changed. The share of dollar assets perceived as easily bought and sold has shrunk as the asset backed corporate paper has — if not frozen, then — slowed.
The first point, regarding desired holdings by central banks, could also change as the perception of the dollar’s trajectory is shifted more and more to a downward one (see here). While central banks do not have a primarily profit, or even mean-variance optimization, motivation, they must be somewhat concerned by returns on holdings.
Many students of central bank behavior will point to the fact that East Asian banks held low yield Treasurys for many years, with little apparent complaint. However, currency valuation changes can dwarf the effects of different interest yields. Recall:
“excess returns” = i USD – i * – E(USD %depreciation)
where USD denotes US dollar, a given non-US country currency, and E(.) denotes a subjective expectation.
The excess return on a dollar denominated asset could be very negative if a distinct trend appears in the the rate of dollar deprecation. Sufficiently negative returns might induce an attempt to reduce dollar holdings (proportionately, even if not in absolute dollar terms). Of course, this has been something that many analysts have worried about for many years, with those worries largely unrealized (see this post).
Fears of dollar collapse as Saudis take fright
By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:18am BST 20/09/2007
Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.
“This is a very dangerous situation for the dollar,” said Hans Redeker, currency chief at BNP Paribas.
“Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States,” he said.
The Saudi central bank said today that it would take “appropriate measures” to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.
As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy.
advertisementThe Fed’s dramatic half point cut to 4.75pc yesterday has already caused a plunge in the world dollar index to a fifteen year low, touching with weakest level ever against the mighty euro at just under $1.40.
There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries.
The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit — expected to reach $850bn this year, or 6.5pc of GDP.
Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America’s credit and short-term paper markets over the last two years.
“They were willing to provide the money when rates were paying nicely, but why bear the risk in these dramatically changed circumstances? We think that a fall in dollar to $1.50 against the euro is not out of the question at all by the first quarter of 2008,” he said.
“This is nothing like the situation in 1998 when the crisis was in Asia, but the US was booming. This time the US itself is the problem,” he said.
Mr Redeker said the biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen “carry trade”, causing massive flows from the US back to Japan.
Jim Rogers, the commodity king and former partner of George Soros, said the Federal Reserve was playing with fire by cutting rates so aggressively at a time when the dollar was already under pressure.
The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis.
“If Ben Bernanke starts running those printing presses even faster than he’s already doing, we are going to have a serious recession. The dollar’s going to collapse, the bond market’s going to collapse. There’s going to be a lot of problems,” he said.
The Federal Reserve, however, clearly calculates the risk of a sudden downturn is now so great that the it outweighs dangers of a dollar slide.
Former Fed chief Alan Greenspan said this week that house prices may fall by “double digits” as the subprime crisis bites harder, prompting households to cut back sharply on spending.
For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc.
The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc.
Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.
To the extent that demand for dollar assets falls in response to depegging or relatedly reserve diversification, yields on US dollar assets will have to rise or the dollar’s value will have be lower (unless dollar, euro, yen and other assets are perfect substitutes). CR calls this a “vicious cycle”; I’d call it a self-reinforcing feedback loop, but you get the idea.
Lest I be accused of doom-mongering, I should say that the change in central bank reserve behavior is (in principle) something that is desirable. An increase in the required rate of return on dollar assets — including Treasurys — is probably not desirable in of itself, although it might impose some disciplining on a spendthrift government. A lower dollar also spurs further expenditure switching away from foreign goods and towards US goods.
Of course, if the depegging happens in a discrete fashion (say, as all the central banks herd), then that would be problematic.
Postscript: Note that one has to be careful about interpteting the magnitude of the drop in the dollar’s value. If prices are sticky, then according to the Dornbusch monetary model of exchange rates , the dollar will overshoot on the way down its long run value.
foreign exchange reserves,
Federal Reserve, and financial balance of terror.