Monday, September 22, 2014

The Counter-Intuitive Rise of the U.S. Dollar

by Charles Hugh Smith

As things get dicier globally, assets in periphery nations typically get dumped as mobile capital flees risk and migrates to lower risk core nations and currencies.


I received many thoughtful comments on Why the Dollar May Remain Strong For Longer Than We Think. Given the many weaknesses of the U.S.--ballooning social-welfare and crony-capitalist liabilities, free money for financiers monetary policies, etc.--a strengthening dollar (USD) strikes many as counter-intuitive.

The dynamic complexities of fiscal and monetary policies, global capital flows and the foreign exchange (FX) market complicate any inquiry, so I try to keep it simple.

In my view, the USD serves both transactional (global trade) markets and the global need for currency reserves (i.e. as a store-of-value). Sorting out the various influences on its relative value in each capacity is complex enough, but there is also the X Factor--the hard-to-quantify components of any currency's relative value.

For the USD, the X Factor is hegemony, which includes financial dominance based on debt issued/denominated in USD and what might be called the real-world assets of the issuing nation: that nation's food, energy and water security (what I call the FEW resources), its proximity to potential enemies, its external environmental costs, its overseas financial assets, the strength of its legal system in protecting private assets,its demographic profile and of course its ability to project power to defend its interests.

By these basic measures, the U.S. scores pretty well. We can get some perspective on this by putting ourselves in the shoes of wealthy people in periphery nations where the risks of capital controls, currency devaluation, etc. are perceived to be high, or in the shoes of corrupt elites in countries where they fear their ill-gotten gains might not survive blowback (hence the almost universal desire of elites to leave China with their loot).

The strength of the USD is attractive to at-risk capital, even if transferring at-risk wealth into dollars requires a significant foreign-exchange haircut. Better to preserve 75% of your wealth in USD than leave it exposed to confiscation, capital control, etc. This is the basic flight-to-safety mechanism.

Ubiquity also counts. The USD is the proxy global currency. A $100 USD bill is recognized as money virtually everywhere. If you're stranded just about anywhere, USD will buy you food, transport, official "assistance" via bribes, etc. No other paper currency is even close to ubiquity/recognition. (Clean, crisp $100 USD bills are recommended--dirty crumpled bills are not highly esteemed.)

It's also critical to look at the relative scale of the money-printing that erodes the value of currencies: -China's credit expansion is much larger as a percentage of its economy and financial system than the Fed's money-printing as a percentage of the U.S. financial system.

Then there's the scramble-for-yield issue: imagine you're managing $10 billion. You need to preserve this wealth but you also need to earn a yield, or you'll be fired at the end of the quarter. Since FX (foreign exchange) is a much larger market than stocks or bonds, you're highly attuned to FX so you don't get blindsided by a shift in FX that wipes out your yield. You might wisely build an "insurance" position in precious metals, but because you need yield then you have exposure to bonds, stocks and as a result, FX.

As things get dicier globally, assets in periphery nations typically get dumped as mobile capital flees risk and migrates to lower risk core nations and currencies.

For money managers, the USD is an FX safe haven--especially since the capital flowing out of the riskier periphery pushes the USD higher. This makes for a secondary yield--as the USD rises, any asset denominated in USD will gain in relative value. So there's a self-reinforcing feedback loop: as the USD value rises, it attracts more of the money fleeing risk.

In a way, the USD acts as a currency equivalent of the English language. There are many languages and many currencies, but at present the indispensable language/currency in the global economy is English/USD.

How can we summarize this discussion?

1. FX is the "master market" of the global financial system.

2. The flow of mobile capital out of the periphery into the core will turn into a flood as global risks rise.

Both of these conditions favor the USD.

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