Monday, March 9, 2009

The Strong Dollar Paradox

I touched briefly this morning on the paradox of the strong dollar as the economy collapses. After all it is none other than Ben Bernanke who acknowledges that one of the key things Roosevelt did to drag the U.S. out of the first great depression was the dollar devaluation, i.e. taking the U.S. off the gold standard. If no one else, he should be quite aware of the irony of facing another depression with the USD again serving as the de facto reserve currency (Kyle Bass in his fascinating letter also touches on this). How should mere non-Fed Chairman mortals interpret this dichotomy?

An interesting point of view comes from Mike O'Rourke, who provides an objective evaluation of the pitfals and possible opportunities of an overvalued dollar. We present it here.

Market Observations from Mike O'Rourke of BTIG

As economic data and market prices continue to deteriorate, the Dollar has continued to strengthen. Until September 2008, many believed that the Dollar had lost its status as the reserve currency of the world. As the bottom fell out of both the economy and the market, the Dollar index has rallied in a global flight to quality and the Dollar has quickly regained its status as reserve currency. As assets have been liquidated throughout the global financial markets, the resulting cash has quickly been converted to Dollars, which have flocked to the safe haven obligations of the U.S. Treasury. One does not need to look any further than the chart below to see that the strong Dollar has hurt Equity prices. It is classic beltway irony that we have a strong Dollar at such an inopportune time.

One cannot help but to wonder how the strong Dollar fits into the Fed Chairman’s thinking. Among the actions widely believed to contribute to the speculation of the 1920’s was the Federal Reserve’s decision to follow a highly accommodative monetary policy in the twenties to support Great Britain’s return in 1925 to the gold standard at pre-war levels. Great Britain was among the first economies to abandon the gold standard in 1931. It was joined by 13 other nations. In retrospect, the gold standard is believed to have been too rigid to accommodate the necessary expansion of monetary policy during the Depression. In the Fed Chairman’s book, Essays on the Great Depression, he discusses the influence of the gold standard on industrial production. “While the countries which were to abandon the gold standard in 1931 did slightly worse in 1930 and 1931 than the nations of the Gold Bloc, subsequent to leaving gold these countries performed much better. Between 1932 and 1935, growth of Industrial Production in countries not on gold averaged about seven percentage points per year better than countries remaining on gold, a very substantial effect.”

The Fed Chairman discussed the U.S.’s 40% devaluation of the Dollar versus gold in his deflation fighting playbook speech of 2002, when he was a Fed Governor. As recently as a week and a half ago, during the Senate side of the Chairman’s Humphrey Hawkins testimony, the Fed Chairman again cited the devaluation. Senator Brown asked Bernanke about FDR’s response, “Specifically, what worked that Roosevelt did? What did we learn from that? What worked that applies to us now?” Bernanke responded, saying, “Well, there were two things that he did almost within months of taking office that were extremely important. One was the bank holiday and the subsequent measures, like the deposit insurance program that stabilized the banking system. And it's a point I've been making all morning, that we need to stabilize the banks. The second thing he did was to take the U.S. off the gold standard, which allowed the Federal Reserve to ease monetary policy, allowed for a rise in prices, which, after three years of horrible deflation, allowed for recovery.”

In Congressional testimony, the Chairman has analogized the “stress test” to FDR’s bank holiday. It is the first part of the movement to stabilize the banking system. Once the stress test complete, every major financial institution in the country will have access to the capital necessary to survive any additional downturn in the economy through the Capital Assistance Program (CAP). The other key program to stabilize the banking system is the Public-Private Investment Fund (PPIF). In addition, TALF 1 and TALF 2 are intended to re-start the shadow banking system. This brings us back to the Dollar. In a fiat currency world investors are flocking to the U.S. Dollar as a reserve currency as they would under a Gold Standard. The question is whether we are running the risk of history repeating itself. Considering the only person we have quoted in this note is the Fed Chairman himself, one would think he is fully aware of the consequences of the Dollar’s strength. The question then becomes why permit such strength. The first and most obvious consideration is that the Treasury needs to sell $2 Trillion of Government Securities this year. With low current yields, the currency strength is a key attraction to buyers. Permitting the Dollar to strengthen aids Europe in taking on its economic challenges, which are deemed by many to be more severe than those here in the U.S. At some point, the rise in the Dollar will either be halted, or will halt on its own. It could (and should) happen on its own. Potential catalysts are fears about the deficit, which may only finally be realized as Treasuries’ issuance begin to push yields higher, or another catalyst could be the expansion of the Fed’s balance sheet. The Fed and Treasury should use the strength as an opportunity to provide liquidity to the markets soon, which would help cap the Dollar’s strength. One interesting item to note is the strength that commodities have exhibited in a strong Dollar environment. Imagine their potential to run if and when the Dollar weakens.

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Unknown said...

Dollar up 20%, SP down 50%. These things aren't equal as the graph suggests.

Doesn't the unwinding of the carry trade also contribute to the dollar's rise?

Anonymous said...

"The question then becomes why permit such strength. The first and most obvious consideration is that the Treasury needs to sell $2 Trillion of Government Securities this year. With low current yields, the currency strength is a key attraction to buyers."

I'm not sure I buy that. If I am an overseas investor considering buying Treasuries, I should prefer it if the Dollar is weak today, but stronger in the future when I decide to sell. In other words, I would be looking at some capital appreciation to compensate me for the very low current interest rate.