This article was published by The McAlvany Intelligence Advisor on Monday, August 19, 2019:
Few financial commentators are willing to say what they really think about the tenuousness of the world’s financial system. They refer to the U.S. dollar as the world’s “reserve currency,” that somehow the Bretton Woods agreement in 1944 and the construction of the International Monetary Fund and the World Bank assured the stability of the newly established paper money system. When Nixon repudiated what remained of those gold-backed promises by “closing the gold window,” all that was left was the paper.
Brian Chappatta, a holder of the coveted CFA designation, is one of just 150,000 charterholders worldwide who passed the four years of intense study successfully to achieve it. He is in the company of worthies like Bill Gross, the founder of PIMCO. He was able to get his views published by Bloomberg, which prominently displayed its disclaimer: “This column does not necessarily reflect the opinion of the editorial board of Bloomberg LP and its owners.”
And no wonder. Chappatta treads where few care to:
Like most people, I aim to avoid existential dread. I try not to think about the fragility of the vast interconnected global economy or the complicated infrastructure systems that we take for granted, or what would happen if the social contract broke down.
Usually, that’s not too difficult. Lately, however, American politicians’ reckless attitude [that would include President Trump and a number of Democratic presidential posers] toward the U.S. dollar has made me consider those uncomfortable thoughts … they’re putting at risk a policy that could bring the financial ecosystem to its knees.
At issue is a weaker dollar. The real issue is whether a weaker dollar could trigger the avalanche of selling that could bring that “financial ecosystem to its knees.” Mr. Trump wants a weaker dollar, for two reasons. First, he is determined to keep two of his primary campaign promises: a stronger U.S. export industry and a smaller trade deficit. Second, he is running for reelection.
At the moment, his strategy consists of using his Twitter account to accuse China of manipulating the value of its currency while at the same time pressuring the Fed to lower interest rates. But he could move beyond Twitter by ordering the U.S. Treasury (over Secretary Steve Mnuchin’s objections) to buy more foreign currencies, forcing their values higher. Meanwhile the Fed appears to be open to reducing interest rates further in the coming months. It has already announced the ending of its balance sheet roll-off two years earlier than planned. In effect, that is an admission that “easier money” is a good thing.
Is this a good thing? Will a cheaper dollar achieve the president’s objectives? Or will he be setting the stage for a catastrophe most commentators are studiously avoiding?
Let’s first consider the benefits of a weaker dollar. Foreign buyers of American goods would find that their currencies buy more U.S. exports. Higher prices of foreign goods would reduce those imports into the U.S., closing the trade gap. As Max Ehrenfreund noted in the Washington Post: “If foreigners can buy U.S. dollars cheaply, products made in the United States become cheaper for them. As a result, there is more demand for U.S. exports – a shift that would help Trump achieve his ongoing promise to reduce the U.S. trade deficit.”
The U.S. dollar, compared to foreign currencies, has been getting stronger. The ICE Dollar Index, which measures the purchasing power of the U.S. dollar compared to a basket of six foreign currencies (the euro, the Japanese yen, the pound sterling, the Canadian dollar, the Swedish krona, and the Swiss franc), is close to its highest level in more than two years. The much broader trade-weighted U.S. Dollar Index published by the Federal Reserve Bank of St. Louis reveals that the U.S. Dollar has increased in value, relative to the world’s currencies, by more than 12 percent in just the last 19 months.
Let’s put this into perspective. Exports amount to about 11 percent of the nation’s gross domestic product, or about $2.4 trillion in a $22 trillion economy. The rest of the economy consists of American consumers purchasing homemade and foreign-produced goods.
A stronger dollar has numerous benefits for Americans. A dollar now buys 12 percent more of foreign-made goods than it did less than two years ago. That means that importers of foreign goods such as Walmart are paying less for them and passing the savings on to the U.S. consumer.
A stronger dollar is good for the housing industry. It takes around 400 pounds of copper and thousands of board feet of lumber to build a single-family home. Those commodities are traded in dollars, which make them cheaper.
A stronger dollar is good for oil refiners. Since oil is traded in dollars like lumber and copper, a refinery gets more crude for their dollar, which lowers gas prices for consumers.
A stronger dollar keeps price increases in check. It’s no wonder that the Fed continues to be surprised that its measure of inflation, the PCE, continues to come in under their two-percent threshold. If the dollar buys more, that means that prices are declining, not increasing. Please note: the Fed wants the dollar to continue to lose value at the rate of two percent a year. The fact that it is losing value more slowly is a bad thing to the central bank, not a good thing.
A stronger dollar makes it more attractive to investors, especially those buying bonds, for two reasons: The dollar is the world’s de facto reserve currency (more than 90 percent of the world’s economic transactions use the dollar), and the U.S. Treasury continues to pay interest at rates far above those offered elsewhere.
That last point is critically important in understanding the risk of a potentially weaker dollar. The U.S. Treasury has sold some $22 trillion worth of government bonds, but interest rates have remained low. At present, the federal government is only paying about 1.5 percent interest to investors (buying 10-year Treasuries), who are happy to receive it. This is keeping the federal deficit far below where it otherwise would be.
But if the president is successful in jawboning (tweeting) the dollar down, it could trigger an event that most commentators are not touching. Treasuries could lose their luster, higher costs of basic materials from abroad – steel, oil, copper, lumber – could trip up the economy, which would reduce tax revenues. This would force the Treasury to sell more bonds to cover the increased deficits into a market that has lost its appetite for them. Putting it another way, a weaker dollar could set off an irreversible downward slide: first the economy, then tax revenues, then widening deficits, then more issues of Treasury debt to cover them, forcing bond investors to conclude that the U.S. government isn’t the AAA-rated credit risk they have long believed (or hoped) that it is.
Fools rush in, it is said, where angels fear to tread. Credit to Chappatta who not only is no fool, but is willing to tread where most commentators won’t.
TheStreet.com: 10 Reasons to Love the Strong Dollar
The Wall Street Journal: Dollar Towers Above Rivals, Posing Fresh Threats to Financial Markets
Bloomberg.com: Brian Chappatta: Don’t Fall Into the Weak-Dollar Trap
WorldBank.org: Exports as a percentage of GDP: 12.1 percent
StLouisFed.org: One year chart of PCE: 1.6 percent inflation