Dollars on Sale, 30 Percent off

By Richard Benson              May 8, 2006 http://www.sfgroup.org

The dollar was once the almighty dollar. It became the world reserve currency. Every investor and government wanted dollars over all other currencies. Those were the glory days for the economy but now it appears the United States has been running a trade deficit for so long that is so large, those glory days are nearing an end. It may be time to sell your dollars before the upcoming 30 percent off sale.

When the Federal Reserve cut short-term interest rates to one percent, the dollar versus the euro adjusted down from 85 to 125. In retrospect, the decline in the dollar should have lowered the trade deficit – as foreign goods became more expensive in America, and American goods became cheaper abroad – but that didn’t happen. Instead, we took advantage of lower interest rates to borrow against our houses and spend more, so the trade deficit has just kept on growing! Americans now spend approximately $800 billion more than they make each year; a mind-numbing amount of money! To paraphrase an election slogan we remember hearing from former President Clinton, “It’s about the trade deficit, stupid”.

Currencies in every country need to adjust from time to time to close trade deficits. Trade deficits reflect more purchases (than sales) of goods and services abroad, and are financed by the flow of financial capital. Since Americans don’t save, capital, as well as goods, must flow into our country to pay for the trade deficit. (Indeed, the trade deficit creates a financial deficit.)

The fact that our federal government spends more than it taxes, adds to the problem. This basically means that our government is borrowing $400 billion at the same time it needs to find lenders willing to cover the $800 billion needed to finance the trade deficit. Congress has let spending run out of control, pushing up the Treasury’s need to borrow.

It also doesn’t help that we have a war President who has not used the spending veto – and is not likely to in an election year – and only wants to spend more on his war.

You may wonder where all the money comes from to pay for all those extra goods and services bought abroad by spendthrift Americans who don’t save a penny, especially when this spending is not matched by earnings from selling America’s goods and services abroad.

To finance our trade deficit of seven to eight percent of GDP and encourage the buying of dollars worldwide, a form of “financial bribery” through interest rate differentials has been used. Up until now, it has worked like a charm with investors, speculators and hedge funds to place hundreds of billions of dollar assets. For instance, as the Fed raised interest rates well above those paid on euro and yen accounts, a lot of money was made by borrowing low-cost euros and yen, and then investing them in higher-yield dollar assets.

Remember, it has taken a widening interest rate differential just to keep the dollar stable. A falling interest rate differential between what investors can earn in dollars, euros and yen, etc., will be the death of the dollar as hedge funds (loaded up with dollar assets) begin to unload them.

In addition, virtually every central bank in the world has been buying U.S. financial assets. Without this continued magnitude of buying, the dollar will fall. Why is there such enormous buying of dollars from world central banks? To start with, the Japanese, Chinese and Asian central banks have found it in their commercial interests to buy dollars to prevent their own currencies from appreciating. (China and Japan now hold about a trillion dollars each.) In addition, the United States government uses political blackmail and the arm-twisting of our allies and their foreign central banks, to buy dollars. Two clear examples are the Gulf Arab States stashing their earnings on oil, and the United Kingdom helping to fund the “oil” war in Iraq.

We may see a slight shift in global trends in the form of a sell-off of the dollar as central banks worldwide seek a buffer from the burgeoning U.S. trade and budget deficits.

Developing countries have for years been told that building up U.S. dollar currency reserves was the best way to maintain financial stability in their countries.

Now that the Fed has slowed raising interest rates in our country, interest rates are creeping up in Europe, Japan, China and the rest of Asia, making these currencies more attractive. However, the Fed realizes there could be a significant economic slowing and the winding down of the housing market (with declines in home sales, new home construction and housing prices) will surely guarantee the interest rate differential will shrink.

More importantly, the G7 and the IMF have gone on record to say that currencies need an adjustment; a very big adjustment! This implies that Asian currencies must go up and the dollar must go down. Also, it will be virtually impossible to prevent the euro (as well as the currencies from countries that sell oil and other resources) from going up against the dollar.

In order to fully understand what is really happening on the central bank front, Larry Summers is worth listening to, now that he is free of all the politics at Harvard. Mr. Summers who served in a series of senior policy positions – most notably as the secretary of the treasury of the United States – specialized in the currency markets. Indeed, he was “the man” who successfully engineered foreign central bank gold sales to help hold the price of gold down and make the dollar look strong!

Mr. Summers is now urging the poorer, smaller countries with excess dollar reserves, “to do something with them”. Perhaps his advice is to sanction foreign aid, but I suspect he may be encouraging these smaller central banks to swap out of dollars early before the big banks do. This would preserve the real value of their foreign exchange reserves, and save the IMF a lot of money down the road for not having to bail them out.

Just remember, when someone yells fire in the move theatre, you want to be sitting in the back row near the exit door, so you can get out before it’s too late. Larry Summers has just yelled “fire”.

The dollar is in grave danger because there are hundreds of billions of dollar assets funded by hedge funds that will be sold. Worldwide, central banks are beginning to buy fewer dollars at a time when the U.S. needs new buyers of dollar assets to fund our escalating trade deficit.

If America, as a matter of policy, is going to let the dollar go, there are many investments you must not own as an investor or saver: One investment is dollar-denominated bonds. A falling dollar is very inflationary. As inflation rises, it forces interest rates up so you’ll lose on the currency devaluation, as well. U.S. Stocks will fight the headwinds of inflation and may go up in dollar terms, but they will most likely not keep pace with inflation.

When the dollar is declining, if you own paper-assets denominated in dollars (cash, stocks or bonds) sell them and wait for the dollar to crash before going back to owning dollar assets. The dollar could fall 20 to 30 percent before there is a material improvement in the trade deficit. You should, instead, consider owning real assets: Gold, silver, other precious metals and commodities, come to mind.

For investors who prefer being in cash, it’s not easy but it is possible to open up a foreign currency account. Everbank even offers foreign currency CDs insured by the FDIC, and there is a new, short-dollar currency fund offered by RYDEX Funds that offers a two-percent increase in value for every one-percent the dollar goes down.

So, if you truly value a good night’s sleep, and the thrills and terror of the stock market have you spinning, put your money in cash, just not dollar cash!

Richard Benson
President
Specialty Finance Group LLC
Member NASD/SIPC
www.sfgroup.org
800-860-2907