Rationale & Method of a Dollar Decline
The Rationale: Background Check for a dollar decline
If the 19th century was dominated by the British Empire, the 20th century by the United States; we
may now be entering the Asian century, dominated by a rising China and its currency. While the
dollar's status as the major reserve currency will not vanish overnight, we can no longer take it for
granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the
Chinese yuan. This would have serious costs for America.
Traditionally, empires that hold the global reserve currency are also net foreign creditors and net
lenders. The British Empire declined - and the pound lost its status as the main global reserve
currency - when Britain became a net debtor and a net borrower during World War II. The US is in a
similar position today. It is running huge budget and trade deficits, and is relying on the kindness of
restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets.
The resulting downfall of the dollar may be only a matter of time.
But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor
reserve currencies. Gold is still a barbaric relic whose value rises only when inflation is high. The
euro is hobbled by concerns about the long-term viability of the European Monetary Union. That
leaves us the yuan.
China is a creditor country with large current account surpluses, a small budget deficit, much lower
public debt as a share of gross domestic product than the US, and solid growth. And it is already
taking steps towards challenging the supremacy of the dollar. Beijing has called for a new
international reserve currency in the form of the International Monetary Fund's special drawing
rights. China will soon want to see its own currency included in the basket, as well as the yuan used
as a means of payment in bilateral trade.
At the moment, though, the yuan is far from ready to achieve reserve currency status. China would
first have to ease restrictions on money entering and leaving the country, make its currency fully
convertible for such transactions, continue its domestic financial reforms and make its bond
markets more liquid. It would take a long time for the yuan to become a reserve currency.
China has already flexed its muscle by setting up currency swaps with several countries and by
letting institutions in Hong Kong issue bonds denominated in yuan, a first step towards creating a
deep domestic and international market for its currency. If China and other countries were to
diversify their reserve holdings away from the dollar - and they eventually will - the US would suffer.
It has reaped significant financial benefits from having the dollar as the reserve currency.
In particular, the strong market for the dollar allows it to borrow at better rates. It has thus been
able to finance larger deficits for longer and at lower interest rates. It has been able to issue debt in
its own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar
to its creditors. Having commodities priced in dollars has also meant that a fall in the dollar's value
doesn't lead to a rise in the price of imports.
Now, imagine a world in which China could borrow and lend internationally in its own currency. The
yuan could eventually become a means of payment in trade and a unit of account in pricing imports
and exports. Americans would pay the price. They would have to shell out more for imported goods,
and interest rates on both private and public US debt would rise. The higher cost of borrowing could
lead to weaker consumption and investment, and slower growth.
This decline of the dollar might take more than a decade, but it could happen even sooner if the
Americans do not get their financial house in order. The US must rein in spending and borrowing,
and pursue growth that is not based on asset and credit bubbles. Americans need to shift their
priorities. This will entail investing in their crumbling infrastructure, alternative and renewable
resources and productive human capital - rather than in unnecessary housing and toxic financial
innovation. This will be the only way to slow down the decline of the dollar, and sustain America's
influence in global affairs.
The US dollar Drivers
Almost all the international trade in oil is conducted in US dollars, which means, according to some
that a higher price of oil will create additional demand for dollars and, therefore, that a rising oil
price is bullish for the dollar. This 'logic' is back-to-front, however, because one of the main reasons
for the higher US$ oil price is WEAKNESS in the US$.
It is true that higher prices will tend to increase the demand for a currency (if prices are higher then
more money will be needed for each purchase), but this is not a 'chicken or the egg' situation
because prices wouldn't have risen in the first place unless there had been an increase in the supply
of the currency relative to the demand for the currency. The way it works is that inflation (growth in
the supply of money) causes the purchasing power of a currency to fall, resulting in an increase in
the demand for the currency. (The current price of anything, including currencies, is, by definition,
the price that brings supply and demand into balance; so an increase in supply will always lead to a
corresponding increase in demand and, most likely, a lower price). But if this increase in currency
demand is followed by a further increase in currency supply then more purchasing power is lost,
prices rise again and more currency is then needed to complete each transaction (there's a further
increase in the demand for currency). This process will continue until the currency becomes
completely worthless or until the inflation ends.
The argument is, in effect, that a loss in the dollar's value relative to oil is BULLISH for the dollar,
which implies that the faster the dollar loses its purchasing power the more bullish it will be. This is,
of course, ridiculous. Another fallacy is contained in the following statement: "Given that the world
needs US$ to trade, the US is sort of forced to run a current account deficit and export US$
(otherwise, how would Nokia get the US$ to fund its purchases in Taiwan?). This explains why
improvements in the US current account deficit usually lead to global economic meltdowns
somewhere in the world - all of a sudden, there are not enough US$ to go around...".
The fact is that the world could make do with almost any quantity of US dollars; the purchasing
power of the US$ would simply adjust based on the dollar's supply relative to its demand. Obviously,
if the global supply of dollars were to suddenly contract then this could cause big problems because
today's price levels for assets, debt, commodities, and everything else are based on the current dollar
supply. However, if dollar inflation had been consistently lower over the past 20 years such that the
total supply of dollars was now half its current level there would be no dollar shortage; instead, each
dollar would buy, on average, twice as much as it currently buys.
We are in full agreement with the notion that a contraction in the US current account deficit would
be accompanied by a global economic downturn, but implying that the reduction in the current
account deficit was the root cause of the subsequent economic downturn would be akin to saying
that a lack of drugs was the root cause of the sickness felt by a drug addict who was trying to 'kick
the habit'. The financial system has become addicted to a high level of inflation and the solution,
according to many others, is to continue 'feeding the habit'.
On a side note, there will be no danger of the gold bull market coming to an end as long as
continuing to 'feed the habit' is widely believed to be the right economic remedy.
From trade deficits to budget deficits to GDP-growth differences to the absurd "massive dollar short
position" theory, we never cease to be impressed by the large number of irrelevant factors that are
regularly put forward to explain and forecast currency exchange rates. In our opinion, the only
things that matter over long time periods (periods exceeding 5 years) are inflation rate differentials.
Specifically, if Currency A is inflated at a faster rate than Currency B over a long period, causing it to
lose its purchasing power at a faster rate, then Currency A will be in a long-term downward trend
relative to Currency B. End of story.
Over shorter time periods (periods of 6 months to 2 years) the only things that matter are real
interest rates and interest rate spreads, where the real interest rate is calculated by subtracting the
EXPECTED rate of currency depreciation from the nominal interest rate. Interest rate differentials
suggest that the dollar's exchange rate is going to be higher in 6 months time than it is today.
A Methodical Dollar Decline and technical chart outlook
Perhaps one of the key themes which is fairly clear is that the global monetary system is in strong
need of re-alignment. Profligate central banking practices virtually guarantee a new cycle of
competitive currency devaluations in the years ahead in what will most likely be a controlled
decline. At the moment, it is in virtually no one’s interest, including China, to see the US Dollar
collapse in a hail of bullets. The resulting currency market turmoil would drive rates up around the
world, and would further cripple any prospect of even marginal growth. In fact, it is not an
exaggeration to suggest that a major uncontrolled currency crisis at this juncture could easily send
the world in a second Great Depression, which would fuel protectionist fires in virtually every corner
of the globe.
For this reason it is very unlikely that the greenback will be cast asunder in unceremonious fashion.
For China and other US Creditors, the path ahead is likely two-fold. First, to work within the system
and seek reform of the monetary mechanism with the IMF and possibly using the SDR’s, -- special
drawing rights -- as a means of correcting the long term trade imbalances. Much discussion in recent
days has focused on realigning the SDR basket which is based on the value of export trade and a
country's individual reserve backing. Since this process of haggling out an updated mechanism will
likely take some time, creditor countries like China are also likely to, and probably have already
begun, a stealth diversification process where Dollar holdings are reduced.
Since Dollar creditors like China find themselves in a ‘prisoners dilemma,’ where bold steps quickly
backfire with severe repercussions, the odds are high that China will seek another recourse. Since
China is the primary creditor, the one high card that it presently holds is the ability to dictate when
(and if) a crisis is going to occur. A currency crisis would only be evoked by a major creditor nation.
In the case of China, by avoiding obvious Dollar divestitures, the Chinese can gain ‘time’ which at
the moment is their most valuable asset.
For China, additional ‘time’ means they can hope to install and see the benefits of a reshaping of
their economy to one which shifts the focus over time from an export based model to a domestic
consumption based model. China knows this process will probably take 10 years, but has a long run
view of things, not often found in the. As a result, it is very likely that China will try to hold back
the ‘dollar dam from bursting’ as long as they possibly can. This is not to say that a highly
inflationary Dollar crisis may not erupt at some point in the years dead ahead. At the present time,
the US Federal Reserve is embarked on the grandest monetary experiment possibly ever seen. It is
highly debatable for how long global confidence will ‘hold together’ enough to prevent a self-
reinforcing Dollar panic.
Panics and crashes are in and of themselves the result of crowd psychology and herd thinking. It is
possible that even with a number of major creditors trying to forestall a future currency collapse that
such a collapse could develop in time as a result of rapidly deteriorating budget outcomes, and what
could be an ever escalating set of future demands for rolling over sequentially greater and greater
quantities of debt. Once embarked upon, many countries have found that the inflationary trend-mill
knows only one direction-that of escalating, sequentially higher speeds. For the US, the current
central bank money creation scheme seems to point to the idea that as time passes, it may be harder
and harder to disembark the easy money policy, and draining excess reserves could be far too painful
For participants new to the markets it is worth understanding a typical picture that often precedes a
major panic. Unlike the popular conception that ‘panics’ tend to hit out ‘left field,’ a fair amount of
time they act as an exclamation point of sorts to a market trend that had been in force for some
time, often years. While we are not saying that there are not occasions when crisis can erupt from
‘thin air,’ what we are saying is that a lot of the time, real panics tend to come from trends that have
already been in motion for some time. The classic picture of this outcome is the curvilinear decline
where a market down trend slowly gains increasing downside momentum over a long period of time.
Eventually, the building downside momentum snowballs into a full-blown crisis, and prices fall
precipitously in a short period of time.
This is then followed by an extended period of stabilization, stability and usually reform. In the case
of the US Dollar and today’s monstrously unbalanced global trade condition, this kind of outcome
makes sense when one starts to look at the individual motivations of all countries involved, and
some of the policies and demographics that could define the path ahead.
In the next chart ( above )we show a long term chart of the Dollar, with the dashed lines showing how
a slow building exponential decline could develop in the years ahead. We do NOT attempt any level of
exactness in our diagram, and include the chart simply to illustrate THE IDEA that a future Dollar
Crisis could be an event that we build into slowly and steadily at first, and then more rapidly through
the passage of time. In the final analysis, the worst portion of a potential Dollar crisis may not be
seen for several years or more.
For investors a steadily developing curvilinear decline in any asset can be an excellent market for
generating outstanding returns. As an aside, some might look at the scale above and see the Dollar
Index moving down to values such as “3” or “5” or whatever value and think, ‘well, that can’t
develop… that’s not possible.’ To that idea I would reply that currencies are ‘different’ than other
assets in that the supply of currency can be potentially unlimited via Central Bank money printing
as opposed to the supply of Oil or some other commodity, which in theory even under the worst
circumstances, will find a market clearing price. The DJIA, for example, or the SENSEX cannot drop
below zero. This is not true with an index of a currency which can, and down thru the centuries, has
on more than one occasion, fallen to levels below zero.
In the case of a currency index, if a currency falls a particularly large distance, over time the index is
likely to be reverse split, creating new higher values from which new declines can begin. Our point is
that a currency index is a very tricky item and while an index may never be allowed to go into
negative territory by its publishers, unlike other asset classes the sovereign currency of a nation can
fall for years on end. If anyone doubts this we would suggest looking at some century long charts of
currencies like the Japanese Yen and the British Pound where they fell over the course of decades.
It is my view that because every country in the world is, at the moment, desperate for growth and
jobs, and that because places like China are already witnessing riots among the masses, that a Dollar
decline will be a ‘developing’ phenomena, not a sudden panic or collapse. Over the course of several
years a Dollar decline could morph or build into a massive collapse, but we believe that there is a
long forward tail on this kind of event.. While there are times when any trend following indicator can
be whipsawed, for the most part this gauge—( chart below ) gives only one or two signals per year.
That means we tend to pay close attention when they develop as once a trend begins in the currency
markets, there tends to be a high level of persistency
Above: US Dollar Index with key support at the Dec. 2008 and June 2009 lows.
While I believe that the Dollar still has a chance to strengthen in the near term (next few weeks or
months), perhaps the most important key level to be watching over the next few months will be the
area of the December 2008 and early June 2009 lows for the Dollar Index which come in as major
support at the 78.50 to 79.00 level.
Any move below those lows in the weeks and months ahead would have to be viewed as a negative
breakdown in the Dollar and would likely add confirmation which has been very fragmented with
currencies like the Yen trending strongly, while the Euro has remained in a very narrowly confined
Overall, volatility in currency markets to the longer range bearish signal has been coming down, and
that tells us to expect larger moves in the months ahead and the beginning of what could be a
methodical Dollar decline.