A bear market for the U.S. dollar

Even though the U.S. dollar rebounded approximately 25 percent from mid-July to mid-November, it ended 2008 as only the third best performer vs. gold among the eight major currencies.

Long-term dollar bears have two major arguments against the currency: First, central bank purchases of government and corporate debt will remain the Fed’s principal strategy in maintaining ultra-low interest rates; second, President Barack Obama’s stimulus plan, primarily financed by new borrowing, will exacerbate the deteriorating fiscal imbalance.

While the tripling of the Federal Reserve’s balance sheet to more than $2.25 trillion poses inflationary dangers as far as the quantity and value of money are concerned, the Obama Treasury will push the budget deficit well above the $1 trillion mark, translating into a record deficit/GDP ratio of 9 to 9.5 percent of GDP.

It would be erroneous to deem these measures by the Fed and the Obama Treasury as long-term positives for the U.S. currency simply on the premise of “aggressive economic stimulus,” while ignoring the resulting fiscal imbalances and eroding value of fiat money once the global recovery emerges. As the Federal Reserve increases its excess reserves (those in addition to required reserves in the monetary system) with the goal of keeping the price of money at ultra-low levels through a zero-percent fed funds rate, the dollar will be driven lower, increasing the risk of a quick bounce in inflation once the global recovery begins.

This process manifested itself most recently between 2004 and 2007, when the recovery of industrialized and developing nations prompted interest-rate hikes in Europe, Canada, and Asia, and increased demand for metal and agricultural commodities. As commodities (which are primarily valued in U.S. dollars) gained in value, the dollar extended its bear market (which began in 2002) to all major currencies.

This time around won’t be any different. Once global monetary policies are normalized, interest rates have bottomed, and demand for commodities returns, currency markets will shift emphasis from “cyclical” issues (relative growth rates and other macro variables) to “structural issues” (budget and current account imbalances). Since the U.S. dollar is saddled with a soaring budget deficit and existing current account deficit, these two elements of structural imbalances will place the burden on the greenback.