Too big to fail

A towering black cloud hangs over the dollar: the chronic and ever-rising trade deficit, $765.27 billion in 2006, an all-time high for the fifth straight year. China accounts for $232.55 billion (30.4 percent) of that deficit, the highest ever registered with a single country. Every once in a while the FX market gets religion and trashes the dollar because such a massive trade deficit, about 7 percent of GDP, is “not sustainable.” Plenty of respectable academic economists and high financial officials agree, including former Federal Reserve Chairman Alan Greenspan.

They are wrong. Such a high deficit might be unsustainable for lesser countries, but not the country that has the world’s biggest economy and financial markets — not the issuer of the world’s reserve currency and the currency in which more than half of world trade is denominated, including oil and other benchmark commodities. The U.S. is simply too big to fail. However, this is a decidedly contrarian point of view and one wise traders and hedgers should be wary of embracing.

When the market gets a bee in its collective bonnet that the U.S. structural imbalance is a bad thing, it sells dollars with a vengeance. Even the relative yield advantage of the U.S. has failed to provide support for the dollar against a major currency such as the Swiss franc. In Figure 1 the dollar-Swiss (USD/CHF) rate is inverted (CHF/USD) so a rise in the Swiss franc relative to the dollar is shown as an up move.