By Martin HutchinsonContributing EditorMoney Morning
The plethora of bank and corporate bailouts, stimulus plans and interest-rate cuts that the U.S. government has produced over the last three months can only lead to one outcome: The U.S. dollar has to decline.
During the crisis so far, the dollar in general, and U.S. Treasury bonds in particular, have been regarded as a “safe haven,” making the dollar strong and pushing long-term U.S. Treasury rates downward. In the New Year, however, this is likely to change – the weight of the added supply of dollars in circulation will be too great for the greenback to shrug off.
Back in November 2007, when I wrote about the U.S. dollar becoming the “Bernanke peso,” I suggested that the dollar – then trading at $1.50 to the euro – would get weaker. Alas, I was wrong: It is currently trading at $1.29 to the euro, although it did reach $1.60 in May. However, I recommended buying not euros, but yen. The chaos of 2008 has reversed the decline in the dollar against the euro, but not against the yen, which has reached Yen 92.8 = $1 compared to a rate of Yen 114.8 = $1 when I wrote the piece. A gain of 24% against the dollar is not bad, and indeed I defy you to find a stock market that has done as well over that period.
The fundamentals tending to weaken the dollar remain. The U.S. trade deficit was $57.2 billion in October, which annualizes to $700.3 billion – down but a little from the 2006 peak of $758 billion. Although the recession and recent sharp decline in the value of U.S. oil imports will reduce the U.S. trade deficit further – perhaps to $500 billion annually – there is still no reason why foreigners should continue to so highly rate the currency of a country that is running a $500 billion balance-of-payments deficit, and a $1 trillion budget deficit.
After a pause during the summer, the U.S. money supply has begun rising again rapidly. The excess money has flowed into Treasury bonds, sending the yield on the 10-year bond down to a recent 2.71%. The distortion in the market can be shown by the yield on the 10-year Treasury Inflated Protected Securities (TIPS), which was 2.44%; that combination of prices said that investors expect U.S. inflation to average a mere 0.27% annually over the next 10 years.
Clearly that’s nonsense; the explanation is that yields on long-term Treasury bonds have been driven far below their economically appropriate level. In other words, U.S. Treasury bonds are currently benefiting from a bubble, and like the bubbles that we’ve seen in Japanese stocks, real estate, U.S. tech stocks, the American housing market and global commodities, this bubble, too, will ultimately burst.
The budget deficit in the 12 months through to September was $455 billion, but that’s expected to expand to close to $1 trillion in the year to September 2009 – and that’s even before President-elect Barack Obama’s stimulus plan, which is expected to cost at least $500 billion, and could possibly cost that much a year over several years.
If that’s surprising, consider this: The U.S. budget deficit was $237.2 billion in October 2008, a record monthly figure. That puts a huge strain on the U.S. Treasury Department’s financing capacity, and will probably result in the U.S. Federal Reserve printing yet more money, since the alternative would be for the huge amounts going into Treasuries to choke off demand for private investment – not the desired objective. With more money being printed, inflation is likely to soar and the dollar to weaken.
Net foreign purchases of long-term U.S. securities declined to $793 billion in the 12 months to September 2008, from $1.03 trillion in the previous year. Of those purchases, Treasury bonds and notes represented $385 billion, up from $192 billion in the previous year, while purchased corporate bonds shrank from $447 billion to $168 billion. Thus, the “flight to quality” has so far been enormously helpful in enabling the U.S. Treasury to finance its growing budget deficit; in October and November it will doubtless have been even more so.
Once the inflow into U.S. Treasuries slows, or the huge volume of Treasuries issued simply overwhelms it, the dollar will weaken and Treasury yields will rise. At that point, there is likely to be a stampede for the exits from the Treasury bond market, which will be self-reinforcing. As a wise investor, you could prepare for this stampede in four ways:
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