September 22, 2003

Thirty One Words and the End of the Dollar Standard

This weekend’s G-7 statement has revealed the U.S. strategy for correcting the trade deficit without crashing the dollar and spiking interest rates. But will it work? First, here’s what the G-7 said, “We emphasize that more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.” Smooth and widespread adjustments based on market mechanisms…sounds like the G-7 is telling China to let the yuan float and Japan to quit buying dollars and selling yen. The markets seem to think so. Tokyo stocks were down over 4% today. And the dollar is weaker against the Yen this morning. In other words, it takes fewer yen to buy a dollar today, about 111.You can see from the chart below that after 2001, the Yen enjoyed predictable support at around 116. That appeared to be the point at which the Japanese Central Bank would intervene to prevent further yen strength--and keep Japan’s shaky export-led recover going. The Japanese Central Bank sold about $80.5 billion in yen in the first seven months of the year to keep the yen down. It’s going to be a lot harder for them to fight the market and successfully intervene to weaken the yen if traders think the yen is getting stronger against the dollar. However, I doubt the Japanese are willing to allow the Yen to get too strong and start threatening their stock market rally. The Japanese economy grew at 3.9% in the second quarter. After 12 years of a soft-slow motion depression, you’d think they’d be unwilling to sacrifice their vulnerable recovery for the sake of George Bush’s reelection efforts… …Then again…Junichiro Koizumi just won reelection to his party’s leadership and cleaned house in his cabinet. He may be feeling secure enough in his political fortunes to do something nice for Bush. He needs the U.S. at his side on North Korea, as well. The nice thing he could do is let the yen strengthen to the point that a weaker dollar started to have some effect on the U.S. economy prior to next year’s election. The easiest effect to achieve would be higher corporate profits for U.S. multinationals between now and next November. For example, Bloomberg reports that, “Coca-Cola Co.'s second-quarter profit increased 11 percent, with the dollar's slide accounting for 3 percentage points. Caterpillar Inc. said in July second-quarter earnings doubled and full-year profit will be more than forecast, partly because of currency-related gains.” It’s a side benefit for Bush that a weaker dollar helps Detroit even as it hurts Toyota. What’s good for Detroit might be good for Michigan. And if it’s good for Michigan before next November, that’s good for Bush. Michigan has 18 electoral votes. Illinois has 22. Both went for Gore in 2000. And even Michigan’s Republican congressmen are urging Bush to scrap the steel tariffs he imposed two years ago. A cynic would say he imposed those tariffs to win votes in steel-producing states, or to gain electoral votes in West Virginia (5 votes), Ohio (21 votes) , Pennsylvania (23 votes), and Indiana (12 votes). The problem is, the tariffs have hurt steel-CONSUMING states. The U.S. International Trade Commission said in its report on Friday that the steel tariffs have resulted in a $680 million loss to U.S. business. A Republican congressman from Michigan claims that for every one steelworker job saved, three to seven jobs have been lost in steel consuming industries as a result of higher steel costs. Regardless of the domestic politics involved, the weaker dollar ought to lead to rising earnings in the fourth quarter of this year and the first and second of next year should be supportive of higher stock prices--if Wall Street gets behind the hype. I doubt that even a sustained weaker dollar will lead to a turnaround in the jobs numbers, though. What’s more likely is that the pace of job losses may slow enough for Bush to say that we’ve turned the corner and the worst is behind us. As I’ve said before here, even a much weaker dollar is not going to make U.S. industry suddenly more competitive with Chinese industry. And besides, it’s U.S. industry that’s decided to move to China anyway. If profits for multinationals are helped by cheap labor but hurt by a strong dollar, how will they change materially if they are helped by a weaker dollar but hurt by falling exports to the U.S.? The truth is, most multinationals can only hedge currency risk, they can’t eliminate it. Will U.S.-based manufacturers really benefit if good made in China are now more expensive? Or will the rising prices simply cause consumers to consume less…defeating the whole purpose of trying to use politics to manage the marketplace? Stock Market Implications A weaker dollar is not necessarily better for corporate profits, once you factor in the reduced consumption that will come from higher prices for imported goods. Will consumers suddenly decide to buy the overpriced America-made refrigerator instead of the Chinese refrigerator because they are now roughly the same in price? Or will he not buy anything at all? We’ll have to see. But my guess is that in the long run, the lowest cost producer wins. You can inflate prices through currency exchange rates. But ultimately, there are very few industries in which the U.S. will have the lowest labor cost. That means when you come down to it, somebody else is always going to beat America on price, and maybe on quality. And with so many countries in the world now producing manufactured goods…the future doesn’t bode well for strictly American-based industries. But I digress. Stocks are the issue. The irony in the whole weaker dollar paradigm is that while it might make U.S. companies more competitive, it makes U.S. stocks less attractive. Who wants to own assets in a currency that’s losing value? And when you throw in the stock market’s sky-high recent valuations, now is a good time to take profits for foreign buyers. What the Fed desperately hopes is that it can talk down the dollar without spooking a sell-off in U.S. bonds and sky-high long-term yields. A sell-off in the dollar with a collapsing bond market would bring the whole U.S. financial house of cards down. Down would go housing, supported by historically-low mortgage rates. Blown up would be the bets of mortgage lenders. And up would go the cost of capital for businesses already reluctant to invest in a recovery they’re not confident in. The only way the Fed can accomplish this is by promising to buy bonds. If the Fed buys bonds, it keeps interest rates low AND gets a weaker dollar. Presumably, Fed bond buying reassures foreign governments that there’s no need to liquidate U.S. bond holdings--even though the dollar is falling…no need at all. You get the feeling that if you were a fly on the wall in a meeting of the world’s central bankers they would all nervously agree out loud that supporting a gradual decline in the dollar was, ideally, the best way to bring about the structural rebalancing of the world’s economy. But in the back of their mind, you’d have to wonder how many of them are thinking of the moment when they realize they’re being asked to finance America’s twin deficits and take all the risk for it, all while getting a low rate of return in a currency that’s losing value. In a T-Bond sell off, the guy who sells the most first loses the least…and everyone knows this…the question is, who will make the first move….and what will spark it? And also, get gold.


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