Concerned About The Dollar? How to Manage Dollar Risk

By: Axel G. Merk, Merk Investments / GoldSeek.com

Are you concerned about the U.S. dollar? Are these concerns justified? If so, what do you do about it?

Fiscal sustainability

In a recent Merk Insight entitled “Why I own gold“, I wrote:
“In a recent presentation, the 67 year-old Erskine Bowles (of the Simpson-Bowles commission) said, among others things:

• We are doing this (traveling around the country to drum up support for fiscal reform) not for our grandkids, not even for our kids, but for us.
• If we don’t get elected officials to pull together, we face the most predictable economic crisis in history. The most predictable, but avoidable crisis.”

Mr. Bowles doesn’t just lament: he drives the discussion, engages in constructive criticism, proposes solutions and encourages others to get involved. However, as investors, we have to take into account the possibility that he will not succeed before markets assign a higher probability to the said “most predictable economic crisis.” Things aren’t made any easier by the fact that tax revenue are coming in ahead of expectations, reducing the sense of urgency amongst policy makers.

Bonds at risk

Europe has shown us an important part of the playbook when the market loses confidence in the fiscal sustainability of a country: investors sell their bonds. Maybe more importantly, the selling of bonds by investors gets the message to policy makers. In that context, we are actually rather optimistic that U.S. policy makers will get their act together to engage in entitlement reform to make our budgets sustainable. However, when dissatisfied citizens looking for change on both the political left and right are understandably drawn to ever more polarizing politicians, necessary reform may only happen when the pain of acting is less than the pain of not acting.

Current account deficit

So what does a fiscal crisis, or a possible crisis in the bond market, have to do with the vulnerability of the U.S. dollar? You see, unlike the Eurozone, the U.S. finances its budget deficit by borrowing from abroad; through what economists call a current account deficit. In Europe, when the bond market “acted up,” money fled from weaker Eurozone countries to stronger ones, but on a net basis, didn’t really ever leave the Eurozone. In the U.S., however, the current account deficit is exactly the amount of U.S. dollar denominated assets that foreigners need to buy, all else equal, to keep the dollar from falling. As Mr. Bowles quips: if the U.S. were to ever have a military conflict with China, say, because of treaty obligations with Taiwan, the U.S. would need to borrow money from China to fight the war. That makes the U.S. vulnerable in more than one way. Relevant to the discussion about the U.S. dollar is that it might be under pressure should foreigners be less inclined to finance our deficits.

Before we get too scared about foreigners dumping their bonds, the notion just presented might give the wrong impression on two accounts:

• If investors lose confidence in U.S. bonds, it matters little whether it is U.S. or foreign investors losing confidence.
• One does not need to conjure up images of war to think of reasons why the dollar might be at risk should bonds come under pressure.

Confidence

We have discussed how market concerns of fiscal sustainability could cause the bond market to sell off. Important to note here is that perception might be more important than reality. Spain, for example, has had rather prudent debt management, with the average duration of government debt at roughly 7 years; however, when markets get nervous, math matters little. Similarly, the saying that markets may stay irrational longer than investors can stay solvent also applies to investors pricing U.S. bonds. U.S. bonds might sell off either much earlier or much later than some investors expect. Those who believe the U.S. bond market has already held on longer than it should have are told that the U.S. is different, because the dollar is the primary international reserve currency. Maybe, but note that such status must be earned. In our humble opinion, one cannot turn that concept upside down and pursue what might be considered fiscally irresponsible policies and then assume the reserve currency status is some ex ante right never to be questioned.

A key reason why investors have more confidence in the U.S. to finance itself than weak Eurozone countries is that the U.S. can print its own money whereas Eurozone countries have delegated that responsibility to the European Central Bank (ECB).

Inflation

Fear of inflation could also derail the bond market. However, as we are told over and over again, inflation is not today’s problem. Skeptics point out how the Consumer Price Index (CPI) has been redefined about 20 times since 1980, and that if we were to apply inflation measures of those days, inflation would indeed be a serious concern. We sympathize with the view that the CPI understates inflation, however, it matters little what we think: what matters is that the bond market appears to shrug off inflation concerns – at least for the time being.

The biggest threat to the bond market: economic growth?

Which brings us to what the market does appear to care about: good economic data. A more positive assessment of the economic outlook by the Federal Reserve (Fed) has the potential to send shockwaves through the bond market. The shockwaves of recent months appear to have surprised even the Fed. We haven’t been surprised for the simple reason that when you artificially inflate bond prices (keep yields low) for an extended period, a violent reaction should be the base line scenario when the Fed takes a step back (“tapers”).

In some ways, it’s of course perfectly feasible that more economic growth is associated with higher inflation. But the canary in the coal mine appears to be good economic data that might foreshadow higher inflation. The reason for concern, in our assessment, is justified because we don’t see how the Fed can mop up all the liquidity when needed. We have already seen what a fit the market can throw at even the talk of tapering. Good luck trying to “fine tune” an “exit” from super-accommodative monetary policy.

And this is where the loop closes to fiscal policy. With bond prices falling, it becomes more expensive to finance debt. In 2001, the average cost of borrowing for the U.S. government was around 6%. Currently, it’s a little over 2%. I’m not suggesting that the average cost will move back up to 6% in the near future, however, financing debt that matures in the coming years, as well as the trillions in additional debt we have been piling on, and we are faced with a gargantuan task to find ways to finance government spending. On a side note, there aren’t enough rich people around to tax to “fix” the problem. The challenges can be fixed currently with what are still rather minor adjustments to entitlements, but cutting benefits is politically an extraordinarily difficult task; possibly all but impossible with gridlock in Congress. 

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