Why higher interest rates won't save the dollar
Jun 20, 2006
The most important stock market in the world in terms of what is going to happen next, is the US stock market. And the most important currency in the world is unquestionably the US dollar which, for seven consecutive days ending Tuesday 13th June, moved higher.
It was presumed by most commentators that this was because of fears that a higher inflation risk would lead to higher US interest rates. That was until the villain of the piece, the US CPI figure, was published. It was not a good figure and yet, on that eighth day, the dollar fell back.
Of course, the truth is that there is no fixed link between published data and market reaction because it is people’s reaction to the data that determines what happens, not the data itself. If that wasn’t the case, it would be just too easy!
We are grateful to Mark Aarons, a long-term reader who works in the financial markets, for his recent e-mail. His observations, which follow, highlight the economic imbalances that identify why the US dollar is set to fall.
'America is now hopelessly caught in a trap whereby it must persuade its international creditors that their money is safe at the same time as urging its domestic consumers to keep on borrowing and spending. A tough job at the best of times - but now look how big the numbers are getting.
'Here are just two pieces of evidence:
'(1) Total Non-Financial Debt in the USA increased on average $706 billion annually during the nineties. The system now creates approximately this amount of credit every three months!
'(2) Rest of the World (ROW) holdings of US debt were up $1.246 trillion over the past year (12%), with a two-year gain of $2.7 trillion (31%). ROW holdings of US financial assets have now almost doubled in six years!
'The near-term course of asset markets (stocks, commodities, houses) will depend on this balancing act being maintained. Ex-post rationalisations of recent corrections that talk about inflation fears/growth fears, etc., are by-the-by. The long term course of asset markets is, as you point out all the time, depressingly and distressingly obvious!”
The Central Banks of oil-producing nations such as Russia, who already have reported a reduction in the percentage of their dollar holdings, will probably view gold’s recent decline as an opportunity to trade dollars for the yellow metal.
Chris Turner, head of Currency Research at ING Financial Markets, reports that: “The dollar moves smack of diversification. It has all the hallmarks of reducing dollar demand from oil exporters.”
Emma Lawson, FX Strategist at Merrill Lynch agrees, saying: “Diversification is happening much quicker than we thought it would.”
Ongoing currency diversification by Central Banks will most likely benefit the euro and the yen and gold to the inevitable detriment of the US dollar.
The dollar index sold off very sharply from March to early May, since when we have witnessed a period of consolidation. A quite normal procedure and one that we would expect to be followed by another significant fall because that is how markets work. A big move, then some consolidation, then another big move. We certainly expect, later this year, for new dollar lows to be plumbed.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit http://www.rhasset.co.uk/
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