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Thinking 'Outside' the U.S. Dollar

Friday, 28 March 2008 03:37 PM Current | Bio | Archive

In March, Goldman Sachs analysts estimated that — because of the U.S. dollar's plunge — the eurozone had become the world's biggest economy, if measured in U.S. dollars.

Around that same time, European Central Bank (ECB) President Jean-Claude Trichet made an important public statement.

"We are in a largely interdependent world so anything that happens in Europe has an influence on the U.S., I am happy to tell you, and anything that happens in the U.S. has an influence in Europe."

Nevertheless, he added that, "We have our own economies, they are not the same. We are in different universes."

That statement shouldn't be taken lightly. While the financial crisis and its contagion are still unfolding, the wise investor should always remember the following two facts.

First, that the primary objective of the European Central Bank is to maintain price stability. By its own policy, that is defined as inflation across the eurozone of under 2 percent in the medium term.

Second, that the statutory goal of the U.S. Federal Reserve is "to promote effectively the goals of maxi¬mum employment, stable prices, and moderate long-term interest rates."

Note that these two central bank priorities are not compatible.

To put it bluntly, the ECB is obliged to defend the euro's purchasing power at all cost and before anything else. This is not so for the Fed, whose primary task is trying to provide maximum employment.

This explains in part why the ECB hasn't cut its leading interest rates and doesn't seem intent upon doing so any time soon, while the Fed has cut its leading interest rates dramatically. In the mean time, we all know that interest rate differentials do not support the dollar.

ECB Governing Council Member Axel Weber, also head of Germany's Bundesbank, reiterated the policy this week. He said that the ECB will raise interest rates if needed to curb inflation in the 15 nations using the euro — even if economies slow as credit dries up.

Last weekend, at a meeting in Jakarta, central banks from 16 Asian countries have said that they might invest more of their $1 trillion in reserves in one another's sovereign bonds instead of U.S. Treasurys, given the dollar's volatility.

Later, South Korea's National Pension Service (NPS), the world's fifth-largest pension fund announced it will "diversify" its portfolio away from Treasurys because of low yields.

If we see continued diminishing of foreign holdings of Treasurys, the expected U.S. credit losses could hit $750 billion. If analysts at Morgan Stanley have it right, the yield curve from Fed funds to 10-year Treasury notes would have to stay at 275 basis points for at least two years to increase net interest margins to offset that loss.

Nobody knows what the dollar's and euro's proportional share of dominance as international reserve currencies will become in the future. What we do know is the importance of the euro as international reserve currency is growing.

Meanwhile, recent Fed monetary policy has accelerated the dollar's decline, which in turn has caused an increase in expectations of U.S. domestic inflation.

Rising U.S. inflation will weigh heavily on the global reserve role of the U.S. currency. Today, practically all U.S. dollar-pegged developing countries encounter rising difficulties in keeping their dollar peg because of imported inflation caused by the weakness of the dollar.

They may still be reluctant to drop their dollar peg, but a tipping point will be reached when inflationary pressures will become unbearable.

If and when they drop their pegs, they will almost certainly rebalance their reserve portfolios as well, which, of course, will be negative for the value of the dollar and its role as international reserve currency.

As yet, central banks have not abandoned the dollar quite as swiftly as the private sector. Nevertheless, the rise of sovereign wealth funds suggests that there will be increased interest in portfolio diversification for their national funds.

This diversification will place less emphasis on liquidity and more emphasis on returns, and thus could lead to a permanent reallocation away from the dollar.

All this means that the long term investor should start to learn to think "outside" the dollar.

Remember, at the end of WWII, when the U.S. dollar had finally replaced the British pound as the dominant international reserve currency, $4.03 bought a single British pound.

Five years later, in 1950 you only needed $2.80 — 30 percent less — to buy a pound.

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In March, Goldman Sachs analysts estimated that — because of the U.S. dollar's plunge — the eurozone had become the world's biggest economy, if measured in U.S. dollars.Around that same time, European Central Bank (ECB) President Jean-Claude Trichet made an important public...
Friday, 28 March 2008 03:37 PM
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