The danger of a weakening US dollar

The global economic situation is still fragile, and one of the symptoms is the nervousness about currencies. All it takes is a rumor to see a particular currency drop within minutes. The actions taken by central banks during the financial crisis have consequences. The amount of debt and the ability, or inability, of individual countries to manage the situation will influence the relative strengths of all currencies.

One currency has a special status. Because of the economic and political influence of the USA since World War II, the US dollar is the currency for most commodities. This special status also influences the actions of financial markets. Since the stock market plunge of October 2008, investors have become cautious. The value of stocks and commodities does not follow fundamentals anymore. A lot of cash has left the markets and, more than before, the active players in the market place their bets for short-term returns. Most transactions are computer-generated. Software programmers have developed algorithms that allow computers to make transactions based on technical analysis within a millisecond. This maybe a technological beauty, but such programs do not analyze data. They act mechanically, in a very sophisticated manner of course, but mechanically nonetheless. When it would have taken half an hour for traders to panic, the computer can now deliver the same result in less time than it takes to blink. When you add to this that investors, and especially speculators, borrow large sums of money to play with derivatives instead of doing so with the actual assets, the consequences for the real economy may be rather high.

Considering the amount of debt that the Federal Reserve Bank has issued, also known as the amount of money they printed, the burden for both taxpayers and the American economy is heavy, and will remain that way for a long time. The bank crisis is not over. Unpaid mortgages and foreclosures will keep on weighing on the health of the financial sector for quite some time.

The low interest rate may help the American economy to some extent, but the key for a true economic recovery will be job creation. So far, the unemployment situation does not seem to present much improvement anytime soon. To consume, Americans need to make money. With the tightening of credit conditions, they now have started to save money again, instead of spending it at the mall. Before the crisis, on average, Americans were spending 105% of their income, thanks to credit cards and loans based on their theoretical home equity, which supposedly would only go up. Retail accounted for 70% of the GDP. Clearly, this model will not come back. All of the above explains why the US dollar will weaken over the long-term. To alleviate this trend, the USA should increase interest rates, but in the current situation this probably would stop the recovery. The USA are somehow stuck.

Lately, it looks like most of the trends in stocks and commodities prices are linked to the relative strength or weakness of the US dollar. Commodities have become currencies. When the US dollar drops, the price of stocks and commodities goes up, and vice-versa when the currency drops. The logic behind this is simple. Investors are interested in protecting the value of their capital. Instead of owning actual dollars, they prefer to own assets. This is why the demand for materials, oil and agricultural commodities is firm. By switching from cash to finite resources, investors want to ensure that they will, at the very least, be protected from the erosion of the currency. Most of the demand is not for the real commodities, though, but for futures contracts. By borrowing money, they can buy even more of such investment vehicles than they normally would, or should. The higher demand for commodities results in an increasing price, in US dollars that is. Since they buy as the US dollar weakens, they will get more dollars back when they sell, although with the potential depreciation, this might not be an actual profit, but at least it is not a loss.

What may be the consequences for food prices? We have had a flavor of what a run on commodities can do in 2008. This time, the level of leverage will be lower than by then, because investors will not be able to access loans as much and as easily as they could prior to the financial crisis. Nonetheless, increased demand for oil futures contracts together with an increased demand for agricultural commodities futures contracts will result in food inflation. Ironically, the most vulnerable country for this are the USA themselves, because the price inflation will be in US dollars, and that is the only currency that they have. Food inflation will put more stress on the income of Americans, and depending on the level of inflation, this can bring the country back into a recession. Considering the importance of the US economy, the whole world would suffer the consequences.

Food inflation will hit globally, because the demand on paper will be higher than the physical demand, and because, the focus will be in the price expressed in US dollars only. The exchange rate between other currencies with the US dollar will not be taken into account immediately. This will happen when consumers start to offer enough resistance. The resistance can be less consumption of consumer goods in rich countries, but it can be riots and violence in poor countries. Although food inflation has not hit consumers too much, yet, the high price of animal feed ingredients is already a concern for companies involved in animal productions. Processors will face a dilemma between a decrease of margins and the need to fill their plants at full capacity to keep costs down. Their margins and the farmers’ margins will be under pressure, because the retailers will resist price increases as long as they can. Another area of margin pressure for farmers will come from the price of inputs, fertilizers in particular. If the rumor, based on paper contracts, turns into the idea that demand for agricultural production is really increasing sharply, suppliers will hike their prices as soon as they can. If farmers get higher prices for their products, they also will pay much more for their inputs.

Reactions to food inflation will be the strongest in Asia. The situation is already sensitive, and the share of food in the household budgets is still relatively high, especially compared with Western countries. For many people, food is already difficult to afford. The situation is such that the Indian government is considering offering subsidized grains to 75% of the population. This represents about 800 million people. This is roughly the combined population of the EU, USA, Canada, Australia and New Zealand together!

What happens with currencies, stocks and commodities exchange markets will have direct as well as indirect consequences. We all need to follow the developments, because we all will feel the consequences in our wallets, eventually.

Copyright 2010 – The Happy Future Group Consulting Ltd.

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