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Bonds & Fixed Income Investments
Re: "The End of Dollar Hegemony"

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By jackcrow
March 1, 2006

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IMHO the proliferation of the USD is tied more to our treasury market and thus our national debt, economic strength and the taxing power supported by that strength. When I consider the situation carefully, I agree that some nations' move to the Euro is less a sign of the strength and stability of the Euro, and more a way to "stick it" to the US. A truly poor reason to make a significant economic change. The characteristics of the EU and EU debt fortunately don't make it a horrible choice.

The US treasury market has greater transparency, greater liquidity, greater depth and breadth then any other securities market. Much international trade is based on the USD in the form of treasuries; they act more as the currency than direct dollar for X currency exchange then any other vehicle. Their value is known with great certainty and clarity.

The Euro, on the other hand, is a confederacy currency. As such the politics behind it are less clean and clear cut, as frightening as that may seem. The faith in the Euro central banks does not compare to the faith the international market has in our central banking system, complete with its warts.

Nations may try to shift some commodities pricing, like oil, to Euros, but when the 800lb gorilla doesn't want to move, it's very hard to make it; I expect dual pricing will reign for a long time. Even if they succeed in the shift, what "real" harm does it do to the strength of the USD, and more importantly, the US treasury market? Currency exchanges between two predominantly stable currencies has little friction when conducted on a huge scale. And it doesn't change the shear utility of the US debt and the US treasury market for international commerce.

The shift may push Euro backed debt instruments prices up in a statistically noticeable fashion. If so, then we can expect a statistically measurable shift down in the price of US treasuries. But the fundamentals of the markets will continue to dominate how the securities are traded. IMHO neither move will dramatically change international commerce, as we know it. Nor will the changes "hurt" either currency or debt.

US debt = GB debt = Euro debt all are predominantly stable debt markets, but the latter two do not compare in liquidity, transparency, depth and breadth.

China remains somewhat xenophobic in its international relations and manages its debt and currency issues accordingly. China or India may be the next nexus of international economic growth, but they do not have stability nor do they have equal natural resources of the US. IMHO real long-term threats would come from a stable and united Africa, South America, or the former Soviet blocks. They have the people and the resources to unseat US supremacy in the international markets.

In order for that to occur they would have to A) Unite in a long term politically stable fashion, B) unseat the 800lbs and 600lbs gorillas currently occupying those seats. The transition, if it occurs, will be slow.

The EU is currently the most viable competitor, but it carries many of the same systemic issues of the US. The two, when economic power shifts, will shift together. The EU is an unlikely candidate to unseat the US in dominance of international market issues. It may grow to be a co-conspirator but the two are too closely linked in methodology and by culture. It will take a significant paradigm shift to move away from current long held, deeply-seated practices (habits may be a better word if we define it as many philosophers have.)

This doesn't mean that the USD's international value isn't flexible or that there isn't potential for significant downside risk with the USD. That is a market driven issue. There are market forces lurking that if they come to fruition can devalue the USD within the international currency market. Historically the USD has moved around $1.20 = Euro (or a basket of European currencies) as a center point. Market forces may create a secular shift that moves that center against the USD but I doubt that the shift will be dramatic. The two western centers of economics are too much alike and too closely tied together.

I wonder if we aren't basing our USD expectations on a very short era of the modern US debt situation. Through the last 2/3 of the Clinton administration the US economic engine provided enough revenue for the US to start to buy down its debt. This had the effect of strengthening the dollar; there was less US debt and thus more competition for it and its underlying currency. There was also a policy within the Clinton administration for a strong USD, which was acted on in concert with the slowing of deficit spending and for a few short years actual reduction in market exchanged debt. This relatively short era allowed us to buy oil and other international commodities and finished products cheaply based on USD terms.

The US has returned to deficit spending and the US Treasury market and thus the USD have been slowly re-priced accordingly. Throw in mid-east stability concerns, refining concerns, international competition for a basic resource like unrefined crude and $50+ is reasonable price for this internationally followed commodity. The price of crude isn't based primarily in a dislike, lack of favor or an inherent weakness in the USD.

As a moderate contrarian, I don't see epic shifts forthcoming in the USD. I respect the potential and act accordingly. But as long as there are international entities willing to price US debt favorably, it's a reasonable decision to finance our obligations using debt. If we viewed the US as a corporation we would applaud them for financing with cheap debt.

I'm not arguing that we are wisely applying that borrowed money. Nor am I arguing that, if viewed as corporation, we are managing our future prospects well. I'm only arguing that the current international market is favorable to US debt. There is a GM-ness to our government's fiscal situation that isn't being prudently managed with foresight. There are potential consequences for continuing down this path.

I continue to believe that the unwinding of those issues will be progressive and visible to those that continue to watch the issues with prudence. In short, the perfect storm is unlikely to hit suddenly and viciously. By their very nature, huge ships take a great deal of time to change vectors; the momentum that needs to be overcome is huge.

We need to be careful not to cry secular or paradigm shifts when the shift(s) may very well be more cyclical in nature. This doesn't mean we should ignore the criers or the potential for secular shifts. We need to be prudent, informed, calm and decisive. To do this we need to respect both potentialities. History may treat the criers as sages but this will only occur if history unveils according to their predictions. History will ignore them if they are wrong.

There is plenty of evidence to make a case but we have no DNA or fingerprint evidence, nor do we have a smoking gun. The evidence is circumstantial. This doesn't make conclusion drawn from it wrong but the evidence isn't definitive. We need to respect this and act accordingly.

jack


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