Talking down the dollar

Addison Wiggin - Thu 25 Aug, 2005

"...Can you imagine what would have happened had the banks not pumped that money into the US Fed's reserves? One former currency trader asked, 'If $40 billion cannot bring about even a minor rally, just how weak and despised is the once-almighty dollar?'..."

In 2004, US Treasury Secretary John Snow was traipsing around the globe trying to "talk the dollar down." Why? In a word, debt. The US national debt stands at about $7 trillion, with interest payments alone in fiscal 2003 totalling $318 billion.

But the US Fed and Treasury have engineered a strategy to pay off the debt with weaker and weaker dollars. And guess what? So far, so good. Since November 2002, the dollar has fallen 25 percent against the euro, and more than 50% since its high in October 2000.

Of course, this is not the first time we've gone through a managed devaluation of the world's reserve currency. But it might be the last. In the 34-year period since Nixon slammed the gold window shut and subsequently ended Bretton Woods exchange rate mechanism we've had only five major trends in the US dollar:

1. Weak dollar 1972-1978 (7 years)
2. Strong dollar 1979-1985 (7 years)
3. Weak dollar 1986-1995 (10 years)
4. Strong dollar 1996-2001 (6 years}
5. Weak dollar 2002- (?? years)

The most notable period spanned the 10 years from 1986 through 1995. Then, as now, the United States was fighting a historic current account deficit through managed debasement of its currency. But because the bear market only began in February of 2002, the current cycle looks like it still has a number of years to run.

In the best-case scenario, if the current bear market follows the trajectory set be the 1986-1995 slump, we could see a weakening dollar for up to 10 years. This presents an opportunity for selling the dollar in one of four ways: direct and indirect speculations, using short- and long-term options for each. These plays will help you safely position your money outside the US dollar bear market. And you stand to make a fair amount of money, too.

But there is a great danger ahead. Since the US trade deficit has passed the $500 billion mark – nearly 6 percent of GDP – those kind foreigners who pump the US economy with cheap gadgets and strong bond prices must shell out about $1.5 billion a day just to keep the dollar afloat. And even during the managed dollar decline of 2003, the trade imbalance continued to grow. According to Stephen Roach, Morgan Stanley's chief global strategist, it was on course to reach $710 billion – some 6.5% of GDP.

Herein lies the drama. The Bank of Japan spent the equivalent of $187 billion in 2003...and $67 billion in January 2004 alone...in a bid to prevent its strengthening currency from choking off the country's export-led economy. In dollar terms, the Bank of Japan spent $1 billion every day trying to keep the yen from strengthening against the greenback.

Over a four-week period in the autumn of 2003, combined foreign central bank purchases of US securities topped $40 billion, more than $2 billion every trading day. Yet these central bank billions merely managed to limit the greenback's decline to just 2.3% over the same period.

Can you imagine what would have happened had the banks not pumped that money into the US Fed's reserves? One former currency trader asked, "If $40 billion cannot bring about even a minor rally, just how weak and despised is the once-almighty dollar?"

In short, the US has relied on the kindness of strangers for too long. "We're like the untrustworthy brother-in-law who keeps borrowing money, promising to pay it back, but can never seem to get out of debt," Jim Rogers writes. "Eventually, people just cut that guy off."

There is no way the United States can possibly pay off its creditors should they decide to cash in their IOU's. Right now, the United States holds only $87 billion in reserves against its obligations. That would last about three minutes should creditors begin to sell the dollar, rather than trying to support it.

It's hard to imagine, isn't it? The world's reserve currency spiralling downward, out of control. But then, that's what the Bank of England must have thought in 1992 when they attempted to manage a devaluation of the pound. Despite the Old Lady's best efforts, sterling got away from them; the currency collapsed and Britain was kicked out of the Exchange Rate Mechanism (ERM). On the day, know as Black Wednesday in Britain, currency speculator George Soros is rumoured to have made as much as $2 billion.

Don't be surprised if more fortunes emerge in the future as the dollar slips dangerously close to free fall.