Rhody Trader

The question “Why has the value of the US dollar not declined sharply?” was asked recently, and not for the first time. It’s one that I think is on the mind of a lot of market observers these days. Here’s the answer I provided:

All the major currencies feature low interest rates (relatively speaking), have governments printing money for quantitative easing and/or fiscal stimulus, having increasing deficits and debt, and negative economic growth. Keep in mind that the dollar rises or falls in value against other currencies, currencies that are in the same boat. Actually, the US is widely seen being the first economy to recover. That helps, as does the fact that the dollar is still the biggest safe haven currency, so when folks are worried that’s where they put their money.

I think the problem a lot of folks have is that they tend to look at the dollar singularly, forgetting the fact that the forex market is one of relationships, the cross-valuation between currencies. When the whole boat is sinking it’s a question of who has the most bouyancy.

In response to my answer I got this follow-up question:

That explains a lot of it. However, what do you see in the long-term? Asia Pacific and other Asian economies might strengthen whereas the US economy has many issues to face for long-term sustainability. The US might lose their edge, at least relatively, in the long-run. Do you see the dollar weakening in the long-run?

If so, which currency do you see as having the most potential in the medium to long-term?

I have no specific view of the long-term future. There are just too many variables, and when it comes to the fundamentals I often find myself seeing contradictory elements. Will the dollar lose at least some of its standing as global reserve currency? Absolutely. It will take a while, though – probably considerably longer than some folks would like. I wrote on that subject on my blog a little while back if the post Enough of the Dollar BRICabrack. 

Naturally, as economies like China and Brazil continue to expand one would expect their currencies to improve against the dollar (if the countries in question allow that to happen), but that’s really only one part of a very complex equation.

What the questioner above was really trying to get at, however, is whether the US is going to turn into Zimbabwe with its hyperinflation. The reason why some folks see this as a potential development for the American economy is all the money the Federal Government, Treasury and Federal Reserve have been pumping into the economy.

First of all, the money the government and the Treasury spend or invest or whatever is funded by the sale of Treasury debt. So basically the money goes into the system, then comes back out again. It’s a sterilizing process which has little to no net impact on money supply.

Secondly, rapid increase in money supply requires both lenders and borrowers to create supply and demand for loans. Banks have tightened their lending standards and consumers are working on paying down debt, not adding to it. That means despite all the money the Fed has put into the system, we”re not seeing overall money supply growth. The chart below shows that well.

The grey line (M1) reflects what the Fed has directly been doing. The red/blue line (M3) is the line the line which most folks look at as the reflection of total money supply. Notice how sharply it’s been falling. That demonstrates very clearly that while the Fed has been pumping money in, it’s not turning into so-called bank money (money created by lending and borrowing). Until that starts to turn back up we won’t have any inflationary issues in the dollar.

Of course that leaves the question about how quickly the Fed will move to drain money from the system as the economy starts to improve.

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