US medicine could be bitter for dollar
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala – The U.S. economy is in trouble, and most of the ways it may get help will be bad for the dollar.
While a weak dollar may help to revive manufacturing and bring inflation to eat away at the mountain of U.S. debt, it will also kill returns for foreign investors and just might be the beginning of a self-reinforcing pattern of weakness and dollar selling.
With the odd exception, the run of economic data out of the United States has been very poor. Monday’s Empire State factory index, put out by the New York Federal Reserve, fell to a negative 7.7 reading, confounding analysts’ predictions that it would claw its way back up to zero and marking the third straight negative month. The survey has only been around since 2001, but successive negative months have since then only happened when the United States has been in recession.
“If sentiment continues to be weak, most of the policy options available to U.S. policymakers are USD-negative. The USD weakness may not manifest itself while markets are under acute pressure, but even limited good news for asset markets driven by policy activism would again be bad news for the USD,” Steven Englander, foreign exchange strategist at Citigroup, wrote in a note to clients.
It must be said that there are strong impediments to effective action by the government or Federal Reserve to address the sliding economy. Fiscal measures may well be necessary, but given Republican opposition and Democratic diffidence, they look unlikely to materialize.
The Federal Reserve’s decision to pin short-term rates to near zero for two years appears to show a central bank that is willing to think radically. But even this decision, which is nowhere near enough to turn the economy around, came at a strong internal political cost, with three voting members of the Federal Open Market Committee voting against the move.
Those internal divisions, real and heartfelt as they are, pale in comparison with the external political divisions and risks that the Fed would take if it pulled the trigger on another round of quantitative easing. Critics from the right would see it as fiscal stimulus by another name, or worse, while the fact that QE2 caused commodity inflation made it widely unpopular and of dubious value.
QE3 is a ship that would face a barrage of artillery as it leaves the harbor, with no tangible evidence it would be capable of reaching its intended destination.
Englander argues that were the Fed to adopt QE3 as a “hail Mary” option it would prompt a “stampede” out of U.S. assets. Other central banks and governments would be forced to respond in kind, if not with QE than perhaps with protectionist measures, as they sought to avoid the pain of having their currencies strengthen even as global growth slows. That would focus asset flows onto the few commodities, such as gold, which cannot be protected or manipulated, as well as to those few currencies whose managers are content to let the market set the price.
QE3 would also raise very ugly questions in the minds of global investors, who may conclude that the Fed will be willing to try ever more extraordinary measures to finance the United States and stimulate its economy. This doesn’t need to happen, and foreign exchange markets only have to fear it for the downward moves in the dollar to be strong and self-fulfilling.
One policy move that could be dollar-positive would be a move to allow corporations tax relief on repatriated foreign profits, perhaps modeled on the Homeland Investment Act of 2004. Much of the $1.3 trillion or so of profits held abroad would flow home, and depending on how the new act was designed, might serve to support equity prices via dividends or share buybacks.
But a corporate profits holiday may not win political support, given the Wall St-Main St divide and political divisiveness.
There are already signs of some foreign unwillingness to hold U.S. assets. Private investors sold a net $18.3 billion of Treasuries in June, Treasury data showed on Monday, an all-time record divestment. This was counterbalanced by purchases by foreign central banks, many of which — notably China — buy Treasuries to keep their own currencies weak, rather than out of any investment or reserve management conviction.
Clearly worries in June about the end of QE2 and the debt ceiling battle have since been replaced by fears over global growth and a striking Treasury rally. But signs of actual policy developments in the United States might reverse that.
Perhaps the dollar’s biggest plus is the shocking state of most of its main rivals. The euro is a traffic accident waiting for an ambulance that may never come. The ambulance may arrive for the United States, but one of the costs will be a weak dollar.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.