http://www.kitco.com/ind/Dorsch/printerfriendly/may232006p.htmlDo you believe in conspiracy theories? Sometimes they are difficult to refute. Such was the case last week, just after the Euro had soared towards a 12-month high of $1.30, and the British pound, itself ridden with large trade and budget deficits, stood mighty tall at $1.90, with traders setting their sights for $2 for the pound. The US dollar lost 7% in just six weeks against America's main trading partners, and was 28% lower since January 2002, to stand just 1% above its 1995 low.
Then on Sunday May 14th, currency traders in London, picked up an obscure report from the UK’s Observer newspaper, that indicated the International Monetary Fund was in behind-the-scenes talks with the EU, Japan, the US, China and other major powers to arrange a series of top-level meetings to tackle imbalances in the global economy, and address the dollar sell-off that was rattling global stock markets.
Fearing a surprise rescue package for the US dollar, London currency traders began to lock in profits from the Euro’s six week old rally to just shy of $1.30. As always, the first line of defense in the currency market is jawboning, and finance officials in Europe, Japan, and the US were out in full force, talking the Euro and Japanese yen down, and the US dollar up. Timely jawboning by G-7 finance ministers, helped to keep a lid on the Euro just below $1.30, and rescued the dollar at 109-yen.
G-7 central bankers understand that a weaker US dollar can exert upward pressure on the cost of US imports, which rose 2.1% in April, and account for 17% of Americans purchases. And a sharply higher Euro and Japanese yen against the US dollar, also subtracts from profit margins of European and Japanese exporters, which is unraveling the EuroStoxx-600 and Nikkei-225 stock market rallies. European and Japanese central bankers have worked very hard to inflate their equity markets for the past four years to stimulate consumer demand through the “wealth effect.”
G-7 central bankers and finance officials are also alarmed by gold’s spectacular surge against all major currencies over the past eight months, a clear signal that global investors have lost confidence in the purchasing power of fiat (paper) currency. A global flight from G-7 government bonds and into gold since September 2005, has lifted bond yields to multi-year highs in Japan and the US, the world’s largest debt markets, and in a long delayed reaction, triggered big shake-outs in global stock markets in mid-May.
However, a guardian angel came to the rescue a half-hour before the London a.m. gold fix on May 15th, by unloading a big chunk of the yellow metal, hitting all bids $35 per ounce lower to the $680 level. Within hours of the gold sell-off, dazed gold traders were hearing Japan’s finance minister Tanigaki and the ECB’s Noyer threatening intervention on behalf of the US dollar, and conducting jawboning exercises about the virtues of currency stability for the global economy.
Then on May 19th, leaving gold bugs on a sour note heading into the weekend, US Treasury Secretary John Snow insisted on CNBC television that the Bush administration still backed a strong dollar. “It’s a policy we’ve made clear, that Japan signed on to, the statement coming out of the G-7 finance ministers' meetings, which said open, competitive markets are the best way to set currency values," Snow said, adding, "I say our policy is the strong dollar."
Gold tumbled as low as $638 per ounce on May 22nd, on concerns that the Bernanke Fed would back up the Treasury’s rhetoric about a strong US dollar, by lifting the fed funds rate 0.25% to 5.25% at its June meeting. "I have full confidence that Chairman Bernanke and the Federal Reserve are committed to price-stability and understand that this is their number one priority," Snow added.
Foreign Central Banks Switching out of US Dollars
The United States needs to draw in more than $3 billion every working day just to break even from external deficits, and prevent the US dollar from falling further and keep interest rates from rising too far. The US current account deficit is the broadest measure of trade, including financial transfers along with goods and services, and widened $136.9 billion from 2004 to $804.9 billion in 2005, representing 6.5% of US gross domestic product, up from 5.7% in 2004. However, Treasury data showed that central banks only bought a net $1.6 billion of US stocks and bonds in March, the lowest since they were $14.4 billion net sellers in March of 2005. Japan, the largest foreign holder of US government debt, sold a net $18.2 billion in Treasuries in February, but still holds a total of $640.1 billion. China bought a net $1.6 billion in US debt in March and holds $321.4 billion. Middle East oil kingdoms recycled $16.8 billion petro-dollars through British banks, and UK holdings rose in March by $16.8 billion and total $251 billion.
Nowadays, the US dollar is heavily dependent upon its role as the world's reserve currency, used for transactions in internationally traded commodities such as copper, crude oil, and gold. Therefore, foreign central banks must stockpile US dollars, which account for more than two thirds of all central bank reserves worldwide. This special reserve status means that the US dollar is always in demand, whatever the underlying strength of the US economy, or the level of US interest rates.
But the US dollar’s counter trend rally from January 2005 to March 2006, that rode on the back of 16 quarter-point rate hikes by the Federal Reserve, started to unravel in April, following news that Sweden's Riksbank Sweden has cut its US dollar holdings, from 37% to 20%, with the Euro's share rising to 50 per cent. Kuwait, Qatar and United Arab Emirates also said they were buying Euros. Central banks in China and Japan hold less than 2% of their combined $1.75 trillion of foreign currency reserves in gold, and instead, hold depreciating US bonds.
But it was Russian finance minister Alexei Kudrin, who on April 21st, dropped the biggest bombshell on the US$ at the annual meetings of the World Bank and International Monetary Fund, by openly questioning the dollar's pre-eminence as the world's absolute reserve currency. The Russian central bank raised the Euro's weight in the currency basket against which it targets the ruble, by 5% to 35% on August 1st, 2005, reducing the dollar's share to 65% from 70 percent.
“The US dollar’s recent volatility and the US trade deficit cause significant changes in the international situation and that is why we do not understand the US dollar at the moment as the universal or absolute reserve currency. The international community can hardly be satisfied with this instability. Whether it is the US dollar exchange rate or the US trade balance, it definitely causes concerns with regard to the dollar’s status as a reserve currency,” Kudrin declared.
The EU-25 is dependent on Russia for 25% of its gas and 25% of its oil imports and sales of raw materials to the EU providing most of Russia's foreign currency and over 40% of the revenue for the Russian federal budget. It might only be a matter of time, before Moscow asks for Euros instead of US dollars for Urals oil. Iran’s hardliner Mahmoud Ahmadinejad said on May 5th, that the Islamic republic still plans to open an Oil Bourse on the island of Kish within two months, and his close ally Hugo Chavez of Venezuela is also threatening a switch to Euros for oil transactions.
If Russia, Iran, and Venezuela decide to switch to Euros for future oil transactions, it could force the Federal Reserve to hike the fed funds rate to much higher levels to defend the US dollar in the foreign exchange markets. That in turn, could crush the US housing sector and rattle the S&P 500 stock index. Such a conspiracy theory is a dollar bear’s dream, but could happen if the US crosses the red line of using military force to shut down the Ayatollah’s nuclear weapons program.
In retrospect, the seeds of the latest US dollar crisis were also planted by Federal Reserve chief Ben Bernanke on March 21st, when he signaled that the Fed could live with a weaker dollar to help correct the US current account deficit.
"Although US trade deficits cannot continue to widen forever, these deficits need not engender a precipitous decline in the dollar, nor should such a decline, were it to occur, necessarily disrupt financial markets, production or employment,” Bernanke said in a letter to Rep. Brad Sherman, a California Democrat. However, two months later, the US dollar came under heavy speculative attack, sparking fears of higher inflation, and triggering a 4.5% panic ridden shakeout in the S&P 500.
Sliding US dollar Rattles European and Japanese stock markets
Germany, which accounts for a third of the Euro zone economic output, has relied heavily on its strong export performance to power growth as high unemployment and weak consumer spending held back the domestic economy. The German economy expanded by a weaker-than-expected 0.4% in the first quarter of this year, while exports soared 3.2 billion Euros in February to a record high of 72.9 billion Euros, or 18% higher from a year earlier.
However, the surging Euro fueled concerns that its rise may begin pricing out European exporters and could stall the Euro area's gradual economic recovery. "If we were to have a lasting strong appreciation in the Euro, then of course that would slow our exports. And exports in Germany remain a very important pillar of our economic development,” said Wolfgang Franz, president of the ZEW institute.
Similar to the tumultuous experience of the US benchmark S&P 500 index, the surging Euro contributed to a more severe 9% shake-out in the German DAX-30 index from a 5-year high of 6150 to as low as 5600 on May 22nd. Because the Chinese yuan is pegged to the US dollar, the Euro’s surge is also subtracting from export profits in yuan. Conversely, a weaker US dollar inflates the profits of S&P 500 companies, which earn 40% of their revenue from abroad.
Jumping to the rescue of the German DAX-30 stock index on Sunday, May 21st, German Deputy Finance Minister Thomas Mirow said, "The whole story is to be seen through the panorama of the US dollar. We do not want to see abrupt changes of exchange rates. So at the level of $1.27 to $1.30, we esteem that there are no acute problems for Germany,” he said.
German finance minister Peer Steinbrueck added, “The development of the Euro can be absorbed easily by Germany. Energy imports become cheaper. I can live with the current development.” Germany has been the world's top exporter for the last three years, with much of its foreign sales driven by technology companies competing in high-end, high quality markets.
France’s Finance Minister Thierry Breton said on May 17th that the French economy could absorb the rise in the Euro's to $1.30 but signaled that further strong gains would not be welcome. "We constantly discuss these risks on exchange rates, notably within the G7. It is true that we must be attentive.”
Japanese financial warlords on Red Alert
Millions of words have been written about Japan’s ministry of finance and its heavy handed interventionist policies in the foreign exchange and Japanese bond market. The MOF is on 24-hour alert for signs of dollar weakness or lower bond prices that could undermine the benchmark Nikkei-225 stock index.
The US dollar’s slide from 118-yen on April 10th, to as low as 109-yen on May 17th, was the catalyst for a 10% slide for the Nikkei-225 from its 5-year highs of 17,600 set in early April to 15850 on May 22nd. A lower US dollar subtracts from earnings of Japanese exporters and multinationals with operations in the US, which is why Japan’s financial warlords spend so much time trying to manipulate the yen’s value.
“The foreign exchange market should reflect the economic fundamentals and the excessive volatility in forex would have a negative impact on growth in the economy including Japan," said Hiroshi Watanabe, Japan's foreign currency chief. Japan holds a whopping $640 billion of US Treasury bonds, so the US Treasury cannot tell Tokyo to keep its hands off the US dollar, nor can it call China a currency manipulator, while Beijing holds $321 billion of US Treasury debt.
Japan's economy grew at faster than expected 1.9% rate in the first quarter, heading for its longest postwar expansion, as consumers and companies became optimistic for the first time in almost 16 years in April, (contrarian signal?) Wages have risen for six of the past seven months. Unemployment is at a seven-year low of 4.1 percent. But the Nikkei’s 10% setback since the start of the second quarter puts the future of Japan’s longest economic expansion in doubt.
Bank of Japan chief Toshihiko Fukui commented on May 19th, “The global economy, including the United States and China, continues to expand firmly. Although signs have not become clear yet, there is some upward pressure on prices. Central banks are gradually making an adjustment in their loose monetary policy. It is still uncertain whether such steps could contain inflationary risks. There is also uncertainty on whether there will be a soft landing in the global economy or whether a slowdown will be too much."
The Nikkei-225 fell 1.8% on May 22nd, to close below the psychological 16,000 level for the first time in more than two months. In Singapore, Japanese yen Libor futures for December 2006, rallied 4 basis points to 99.32, for an implied yield of 0.68%, still discounting a hike in the BOJ’s overnight loan rate to half-percent by year’s end. The BOJ has withdrawn 16 trillion yen ($150 billion) of excess cash from the local banking system since March 9th, when it announced the end of its ultra easy policy.
“The process of drawing down current account deposits is proceeding well,” said Fukui on May 19th. “If we go on at this rate, without disrupting markets and if transactions among market participants go smoothly, we will be able to finish the process of absorbing excess funds in the next few weeks. For now, our target is to guide the overnight call rate at around zero percent.”
"We will reduce (excess cash) to below 10 trillion yen ($90.10 billion) for sure. I would use figures like 6-7 trillion yen or my previous comment about a level somewhat below 10 trillion yen, but we do not have a specific target in mind,” Fukui said. Still, a possible Nikkei-225 meltdown could persuade the BOJ to leave its overnight loan rate at zero percent for a long time.
"We have no preset idea on the specific timing for exiting zero interest rates. It is highly possible that the accommodative financial conditions will be maintained for some time following a period in which the overnight call rate is at effectively zero percent. Through and beyond this stage, the bank will adjust the level of interest rates gradually in light of developments in economic activity and prices,” Fukui said.
No doubt, Japan’s financial warlords will keep a close eye on the Nikkei-225 and the dollar /yen exchange rate, before lifting rates above zero. Japan's Chief Cabinet Secretary Shinzo Abe said May 19th, that he wanted the BOJ to support the economy by keeping interest rates at zero. "We want them to work together with the government to make sure we depart from deflation. We want them to support the economy sufficiently from the monetary policy side by keeping rates zero."
