Making Money During a Dollar Crisis
The dollar’s downfall is having an effect on other currencies as well.
                                       The beneficiary is gold


This has been the worst monthly sell-off in the US dollar since the Iraqi invasion of Kuwait in August 1990, which coincided with a crisis in New York money centre banks that almost led to the failure of Citigroup, Chase Manhattan and JP Morgan. The dollar’s free fall has led to an incredible surge in crude oil and gold, which are seen as safe havens from the Wall Street credit meltdown, and the spike in inflation expectations. The Federal Reserve has made it clear that it will allow interest rates to plunge to bail out the banking system, exactly as it did in 1990-91. So the Fed funds’ rate has fallen from 5.25 per cent to 3 per cent since September and call has moved lower to 2 per cent as Ben Bernanke uses monetary policy as an instrument to offset the housing bust and the financial neutron bomb that has gutted Wall Street.

The dollar’s plunge accelerated after Jean Claude Trichet suggested that the ECB would not cut interest rates as long as eurozone inflation stays above 3 per cent. The divergence between an ultra-dovish Fed and an ultra-hawkish ECB has led to the meteoric ascent of the Euro/Dollar rate could change market sentiments. Despite Treasury Secretary Paulson’s “strong dollar” platitudes, US economic policy makers welcome a weaker dollar because it helps its trade deficit. Yet, a simultaneous plunge in US equities, financial shares, corporate bonds and the greenback is something a lot more ominous – a run on Wall Street. The emergency January 21 Fed meeting failed to revive either the stock market or arrest the credit meltdown in the mortgage, swaps and leveraged loan markets. The Fed cannot ease rates much below the core PCE, now running at 3 per cent. It is significant that the US Treasury bond curve continues to steepen, with short runs responding to Fed easy money policy while long rates rise to reflect inflation risk. Yet, if the capital markets price an end to Fed easing, a global stock market panic will result. This moment, I believe could well mark a bottom in the dollar.

Yen loses sheen
The Japanese yen, the world’s money pump to finance carry trades in risk assets, is the primary beneficiary of the global equity market weakness since August. Yet, the Chicago IMM data suggests that the Japanese yen long is a crowded trade as the gnomes of the Euromarkets unwind short yen positions. The rise in Japanese yen volatility has reduced the attractiveness of the yen as a funding currency. As short positions unwind, dollar-yen falls to 100, where the risk of the Bank of Japan becomes very, very real. Sterling has surged to 2.02 against the US dollar even as it has fallen to new lows against the euro.
 Yet, British macroeconomic fundamentals do not justify a stronger sterling and cable’s strength reflects US dollar weakness. Chancellor Darling has nationalised Northern Rock, one-third of British homeowners are struggling to meet their payments, London and the City are the global capital of structured finance Armageddon, consumer spending on Main Street is anaemic and New Labour’s public finance black hole is of Third World dimensions.
Yet owning sterling is a time bomb for investors. The Northern Rock fiasco was the most embarrassing financial debacle for any British government since George Soros made a billion dollar killing betting against the Bank of England during the ERM debacle in September 1992. The British economy is more leveraged to finance and consumer leveraged than either Germany or the US. The MPC will be forced to slash interest rates even at the risk of higher inflation. So while the current dollar woes can take cable to 2.04 in the short term, I believe sterling will trade at 1.90 in the next six months. After all, investors in the GCC should never forget that the British pound is correlated to the global economic cycle and global growth is headed lower in the next 12 months.

A similar rationale underlies my bearishness on the Australian and New Zealand dollar. As the Reserve Bank of Australia is on hold and Sydney is hostage to financial market stress, I believe industrial commodities are probably headed lower. This could undercut a crucial anchor of the Aussie dollar, which is headed lower to 0.88 against the greenback. The Kiwi dollar’s high yield status is also being offset by the softness in dairy prices. High interest rates will mean consumer spending and housing demand will weaken, meaning the Kiwi is vulnerable to both the US and, Aussie dollar, as also the Japanese yen.

Gold shines through
South African power outages, violence in Iraqi Kurdistan and Gaza, the spike in inflation expectations, speculative buying by Arabian Gulf and Chinese sovereign wealth funds and North Sea Brent crude oil at US$105 have all combined to lead to all time highs in gold, higher than its 1980 peak when the Soviets invaded Afghanistan and the American economy was devastated by inflation. South African mine production is in secular decline due to power outages, closure of marginal mines, Zulu-Xhosa tribal politics and labour stages. The failure of two German banks, an Australian property developer, the Peleton Partners hedge fund and the Carlyle Capital debt fund in Amsterdam as well as dozens of US mortgage banks means there is a rising systemic risk in the international banking system. This suggests gold could well rise to $1,100 an ounce.

The argument for GCC currency revaluations becomes even more compelling if the Fed funds’ rates falls below 1 per cent and the US central bank retains its aggressive easy money policy as long as the US economy continues to weaken. Never in modern times have the business cycles of the US and the GCC diverged so dramatically. Qatar and the UAE, the highest inflation economies in the GCC, will be most tempted to emulate the example of Kuwait and abandon their currency pegs to the dollar. While cement prices, rent, subsidies, property speculation, wages, food prices all contribute to GCC inflation, imported inflation is more a problem in smaller, open economies like Qatar and the UAE than in Saudi Arabia. With GCC monetary union now postponed, the political cost of a revaluation has fallen while a 1 per cent Fed fund rate could make its policy rationale irresistible in some GCC capitals.

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