What is the Future for the US Dollar?

Rodney Johnson  |

China, the biggest foreign creditor of the United States, owns a truckload of our government bonds. Over the past several weeks, it’s been selling some of those bonds to prop up their currency, the yuan. This is supposed to signal the end of the dollar. As the Chinese put our bonds out for the bid, interest rates are going to shoot higher, driving down the value of the greenback and making imports unaffordable. At least, that’s what dollar haters have expected for years.

There’s only one problem: It’s not happening. And in our view, it won’t happen in the near future.

China’s actions have everything to do with their problems, and nothing to do with the valuation of the dollar, or their assessment of US policy moves. Besides, when it comes to US Treasury bonds, we’ve got an ace in the hole, even if we don’t like it very much.

In the early 2000s, the Federal Reserve devalued the US dollar by holding interest rates exceptionally low. Since the Chinese yuan is pegged to the dollar, Chinese goods became ever cheaper in currency terms on the world market.

They sold a lot of stuff, so their exporters were flush with foreign currency. They traded their dollars, euros and yen for yuan, which the Chinese government had to print to satisfy demand. The process led to inflation in China from all the newly-printed currency, and a rapid buildup of foreign reserves in their central bank.

After cries of currency manipulation and a lot of inflation at home, the Chinese allowed their currency to strengthen a bit. The pegged rate moved down from just over eight yuan per dollar to about six yuan per dollar over the course of a couple of years. On a daily basis, the government allows the yuan to trade two percent above or below the pegged rate. To keep the yuan within the band, the Chinese government uses some of its foreign currency to buy or sell yuan as needed.

This all works great until economic trends change.

China's Rising Currency Value Worsens Problems 

The last two years have been particularly painful for China. Economic growth in the Middle Kingdom slowed, and property prices turned lower. But instead of their currency easing, as would be expected if it floated freely, it got stronger. The rising value had nothing to do with the economics of China of course, they were just along for the ride as the dollar powered higher.

The strengthening yuan made Chinese goods more expensive to the world, which is the exact opposite of what they needed to get their economy growing through higher exports. Meanwhile, the currency of competing countries like South Korea, Vietnam, and Japan fell against the US dollar and, to some extent, the euro. This made Chinese goods even less competitive.

In response to all of this, the Chinese recently devalued their yuan. In a surprise move, they increased the number of yuan per dollar by 2.5%, and then allowed the rate to edge up an additional 1.5% over the next few trading sessions. The moves sent shockwaves through the financial markets.

Was this the end, or would they devalue more? What exactly was their currency worth? Are their economic reports believable, or are things much worse than we know?

At the same time, carry trade investors got crushed. These folks borrow money in countries with low interest rates, like the euro zone and the US, and invest it in higher interest rate markets, like China. The trade depends on stable interest rates and exchange rates. Since the Chinese yuan is pegged, this was perfect…right up until it wasn’t. When the Chinese devalued, these investors lost billions of dollars.

Both carry traders and those spooked by the general economic state of China are rushing for the financial exit from the country. To do this, they must exchange their yuan for foreign currency, which puts downward pressure on the yuan. To stop their currency from dropping more than they want, the Chinese must defend it by selling foreign reserves and buying their currency.

This is where the US dollar comes in. The Chinese hold $1.27 trillion of US Treasury bonds, which is the largest component of their $3.1 trillion in foreign reserves. Over the past two weeks, they’ve reportedly sold $100 billion of US Treasuries. This has dollar haters screaming about the coming crash of the greenback.

But as I said, nothing of the sort is happening. The market has easily absorbed the US Treasuries China recently sold, as is evidenced by the fact that US interest rates aren’t shooting to the moon. The world recognizes that China is the one with a currency problem, not the US.

Even if the Chinese sold another $100 billion, or even $200 billion, it’s hard to see the effects on US interest rates, and therefore the dollar, being more than just a passing blip.

If a short-term pop in rates did occur, that would be an opportunity, not a risk. It would give investors a chance to grab some yield before rates fell again in what we see as a long-term deflationary environment.

As for the ace in the hole, the same group that’s failingly tinkered with the economy can always step in. If the Fed felt that the Chinese were going to sell a block of bonds that would destabilize the markets, the Fed could always buy the bonds directly, adding them to their already swollen inventory of US Treasuries.

I imagine such a move has already been discussed.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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