So, what’s happening in the global economy? Let’s start with the weak dollar. As Fed policy tilts toward loosening, the already weak dollar hits a 15-year low, and is less than 2% from an all time low. The carry trade currencies, the yen and the Swiss franc, rallied the most during the dollar sell-off. (Here’s a good summary article on the carry trade.)
It’s not that foreigners are fleeing the dollar (unlike this article), though Treasuries are getting less attractive, because the dollar-based investments must be bought by someone. That doesn’t mean the exchange rates don’t shift down in the process, though, and exports seem to be improving because of the weaker dollar. Also, the idea that China would try to ruin the US through selling all of their dollar-based reserves is unlikely, though not impossible. China is too big of a holder to sell without driving the dollar down massively, which would force down the value of their remaining holdings, and harm their ability to export to the US.
Besides, what would they trade into? The US has the largest, most diverse debt markets in the world. One reas
on why the US is the world’s reserve currency, despite all of its flaws, is that there is no other economy with a currency capable of filling the role. Perhaps this article should have been titled, “Why isn’t the dollar falling more?” because the dollar has been falling, yet there are some things good about the dollar, and the US economy.
China is bumping up against the boundaries of its economy’s current capacity. With few additional young laborers, wage rates are rising. Inflation is now at a 10-year high. That’s leading the government to tighten monetary policy. Beyond that, it is raising the prices of their exports, which slowly forces inflation into the US and other trading partners.
India is facing similar difficulties. Wages are rising rapidly, amid rapid real growth, putting pressure on interest rates to rise. In one sense, this is what you get for taking back US assets in exchange for selling goods and services to the US. So long as your labor pool appears inexhaustible, you can avoid inflation at home, because you aren’t paying new workers much. But when workers become more scarce, the absence of imported goods for those workers to buy means that there will be inflation. Also, excess dollar reserves often produce excess credit, if the central bank allows the money supply to grow from the dollar reserves, which can lead to credit-induced inflation.
Final quick notes:
- Doesn’t look like the ECB, or any other major developed country central bank will tighten anytime soon. India and China are different here.
- As for Japan, if the credit crunch isn’t enough, GDP shrank recently. No tightening likely there.
- For average people planning on retirement, a declining dollar will hurt a little, but not a lot. It will add to inflation, and perhaps raise US interest rates, harming bond returns in the short run. Also, for those with no foreign investments, a declining dollar means foregone returns.
In summary, we are in a situation where the dollar is likely to remain weak. If currency calm returns, the carry-trade currencies will do badly, but if volatility picks up, the opposite will happen. (I can make a case either way.) China and India are on fire, and the developed nations are largely on ice. We are living in interesting times; in the long run, the development of the poorer areas of the world will be a big plus, particularly for US agriculture and resource extraction industries, but there will be bumps along the way. Keep your positions flexible enough to be able to benefit from volatility; I sense we are entering a more volatile period.