The Future of the Strong Dollar Policy

Shortly after Barrack Obama is sworn in next week as the 44th President of the United States, the strong dollar policy turns 14 years old. It may not be much of an exaggeration to suggest as goes Obama’s dollar policy so goes his Administration.

This is not to endorse overly simplistic notions that the dollar is like stock in America. There are a multitude of factors that influence the price of the dollar not all of which have to do with what happens in the United States, like the conduct of foreign monetary and fiscal policy. Rather, a number of issues are involved in dollar policy and the judgments used to resolve them will be reflective of characteristics that may define Obama’s Administration.

The Strong Dollar Koan

First some background. In the early years of the Clinton Administration, the dollar was declining and Lloyd Bentsen, the Treasury Secretary, seemed to threaten to allow the dollar to fall against the Japanese yen to achieve objectives in the trade relationship. It aggravated the dollar’s decline.

It was reminiscent of James Baker, Treasury Secretary in 1987, who also seemed to threaten Germany with a depreciation of the dollar in order to get monetary policy concessions from the Bundesbank (lower interest rates). Some observers still attribute use of the dollar in that way as one of the contributing causes of the 1987 crash.

Goldman Sachs Robert Rubin replaced Bentsen and signaled a key shift in US policy. His mantra became “a strong dollar is in the US interest”, or some reasonable facsimile. Its meaning has confused many observers and it has often been derided. But it is important. As the world’s largest debtor, and getting bigger by the minute, the risk to foreign investors is that the US commits a stealth partial default by driving the value of the dollar down.

It may be lost on many pundits, but it is not lost on ECB President Trichet who has often noted that it is appreciated that the US endorses a strong dollar. The strong dollar policy is a commitment to foreign investors and policy makers that the US will not purposely drive the dollar lower. It will not manipulate the dollar’s value. It wants the markets, the aggregation of the supply and demand, to determine the dollar’s price.

It is especially ironic then that after 1995, Robert Rubin, the architect of the strong dollar policy, authorized intervention once after the dollar reached a cyclical low in 1995 and that was to sell dollars against the Japanese yen in 1998. His successor and top Obama economic advisor, Lawrence Summers also authorized intervention once. And that was as part of a coordinated effort to sell dollars for euros in 2000.

Greenback Returns

Over the past eight years, the euro has risen about 30.5% against the dollar. The Swiss franc has appreciated by about 41.5%, with the yen rising about 16.5%. Sterling is the notable exception of these majors, with a nearly 10% decline against the dollar.

Yet the return should not be considered simply in terms of spot movement. Total returns, which includes the yield of short-term deposits reveals a somewhat different picture. For a dollar-based investor, putting money into a euro time deposit after the controversial 2000 US election would have generated a total return of about 77%, while a time deposit in Swiss francs would have earned nearly 64.5%.

A deposit in yen would have generated a total return of a little more than 19%. Particularly noteworthy is sterling’s total return of nearly 40.5% for dollar based investors, as the higher yield offset the currency depreciation. A dollar deposit would have generated almost a 37% return.

President George Bush will go down in history as the first American president not to have intervened in the foreign exchange market. However, policy makers did take action that is often not appreciated by market observers. And contrary to all the hand wringing, the biggest challenge as the financial crisis became more acute in the last third of 2008 was not a surplus of dollars but a dearth. The Federal Reserve offered increasingly larger currency swaps with major foreign central banks finally making them unlimited and offering specific swap lines with four developing countries (Mexico, Brazil, Singapore and South Korea). Under these agreements the Federal Reserve made dollars available to others who in turn auctioned them in the domestic markets in exchange for the foreign currency and will exchange them back at an agreed upon future date. At its peak, the swap lines were worth more than $650 bln, making it one of the largest Fed facilities.

The multi-year expansion of global leveraging, and it truly was a global phenomenon, was predicated on the use of two financing currencies, the yen and the US dollar. To a lesser extent, some used the Swiss franc and the Hong Kong dollar as well. De-leveraging has meant the unwind of the currency mismatch and a destabilizing surge in the dollar and yen’s value.

The yen has appreciated by more than 30% on a trade-weighted basis since late Aug. This shock exacerbates the headwind caused by the collapse of foreign and domestic demand. It offsets in full the small rate cut the BOJ was able to engineer, given that it failed to normalize monetary (and fiscal) policy during the expansion phase.

In part because of the role of dollar financing in the world economy, the greenback’s shortage was even more acute. At its peak, the dollar rose about 17% on a trade-weighted basis, which also had the economic impact of tightening monetary conditions, offsetting or blunting the impact of the thrust of Fed policy. Although under-appreciated now, the swap lines clearly addressed the acute shortage of dollars, and may be one of the more unambiguously successful steps that US officials took.

The shortage of dollars appears to have largely been met. The swaps helped preclude the need for intervention, which may have confused the strategic signal that the US sends to other countries, especially China that market forces should determine currency values. In contrast, Japanese officials continue to struggle to find ways to address the apparent shortage of yen.

Team Obama

Political and economic trends do not appear to simply coincide with the presidential electoral cycle. Many things, like deregulation and defense build up associated with Ronald Reagan began under Jimmy Carter (airlines deregulation and increased arms spending after the USSR invaded Afghanistan). Obama’s historical election coupled with the low popularity of Bush suggests there are high expectations for change.

Obama spoke for many when he criticized the Bush Administration for “careless and incompetent execution” of the Iraq War. Yet he retained Bush’s defense secretary and put another Bush advisor in charge of the important National Security Council. Similarly, Obama’s foreign economic policy and in particular the dollar policy is unlikely to change substantively from what we have seen in recent years.

President Obama, however will likely be fortunate that the dollar’s multi-year bear market appears to have ended between late 2007 and mid-2008. The financial crisis, as measured by things like the TED spread or OIS/LIBOR, has moved away from the edge of the abyss, though of course the situation remains serious. Our expectation that the combination of the aggressive monetary and fiscal policy, dramatic decline in oil/gasoline prices, and the rise in real wages (inflation adjusted) will lead the beginning of an economic recovery in H2 may be on the optimistic side of the debate, but even the more pessimistic side says we may be off by only six months, which might be a bit of splitting hairs for medium and long term investors.

One element of dollar policy that the Obama team will have to address early on is the report on currency market manipulation. The Bush Administration never found China guilty of manipulating its currency for trade gain. There is some speculation that Obama will reverse this and cite China, which would open the door to possible retaliation (after negotiations). But there is little basis to believe this talk has merit. Obama’s Treasury team is heavily weighted by the free-trade wing of the Democrat Party (yes Mr. Rove they do exist). Obama’s team (and the media) ought to focus on the broad relationship with China and not allow the bilateral nominal currency relationship to dominate his message.