A Temporary Lifeline for the U.S. Dollar 2011
Currencies / US Dollar Jan 18, 2011 - 05:17 AM GMTBy: Q1_Publishing
2011 is set to be the year of the dollar’s rebound.
At first glance, the dollar shouldn’t be on the rise. Official unemployment is stuck at near 10%. Dozens of municipal governments are set to fall into bankruptcy this year. The federal budget deficit is over $1 trillion. The Fed has signaled its intention to monetize more debt.
To top it all off, the government closed out 2010 by enacting a law to delay a tax hike and extend massive “temporary” spending that will widen the deficit by $858 billion over the next two years and, we expect, to push the annual U.S. deficit to nearly $2 trillion.
Despite it all though, the dollar was up last year. The U.S. dollar index actually increased 2.4% in 2010. It was only its third rise in the past 10 years last year. And now, despite widespread expectation the dollar will decline further, the uptrend is likely to continue into 2011. Here’s why.
The Real Winners in Financial Reform
The financial reform legislation passed almost six months ago. All the “benefits” like protection from predatory lenders reduced access to credit and lower fees higher interest rates are already starting to be felt.
Most of the reforms, however, haven’t even taken effect. Law firm Davis Polk & Wardwell put together 26 pages of flow charts to show how it will take up to two years to write the regulations and another 12 years to fully implement them.
There are still a lot of unknowns from the law. But one thing banks are sure of is that they will be forced to reduce the “risky” loans they can make. And that is where the government has thrown itself and the dollar a lifeline.
The chart below, recently featured by the Cato Institute, shows exactly how they’re reducing their risk:
“Safe” lending to government has surged while “risky” lending to business has fallen over the past two years.
In the short-run, this is great for the dollar. Over the long-run, however, this trend is even worse for the dollar because of the difference between business and government debt.
Businesses take on good debt. They borrow to increase productivity and grow. Since they are taking a smaller share of loans, there’s less productivity and growth. Businesses borrow to make more money and pay back the debt.
Governments take on bad debt. They borrow to fund social programs, costly and inefficient infrastructure (i.e. incinerators, high-speed rail, sports stadiums, etc.), and other expenditures which produce a negative return on investment. Government borrowing doesn’t really produce any means of repayment which after a certain point they’ll never be able to pay it back. That’s a point most western governments have already passed.
The Last Kick of the Can Down the Road
Now, we’re not trying to be Pollyannaish or dispute the obvious. We know the U.S. government debt is so large, there’s no real way out other than inflating the debt away or some type of default.
But the politicians who created the debt are not completely clueless. They know the music will stop at some point and government debt will be left without a chair. But there are plenty of steps to take that can keep the music playing.
The financial re-regulation legislation presented an opportunity to do just that. And do it largely out-of-sight from the majority of the public.
The trend of banks increasing lending to government will likely continue for a while. The government debt bubble will continue to grow right along with it.
As a result, this lifeline has pushed back its demise for a while, odds of a dollar rebound this year have increased, the final stage of the dollar’s demise will be even greater, and the window to buy gold at relatively low prices before the top-of-the-bubble-euphoria sets in will be open for at least a few more years.
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.
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