Despite recent weakness in the US dollar, plenty of risk remains

Global attention is quickly turning to the recent weakness in the US dollar. There is a growing concern that the US dollar will continue to make its way lower as foreign creditors, namely China, become increasingly concerned with regards to the problematic debt situation and begin diversifying away from the currency.

Bill Gross, founder of Pimco, the largest bond fund manager in the world, put out what I believe to be a very good piece on the US dollar and the problems it faces in the years ahead (I recommend you read his article by visiting www.pimco.com and clicking on Bill Gross’ Investment outlook for June 2009).

The big point that Gross makes in the article is on the unsustainable level of the US debt to Gross Domestic product or GDP (think of GDP as a measure of your debt to what it is you produce in a given year, your income). Currently, the US debt is at 45% of its GDP. And despite that being somewhat high (Canada’s isn’t much better at 42% but China and Brazil score well at 20% and 36% respectively) the real concern stems from the fact that the annual deficit is of 10% of GDP. In other words, assuming nothing changes, add and compound 10% a year to the existing 45% and within five years the debt to GDP level is at 100%. Now imagine how a banker would feel about loaning money to Mr. and Mrs. Somebody whose debt equaled their annual income and didn’t have enough cash flow to survive without the bank’s willingness to keep lending them money. Mr. And Mrs. Somebody would soon find themselves in bankruptcy protection.

It goes without saying that US policymakers are promising to rein in spending and get the budget under control. And if they are successful in doing so, the concerns of a collapse in the US dollar may well fade away. Keep in mind however that the US economy is still in recession, one in five homes is worth more than the mortgage on it, the unemployment rate will very soon hit double digits, and the US consumer will not be able to resuscitate the economy this time around as they are going into a saving mode. As such, the US government will probably have to borrow more money and provide additional stimulus to an ailing US economy. Balancing the budget will not be easy and this is why we will continue to see increased concern with regards to what the long-term direction of the US dollar is.

Should foreigners choose to slow down their purchases of the US dollar, we are first likely to witness an increase in long-term bond yields, as bondholders demand to be compensated for the risk of holding US denominated debt. Now imagine the fictitious banker upping the rate of interest on Mr. and Mrs. Somebody, who are already in financial ruin. If bankruptcy wasn’t already being undertaken, it sure is now. The US economy would not be able to take higher rates at the current time as it is trying to recover from a recession. If the US economy is not yet in financial oblivion, higher interest rates would sure do it (the cost of mortgages, lines of credit etc. are based on long-term interest rates). What the US would do is simply print more dollars. And therein lies the big problem for the US dollar -- Slice a pizza into twenty pieces and you get a very unhappy group of guys who came over to watch the final game of the Stanley Cup final. Print more US dollars, and the dollar is worth less.

Look for higher taxes in the US (and oh, here in Canada too) as the US government attempts to lessen the worries surrounding its US dollar. But put me in the camp that believes the US will sacrifice their dollar in order to lend support to an ailing US economy.

We highlighted a US sell signal on April 23rd when the dollar was at 1.2395 to the CAD$. However, and this is very important for anyone looking to dump US dollars, trends are never in a straight line. Early last week, my short-term US dollar indicator turned positive and I expect the US dollar to muster up some short-term strength here. Should you wish to follow my ongoing views as to the direction of the US dollar, you are invited to read my Daily Observations on my site at www.moorerasponi.com .

If you have any questions on this, or anything else, feel free to contact me.

Robert T. Moore is an Associate Portfolio Manager and Wealth Advisor with ScotiaMcLeod in Pointe Claire, Quebec. Opinions expressed in this column do not necessarily reflect the views of ScotiaMcLeod or any of its affiliated companies. It is recommended that individuals consult with their own financial advisor before acting on any information contained in this article. Robert Moore can be reached at www.moorerasponi.com

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