Strength is relative

August 31, 2009 07:00 PM

The chatter started several years ago, perhaps around the time the euro came into being. The word was the U.S. dollar would soon lose its status as the world’s reserve currency. A new challenger was up to bat. Further, the world had found some new players that could replace the U.S. economy as the global leader.

However, this line of talk was pooh poohed by many as the U.S. economy was still the largest single country economy in the world. It still is, although the European Union (EU) is larger as a whole. But with the growth surge of China and India in the last several years, and China’s increasing ownership of U.S. debt, the talk has begun again. Also, the United States has turned its surplus into a massive deficit, one that continues to grow today. With the U.S. economy under so much pressure, has the U.S. dollar rightfully lost its reserve currency throne?

First the bad news: It won’t come as a surprise to anyone that the U.S. deficit will get worse, and chances are, much worse. Government spending has been on a binge for years and now has accelerated with the bailouts of Wall Street, Main Street and the U.S. auto companies. Add to that programs with some initially high price tags, such as the health care revamp, and it equals a big, deep hole. Despite the Congressional Budget Office’s (CBO) projection that 2009 will be the worst year before the deficit finally begins to reduce, the U.S. economy, and especially the dollar, will be dragged down by the deficit.

Second: It’s likely the Fed won’t raise rates in near future, which means the dollar won’t have any needed bolstering. (See "Currency outlook: Risk and recovery," by Associate Editor Christine Birkner.)

Third: The U.S. dollar index performs almost directly opposite the U.S. stock market. With analysts believing the stock market could head higher, this means some more downside on the U.S. dollar’s part.

Fourth (and when does this end?): The U.S. dollar keeps getting trash talked by other countries, especially China, Russia and Brazil. But come on, who’s listening to them?

The good news is: Hopefully the world is listening to them, or more exactly, watching them; more specifically, watching China. On one hand the country is talking the dollar down (or at least questioning its place as the reserve currency) while at the same time, and more importantly, it is buying up U.S. Treasuries with a fervor. This is good, in the sense that the Chinese are giving a cautious nod to the United States’ fiscal moves. But the reasoning probably has more to do with China being the largest owner of U.S. debt. If the U.S. dollar tanks too much, it only hurts China’s holdings. The Chinese are too good of traders to take the wrong side in
that scenario.

The second piece of good news is if the CBO is correct in its deficit projections, the hole we’ve dug ourselves into contracts after 2009.

And a third piece of good news is, well, the EU, and the euro, are in worse shape than the United States when it comes to fiscal issues. Although the EU has become a strong economic power, it still has major problems reining in spending. The result is the U.S. dollar, barring unforeseen circumstances, will remain in the reserve currency pole position, just as the U.S. economy will most likely remain the largest in the world for a long time.

What’s this mean for traders? Currency markets run deep but are fraught with political intrigues and commodity assassinations. Keep one eye on the fundamentals, but keep both eyes on the charts.

About the Author

In her many years covering the futures industry Ginger has interviewed some of today's best global hedge fund and commodity trading advisors. Ginger received a master's degree in journalism at Northwestern University's Medill School of Journalism and a bachelor’s in communication arts from the University of Wisconsin – Madison