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Hedge funds are the new sensations of Wall Street, NY Times reports
A Blend of Risks Makes Dollar's Outlook Grim;
Traders' Pessimism Could Bring Selloff
By David Altman
International Herald Tribune, Paris
Sunday, March 27, 2005
http://www.iht.com/articles/2005/03/27/business/dollar.html
Is the writing on the wall for the U.S. dollar? Researchers at one
big fund manager say it is, but the markets haven't read along just
yet.
Since the start of March, Bridgewater Associates, a manager of more
than $100 billion of institutional and hedge fund money based in
Westport, Connecticut, has been issuing warnings in its daily
reports. One on March 11, titled "The Breakdown of the Dollar
System," said, "As we often say, we've seen this movie many times,
and we know the ending."
There is indeed a volatile blend of risks surrounding the dollar.
President George W. Bush's new budget proposal would substantially
expand the government's debt burden in the next decade, potentially
raising doubts about the desirability of its IOUs. Some Asian
central banks have declared that they will diversify their reserves
away from dollar-denominated assets. If China decouples the yuan
from the dollar, it will not need as many dollar-denominated assets
to keep its currency from gaining value, nor will its competitors
for export markets. In recent times, long-term interest rates have
stayed stubbornly low, making it difficult for American companies to
attract new investment from abroad.
These ingredients may just be waiting for the right catalyst. If
enough people start thinking like those at Bridgewater Associates,
the dollar will lose value rapidly. There is no point in buying
dollars today, after all, if everyone thinks that they will be worth
less in the near future. Fundamental economic factors need not
worsen any further; in currency crises, perception very quickly
becomes reality.
Bridgewater says it believes that the dollar is already beyond the
point of no return. To keep the currency at its current value,
private investors will have to buy more American securities as
central banks desert them, said Robert Prince, the firm's co-chief
investment officer. Before private investors will act, they need to
see a higher return from American assets, relative to assets
carrying similar risks abroad.
Prince said that those higher returns had begun to arrive through
lower prices for assets. If an asset comes with a fixed interest
payment, say 4 percent, buying it at a lower price will offer a
relatively higher return. But these higher returns could cause
problems for the economy. Borrowers in the competitive market for
credit will have to offer higher returns, too, and interest rates
may rise.
"The Fed doesn't want that, because too much of a rise in interest
rates will choke off the economy," Prince said.
The alternative is for the assets' prices to remain the same while
the dollar loses value. That way, foreigners will be able to buy
assets at a discount, yielding a higher return, but without putting
too much upward pressure on American interest rates. (The implicit
assumption here is that the assets' future returns will not be
harmed too much by today's lower dollar.)
So, instead of allowing the economy to adjust purely through higher
interest rates, perhaps causing another recession, Alan Greenspan
and his colleagues at the Federal Reserve will have the luxury of
allowing the dollar to do some of the heavy lifting. The numbers?
Bridgewater predicts a further decline in the dollar of 30 percent,
especially against Asian currencies, and a rise in American long-
term rates of one-half to one full percentage point.
Not everyone thinks that events will play out this way. "It's really
too extreme to be talking about potential crises in the dollar,"
said Martin Evans, a professor of economics at Georgetown University
in Washington.
"Yes, we have seen a large movement in the dollar versus the euro in
particular, but to say we're sort of on the edge of a precipice
isn't really merited by the facts. The premise here -- thinking that
it's impossible for the dollar to come back -- I also don't buy."
Evans said the Fed's hand would be forced by the rising tide of
inflation. "The Federal Reserve cares about inflation," he
said, "and they're going to be very reluctant if they start seeing
the inflationary effects of the decline in the dollar to just sit by
and say, 'But we need low interest rates to support exports."' He
predicted that the Fed would put the clamps on credit, leading to
interest rates high enough to attract foreign capital: "We are going
to see quite a sharp tightening in the United States, perhaps
tighter than people are expecting."
Drastic predictions for the government's fiscal position may not
come true, either, even though the White House's budget plans would
raise the debt-to-GDP ratio in 2015 to 37 percent, versus 29 percent
under current law. "I don't think it's big enough to warrant the
attention it's gotten," Douglas Holtz-Eakin, director of the
Congressional Budget Office, said of the U.S. fiscal erosion. "A lot
of the dollar's future will in fact be driven by the other
determinants."
That does not mean the budget can be ignored. Holtz-Eakin said he
expected that the government would eventually have to move back
toward a surplus.
"It is unavoidable that we will rein in our spending," he
said, "because we are unlikely to be able to tax enough to cover it."
Though action by the Fed and a clampdown on government spending
could spare the dollar, they would both be bad news for the economy.
A cutback in government spending will, at least in the short term,
create slack in labor and product markets. And one of the surest
forecasters of recession is a tightening of short-term credit by the
Fed.
Congress and the White House have shown no sign that they are
serious about controlling spending, but the Fed's policy-making
committee may already be proving Evans right. After the committee
opted to raise short-term rates another quarter of a percentage
point last week, its statement acknowledged that "pressures on
inflation have picked up in recent months" and asserted its
willingness to act forcefully if necessary.
Whichever way you cut it, we're in for a bumpy ride.
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