The USD's Downward Trend

The title of this post may be the kindest words you here me say regarding the USD. To call it a downward trend is a compliment. I would like to discuss a few changes in my past opinions regarding this topic.

I'm not changing my overall view of the dollar's trend. I still feel that its eventual collapse is just a matter of time, but I would like to talk about the why of the collapse.

I haven't discussed the 'pillars of support' for a currency in a long time, but let's get back into them. I will first give a list of the pillars and than discuss some of them in greater detail. These pillars are not consistent with all currencies and the list in no significant order.

Support Pillars for the USD

The petrodollar. In other words, the tie of the USD to oil sales.

The USD as the reserve currency of the world.

Controlled money supply.

The ability to finance our debt through foreign investment.

A high Fed Funds rate.

Responsible fiscal/monetary policy.

Now I'm sure that I've missed out on a couple of pillars, but that's a good enough starting point. I need to point out an error in the last post I wrote discussing the pillars of support for the USD. I said the last pillar holding the dollar up was a reasonable Fed Funds Rate. In short, I stated that if the Feds lowered interest rates we would see a sharp decline or the USD. What I've come to realize is that, at this point, the Fed Funds Rate is the least important of the above mentioned factors. Sure at one point it would have been an effective monetary tool, but it's beyond that. Sure if the Feds raise interest rates we might see a brief, and I put emphasis on the word 'brief,' strength in the dollar. That strength will come from the ignorant buyer who feels that this will lead to some longer term strength in the dollar. At this point in time, the future of the USD is essentially independent on whatever the future of the Fed Funds rate.

Let's get into the juicy stuff. The petrodollar is a VERY strong pillar in the support for the USD. The connection of the USD to oil is starting to fade. For example, when Germany buys oil from Russia, they use USDs. That's the equivalent of U.S. buying oil from Canada in rupees or yen. It's ridiculous. How important is this relationship? It was important enough for the U.S. to invade Iraq. I wasn't a coincidence at all that Saddam was threatening to sell his oil in euros right before we invaded. Iran is already waging war on the USD by making it a criminal act to hold USDs.

This topic leads us perfectly into the next couple of pillars. The USD as the reserve currency of the world is an ever important topic. Why do central banks hold USDs? A couple of reasons: The first is that the greenback has been one of the most stable currencies over a long period of time. I'm not saying that that's the case today. In fact, I think it's just the opposite. That's something I will get into at the end of the post. But the other reason that central banks hold USDs is because they have to pay for their oil in USDs. So you can see, how the petrodollar is ever important in keeping the USD as the world's reserve currency. At this point, it is in the best interest for foreign central banks to keep the USD strong for these reasons. I will also dig into that at the end of the post.

The next pillar is again along these lines, and that is the U.S.'s ability to finance its debt through foreign investment in U.S. bonds and treasuries. The U.S. is roughly $9 trillion in debt. 80% of that debt is held by foreigners. We run roughly a $800 billion annual trade deficit which is 100% foreign owned. (Statistics from the guys at the Daily Reckoning) Our ability to sell treasuries and bonds is ESSENTIAL to the value of the USD. If the U.S. can no longer find foreign buyers of treasuries and bonds, we will no longer be able to finance our debt. This leads us right into the next couple of pillars.

I would like to discuss these two topics together. They are controlled money supply along with a responsible fiscal/monetary policy. You can see that they are very intertwined and often used in reference of one another. The value of currencies, like any other commodity or good, is based upon supply and demand. The more USDs in circulation, the less value. At the same time if demand starts to diminish, so will the value of the USD. If you are a reader of this blog you know that M3 money supply is no longer kept track of by the Federal Reserve, but there are other sources to find the statistic. It is currently running at around 12%-13% and it has been running at above 10% annual growth for a number of years now. Like I discussed in my recent post on inflation, money supply growth equals EXACTLY price inflation. How do you think 10%+ inflation would fly with the general public? Not very well, that's why the Fed masks it with core CPI and a bunch of other garbage.

There's the scenario regarding money supply and monetary policy. I touched on our fiscal policy earlier in reference to our current deficit. Please don't get caught in the junk politicians are feeding the public about our deficit decreasing and being ZERO by 2012. The liberals have proposed there new budget plans, and at face value it does appear if it's going down. What they don't tell you is that in that budget are tax increases as well as a repeal of the Bush tax cuts.

So there's a brief over view of some of the pillars that support the USD. Let's look into our current situation of these pillars and how they effect each other. You have to understand that there are tons and tons of USDs abroad. USDs are our main export.

As I mentioned that it, at current, it is in the central banks of the world's best interest to keep the USD at a reasonable valuation. They do this by selling euros or sterling and buying USDs. Again this is simple supply and demand at work. The situation now is that these central banks are starting to hold more euros and gold and less dollars. They understand that the USD doesn't stand a chance in the future. Here's what they plan to do. They want the USD to have a GRADUAL decline and not a free fall, and they are going to do their best to achieve it because a collapse in the USD will result in a collapse in the U.S. economy which will have strong ripples globally.

And here's how everything works. Once one of these pillars falls, the next will fall, and then the next, each breach in support coming faster than the next. Central banks will be unloading there USDs in exchange for physical goods, commodities, energy, euros, and precious metals. They will do this by unloading their dollars on the forex market putting downward pressure on the USD. This will force other central banks, whether they want to or not, to follow suit. Then the USD will no longer be tied to oil because banks will no longer be holding stock piles of USDs.

From there, we have a situation where central banks no longer want our treasuries and bonds because they are denominated in USDs. The U.S. will no longer be able to finance its debt and will be forced to monetize and print money. This will push the dollar further, and this is when we hit free fall stage for the USD. Anyone left holding dollars abroad will rush as fast as they can to get rid of them.

So you can see how this whole thing goes full circle and carries with it a snowball effect. We will see a gradual decline to a point and then it will be a rush to the exit. Ladies and gentlemen this is a transition that we haven't seen since the U.S. economy eclipse Great Britain as the dominate economy in the world. I promise you, this will be a most painful transition for the global economy in its history. Some will be effected more strongly than the others. Here in the U.S., we will see the strongest effects from this transition. This is also the reason why the sky is the limit for gold.