Friday, 15 June 2007

Three years of rate rises - keeping the $ afloat

Over the past 5 years, the dollar has lost 30% against the pound and 20% against the Rupee.

In Nov 2003 the outlook for the dollar then (as now) was very bad indeed. Over the next four months the dollar slid 15% against the pound.

This was a MAJOR slide for the dollar, not just against the pound but against all currencies. For instance, the Reserve Bank of India had to keep the Rupee low otherwise Indian exporters would lose ground against the Chinese (who had a fixed exchange rate against the dollar) but the selling pressure on the dollar was massive. By April 2004 the dollar was down 12% to the Rupee from the start of the chart and looking to go further.

At this time, the US interest rates had been low because the Federal Reserve was trying to pump up the money supply in the economy to help it grow out of the post Sept 11th/dot-com bust slowdown. Although the Fed just about managed to prevent a recession, it created massive debt and a massive property & equity bubble as consumers and hedge funds took advantage of the low rates to borrow way too much to acquire houses and stocks.

Since the US was (and is still) running HUGE trade and budget deficits, it desperately needed some way to attract continue to attract foreign loans to finance these deficits. However, no one wants to loan to a falling currency and this can cause a downward spiral on the dollar value which would have been a cause for recession and inflation.

To stem the dollar decline the Fed was forced to announce the end of easy credit and had to start steeply increase interest rates from Spring 2004 (see chart below). The dollar "bounced" and stabilised as the world rolled back their oversold positions in the dollar. As the tightening cycle proceeded, the dollar "only" lost 10% against the pound over 2 years (until mid-2006) and held steady against the Rupee.

However, since the tightening has stopped, the dollar has resumed its decline and has again lost 10-15% against both the Pound and the Rupee.

At this point the Fed is between a rock and a hard place. Further rate hikes will worsen the property price falls across the US, reduce consumer spending, and lead to a recession.

NOT hiking rates on the other hand will cause the dollar to continue its downward path, losing about 10% an year. If the markets decide that a loss of 10% a year is not worth the 5% interest they get in US treasuries (which to me is a no brainer but Saudis & Chinese seem to be kinder than I am to the US), the dollar decline will accelerate. So any which way you look at it, the risk of holding dollars is too much unless you have some sort of political favour you are doing to the US.

Stick your monies in Rupees/Pounds/Euros/Gold until then. If you are in the U.S., you can do this if you have a brokerage account. Just purchase a Gold Exchange Traded Fund (ETF) (Symbols: GLD or IAU; Charts: Generally, gold goes up when the dollar goes down. A currency ETF can give you convenient exposure to other currencies, but the best idea is to get an excellent Fixed Deposit in India which will give you nearly 10% per year via your NRO account. You can bring back $50k per year so don't worry about the NRE/NRO distinction.

It would be a great idea to get a dollar loan to purchase gold. What you pay in interest will more than compensated for by the likely decline of the dollar while you are paying it back.

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