News from Alpine Capital Bank

Among the many known risks to the global economic recovery, the decline of the USD has been a hot topic lately. After the global economy left the gold standard in favor of fiat currency in 1971, the foreign exchange markets have viewed currency moves in terms of US dollars. The dollar is the currency of choice for global trade and is considered a safe haven during periods of volatility. The U.S. Dollar Index, which tracks its value against six currencies (the euro, the yen, the pound, the Canadian dollar, the Swiss franc and the Swedish krona) has steadily been falling since March, when the U.S. stock market took off on its current rally. As investor risk appetite returned and the safe haven demand for dollars dropped, an uncharacteristic divergence between U.S. equities and the greenback has emerged. The weakness of the USD is now a front-and-center financial topic, but this weakness has been a multi-year trend that was only briefly interrupted by the recent financial and economic crisis.

Essentially, money serves three main purposes for society: as a medium of exchange, a unit of account, or a store of value. Currency rates fluctuate when one currency is perceived to be better than another at fulfilling one or more of those three roles. The massive US stimulus in response to last year's financial crisis jump-started the global economy with cheap liquidity. An unintended, though not unexpected, side effect of this cheap liquidity has been USD weakness. This persistent weakness has called into question the future of the USD as the reserve currency for most of the global economy. While there are fundamental reasons for the USD to decline relative to other currencies, in a fragile recovery, the pace of the decline may be more important to investor confidence.

Continued USD Primacy

Recent IMF foreign exchange reserve data shows that the current share of the dollar in the global total is at its lowest level since 1995. The combination of near zero interest rates and a weak dollar has made the USD an attractive financing currency for traders and speculators. The 3-month interest rate differential between the US and a weighted average of its major trading partners has swung from more than 2% a few years ago to essentially zero today. Exchange rate volatility has also subsided over the past year, thereby lowering the perceived risk of borrowing in lower-yielding currencies to invest in higher-yielding alternatives. While the return of the carry trade could continue to weigh on the dollar for some time, we think there are good reasons for the dollar to remain entrenched as the world's dominant reserve currency.

The economic relationship between the United States and China, the only other global economic power, has been described as an embrace in which both parties are mutually dependant. Although China has voiced its concerns about the status of the dollar as the world's reserve currency, the Chinese renminbi remains pegged to a fixed rate of exchange in USD. This keeps China's exports to the US stable, which is the key to financing their domestic growth. China must continue to accumulate U.S. assets to keep its exchange rate stable, and they have increased their holdings of US Treasuries over the past 3 quarters.

The dollar has already depreciated significantly since 2001 without large-scale diversification of reserves among sovereign wealth managers. As last year's crisis demonstrated, the USD was still the denomination of choice for the global economy. There is little incentive for reserve managers to begin selling their dollars now unless a better alternative emerges.

While likely, USD primacy is not a given. Russia, a huge energy exporter to Europe, has been calling for an alternative to the USD as the global reserve currency. World Bank President Robert Zoellick said, "The United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency." Last month in Pittsburgh during the G20 meetings, U.S. Treasury Secretary Timothy Geithner defended the dollar, emphasizing the dollar's "special responsibility" to preserve confidence in the global financial system. He also reiterated the need to "sustain the dollar's role as the principal reserve currency in the international financial system." Dollar primacy reflects the incomparable strength and stability of the US financial markets, even during times of economic upheaval. With such power also comes great responsibility, and US officials seem to understand the need to keep any further weakening under control.

Central bankers around the world have had currency stability as a mandate for over a century, so any perceived instability can shake long standing assumptions and lead to a crisis. A weak dollar promotes exports and growth, but in the longer term, the potential for a dollar breakdown exists due to the massive and increasing fiscal deficit. Once the economy recovers, policy makers will have to focus on deficit reduction in order to avoid a USD collapse. The unexpected appearance of either inflation or deflation could result in a sudden withdrawal of capital from US equity markets and unravel the signs of growth carrying the market since spring. Mohammed El-Erian, a former deputy director of the International Monetary Fund and current co-CIO and CEO of PIMCO, said, "the real risk is that you will get a disorderly decline."

Confidence is the Key

Confidence in the greenback is necessary, as the world needs a stable reserve currency. Tightening credit and raising rates would strengthen the dollar, but doing so too fast or by too much could push the US economy back into a recession. The current divergence between dollar weakness and equity strength can become a catalyst for a renewed asset bubble as money creation leads to inflationary pressure. A potentially worse situation occurs if the stimulus doesn't work and deflation ensues. Instead of looking at the current economic data as evidence that fundamentals are improving, equity investors should not mistake asset inflation for real wealth appreciation. It is likely that dollar will stabilize and reverse course, but it's important to understand and guard against the risks that continued weakness would have on asset prices.

Justin Frankel most recently managed the Structured Investments business at Morgan Stanley, helping the firm's Financial Advisors invest over $4 billion of client assets. Justin began his career on the floor of the NYSE working for a Specialist firm before becoming a Market-Maker for a NASDAQ trading firm in the late 1990's. He spent over 6 years at Merrill Lynch where he helped grow their structured products business before working as a Private Wealth Advisor at both Merrill and UBS, where he and his partners were responsible for advising on over $1 billion in client assets. Justin has a B.A. from Lehigh University in International Relations and was a Martindale Scholar.

Jeremy Berman most recently managed Morgan Stanley's Structured Solutions group for the eastern half of the U.S., creating customized derivative solutions in structured note and over-the-counter format. Prior to Morgan Stanley, Jeremy held similar positions at Bank of America and JP Morgan, where he focused on creating risk managed solutions for ultra high net worth individuals in the United States and Latin America He has been responsible for creating, trading, and marketing structured products throughout his career. Jeremy has a B.A. from Haverford College, and graduated Beta Gamma Sigma with an M.B.A. from Columbia Business School.