The Fall of the Dollar
Over the last decade, a number of countries have forced their currencies to be abnormally weak against the dollar. This resulted in two major effects.
First, there was rapid growth in exports across Asia with a concurrent rise in their trade surplus. These goods and services were artificially cheap to US consumers. This export surge also occurred in major commodity producing countries as they revved up to support the export-driven industrial boom occurring. Some commodity producers directly pegged themselves to the dollar, like the Middle East, resulting in further recycling flows.
The second effect, caused by the first, was a tremendous accumulation of dollar reserves by pegging countries. These dollars were invested by those countries into risk-free assets, driving down real interest rates on longer Treasuries and leading to Greenspan's famous conundrum. Private investors moved to spread assets and bid them far beyond rational prices, compressing spreads and interest rates across the risk spectrum.
These recycling flows were vendor financing on a massive scale. Without the pegs, US real interest rates would have soared, halting the process. Instead, a tremendous drop in real interest rates caused by this vendor financing enabled US consumers and corporations to take out stunning amounts of debt via HELOC's, asset bubbles, cov-lite loans, and so forth.
Through this financial intermediation, more and more money was available to the US to purchase commodities and finished goods from the rest of the world. The rest of the world bought more Treasuries and other safe debt, causing asset values to soar and interest rates to drop. This was all a positive feedback loop.
A lot of people saw the massive deficits being run by the US and thought the USD must inevitably crash. The consensus was that the USD would crash should China cease its massive reinvestment of its surplus. Indeed, the USD weakened gradually for many years in a row.
Compiling this, I posit a completely different explanation. The weak USD was a result of the vendor financing. As real interest rates were abnormally compressed by return-insensitive central banks, private capital fled the US to other destinations in search of higher real returns. Because USD was unable to weaken against CNY, it weakened against other currencies instead, making the real returns available even worse.
The strength of EUR and GBP was partially an export valve for some of the pressure on USD/CNY. As EUR and GBP strengthened against the USD, the asset bubble spread, and they picked up the consumer of last resort role from America's weary citizens.
The Rise of the Dollar
I first became concerned in February that the Earth's magnetic pole had flipped, making this powerful engine turn in reverse.
The weakness of the USD did begin to turn around in March, as the financial crisis began to affect trade in finished goods. It finally truly reversed upwards with the final bursting of the commodity bubble, and it's strengthened ever since.
Everyone is terrified the USD will continue to fall, mainly as a result of the massive quantitative and qualitative easing schemes underway by the Fed, the persistent current account deficit, the U.S. NIIP position, and so forth. I'm scared too, and I want to remain that way. But I can't justify my fear, and haven't been able to for awhile.
The USD cannot weaken against the CNY or JPY, and I'm very skeptical that there is any positive traction whatsoever from the fiscal and monetary programs underway. While there is a great deal of disagreement about what determines exchange rates, it's probable that relative real interest rates matter far more than money supply. And those are only moving in the USD's favor right now.
Indeed, government deficits raise real interest rates, rather than suppressing them. This is intuitively obvious and empirically demonstrable, but theoretically indeterminate, which confuses economists everywhere. Whether that is true in a liquidity trap environment, or whether we're in a liquidity trap now, remains up for debate. But I don't see any reason to believe, outside a stylized AD/AS curve and baseless Keynesian multipliers, that the rules should not still hold.
The effects of an insolvent Fed's debt load are the same as that for Treasury debt, which means that all these stimulus and rescue programs, including direct monetization, should only lead to higher real interest rates. Since the dollar can't lose value right now by imposition of the pegging countries, and nominal interest rates have hit the zero bound, I conclude that fiscal stimulus and debt monetization will strengthen the dollar and worsen deflation. Until the pegs are broken or serious inflation erupts in the rest of the world, this is the only possible outcome.
We have seen a further collapse in trade since September which is only worsening, lessening the odds of these pegs breaking, and reducing further the vendor financing that can be recycled. I expect to see further increases in US real interest rates.
The USD should continue to strengthen until serious inflation occurs in China, Japan, and other countries, or the pegs break. Until such a time, due to the increase in real interest rates and the damage inflicted by deflation, most assets, and particularly longer-dated ones, will decline in value.
If the pegs never break, and inflation never erupts overseas, then we can expect a massive wave of defaults in the US, possibly including Treasury. So, in perhaps the most likely outcome, USD assets could crash while the USD pulls through just fine.