Wednesday, December 17, 2008

Can Big Ben Turn the Credit Crisis into a Currency Crisis?

I think this is the big question facing us today. So far, the world, US pensions, and US investors have been happy to lend to the US government at alarmingly low rates. However, the latest moves by the Federal Reserve seem to indicate that we are tipping into dangerous territory and I suspect that many investors are beginning to question our nation's ability to repay or refinance our obligations.

"The dollar is likely to decline “longer term,” analysts including New York-based Ashraf Laidi at CMC Markets wrote in a report. “Prospects ahead appear particularly ominous for the world’s reserve currency once global economic stability starts to build up.”

The Fed’s debt purchases will cause the dollar to weaken to $1.4860 per euro, analysts led by Robert Sinche, New York-based head of global currency strategy at Bank of America Corp., wrote in a report yesterday. The Fed reduced the scarcity of dollars and investors slowed the deleveraging process, which drove the currency to a 2 1/2-year high against the euro in October, Sinche said.

“Those temporary supports for the dollar appear to have eroded,” Sinche wrote. “Aggressive quantitative easing by the Fed should add to U.S. dollar supply globally and undermine the value of the dollar.”

While there are some benefits to a weaker US dollar (Canadian tourists, improved exports), I sense that this may be the beginning of a global shift away from the US dollar as the reserve currency of the world. Given our current economic condition any signal that this is the case could cause massive moves in the value of the US dollar. This may result in higher oil/gas prices and higher inflation at a time when we can least afford to fight inflation.

Right now I'd only say there is a 20% chance of this sort of rapid devaluation occurring but it is worth monitoring in 2009.

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