Gauging the chances of a collapse in the US dollar
Yesterday, one of my colleagues at the South China Morning Post asked me if he should switch his savings out of Hong Kong dollars.
He had heard a lot of talk about a coming collapse in the US dollar and was worried that if the US currency did collapse, it would drag the Hong Kong dollar down with it, thanks to our exchange rate peg.
Did I think the US dollar really would crash, he asked, and if so, what currencies should he shift his money into? How about the euro?
Offering financial advice to co-workers is a dangerous business, even if they do ask for it. If you turn out to be wrong - and, let's face it, there's a pretty high chance you will be - at best, you risk exposing yourself to public ridicule in the workplace. At worst, you earn the undying enmity of one of your colleagues.
On the other hand, a refusal to answer can cause offence. And the question is an important one, affecting everyone who has an income or savings denominated in Hong Kong dollars. So here goes:
At first glance, it certainly looks as if the US dollar is in trouble. The first chart below shows the greenback's performance against a basket of six major currencies. As you can see, the dollar has been on a downward trend for almost eight years, weakening 37.5 per cent since early 2002.
And concerns are mounting that the slide in the currency will continue and that it could well accelerate. Many private investors are worried that the US government's debt burden is fast becoming unsustainable. They fear Washington will be forced to inflate its way out of the problem, debasing its currency and paying its creditors back in worthless paper.
The world's central banks share those concerns, and many analysts believe their reserve managers are acting on them, diversifying out of dollar assets. A recent report from Citigroup identified central bank selling as one of the two main forces weighing on the US currency.
As a result, the prevailing view is that the dollar's decline is structural in nature and that it will continue through next year.
However, there are some good reasons for believing that the prevailing view is wrong.
To see why, we need to understand what's behind the dollar's present weakness. Despite what many analysts say, it is highly unlikely that big central bank sales are pushing the dollar down.
It's true that the US currency's share of global reserves has fallen from 73 per cent in 2001 to about 63 per cent currently. But remember that foreign reserves are stated in dollars, and that the greenback has fallen 37.5 per cent over that period. As a result, the portion of global reserves held in other currencies is now worth 60 per cent more in dollar terms. That valuation gain fully explains the apparent decline of the US currency's share of reserve assets without the need to invoke any central bank sales.
In all probability, it's not central banks pushing the dollar lower at the moment but a simple carry trade.
With short-term dollar interest rates just a whisker above zero, hedge funds and other investors are taking advantage of the opportunity to borrow dollars on the cheap and selling them in exchange for other currencies and assets offering higher returns.
It's an investment technique often likened to picking up pennies in front of an advancing steam-roller. The profits are small, and the risk of getting flattened is great.
As we know from recent experience, carry trades can come unwound rapidly, causing a sharp rise in the funding currency, in this case the dollar.
The trigger point could well come next year. Although the United States Federal Reserve has promised to keep short-term interest rates low 'for an extended period', at some point early next year, its programme of quantitative easing is due to come to an end. That means the Fed will stop buying US government bonds.
The impact could be momentous. Although US government bond issuance has more than doubled this year to about US$2.5 trillion, most of that debt has been bought by the Fed. The market has only had to absorb about US$800 billion worth. That's far less than in recent years, which is why US government bond yields remain relatively low.
But without the Fed buying, the market may have to absorb an extra US$2 trillion in Treasury bonds next year, which would push bond yields sharply higher.
With few signs of emerging inflation, that would make the dollar considerably more attractive to investors, driving the currency higher in the foreign exchange market and potentially triggering an unwinding of the carry trade.
So back to the original questions: Will the US dollar crash? What should I buy? And what about euros?
Well, the US dollar is certainly on a weakening trend at the moment, but that could reverse abruptly next year.
If you want a hedge against further dollar weakness, the euro probably isn't ideal. According to Morgan Stanley, it's severely overvalued at current levels.
Possibly a better hedge would be to invest some money in Hong Kong stocks. Hong Kong-listed equities are one of the most popular purchases funded with US dollar carry trades.
As a result, as the second chart below shows, the Hong Kong stock market tends to move in the opposite direction to the US dollar index.
So if the US dollar weakens further, the chances are that the value of your stocks will rise.
Of course, if the carry trade comes unwound, Hong Kong stocks will fall. But then you'll be able to console yourself with the knowledge that your Hong Kong dollar savings will rise in line with the resurgent US dollar.
Just don't hold it against me if I'm wrong.