The following article is a special report from World Perspectives Inc. and Mr. David Poe, which they have allowed for publication.
Agricultural market participants are anxious about what the future holds for prices next fall. Most would like to know if the current futures price for December 2013 corn at $6.25 per bushel is $2 too high or too low. The consensus seems to be that price volatility could be intense this spring, but the general hope is that global corn production finally will expand to offset demand, allowing prices to drift back into a lower, more sedate trading range. Unfortunately, financial factors could magnify the long-term price volatility of agricultural commodities regardless of what happens to supply and demand factors.
The U.S. agricultural industry is well acquainted with exchange rate risk. A common concern has been making sure that there is no loss when converting a less stable currency back into U.S. dollars. Such transactions have become increasingly easy due to the tremendous growth of the global foreign exchange market and developments in electronic trading.
In today’s world of the internet and instant transactions, it is possible to forget that the floating exchange rate system (where the value of currencies freely adjusts against each other) only has been around since the 1970s. Currency trading has since mushroomed into an enormous worldwide network in which about $4 trillion dollars’ worth of currencies and derivatives changes hands every day. (Note: $4 trillion = $4,000 billion. The whole global economy is about $70 trillion and the total U.S. economy $15 trillion.)
The global foreign exchange market continues to expand and daily trade volume has increased about 20 percent in the past five years, as the world’s largest commercial banks and securities firms are increasingly joined by institutional investors (such as pension funds, insurance companies and mutual funds) who are transferring global assets and are directly speculating in currency markets. The primary concern of these institutional speculators is to increase returns by being on the right side of the market, but their trading activity also determines the relative value of currencies.
Since World War II, the U.S. dollar has been the reserve currency against which all other currencies are valued. Previously, the dominant global currency was the British pound. Consequently, London and New York still account for over half the volume of daily global currency trading. The international exchange rate prices converge through arbitrage from sites such as New York, Tokyo, Hong Kong and Singapore, with London being the dominant location. In other words, there is no centrally cleared market and there is little cross-border regulation. (Only about 5 percent of the total global currency trading occurs in actual U.S. futures exchanges such as the Chicago Mercantile Exchange.) The U.S. Treasury Department has even exempted many of the foreign currency derivatives from regulations such as the Dodd-Frank Act. After all, the majority of trades are occurring offshore. According to a Treasury Department spokesperson, “Unlike other derivatives, FX swaps and forwards already trade in a highly transparent, liquid and efficient market.”
National banks do periodically attempt to influence the valuation of their national currency, but such actions are becoming less and less successful. For example, the Bank of Japan recently took action to weaken the value of the yen to allow for easier Japanese exports. The Bank of Japan represents a $5.9 trillion dollar economy but that no longer intimidates the combined resources of the global foreign exchange market. Traders drove the yen higher against the U.S. dollar despite the Japanese government’s efforts. (One reason the yen could not be driven lower is because global investors are presently using it as a safe haven to house their financial resources due to recent fiscal uncertainties in the European Union and the United States.)
The EU is seeking to address its excessive debt. Nations such as Spain, Greece and Ireland are paying substantially higher interest rates on their debt and are taking austerity measures to cut public spending. Public outcry against those spending cuts has heightened investor fears, but the odds continue to improve that the world’s largest composite economy will eventually sort out its economic concerns. The total EU economy is about 15 percent larger than the U.S. economy. The size of the EU and the successful creation of the euro in 1999 are increasingly allowing the euro to compete against the dollar for the status of global reserve currency.
Russia prefers to trade with other nations in euros, and currently about 25 percent of total global trading has transitioned away from U.S. dollars into euros. While Great Britain is a member of the European Union, the Brits have never adopted the euro as their currency; they seem to still be having a hard time accepting the fact that they lost their status as a major global reserve currency. (The United States may soon understand how they feel.)
The United States has decided to take a different approach in addressing its fiscal problems. U.S. policymakers appear to be relatively unconcerned about the stability of the U.S. dollar, perhaps because of its status as the global reserve currency and its reputation as a safe haven. Additionally, U.S. policymakers perceive high unemployment and a slow economy to be far more threatening than the prospect of momentary inflation. Consequently, lawmakers have chosen to continuously prime the economic pump with enormous injections of additional dollars rather than reducing spending in an already slow economy like the Europeans.
U.S. policymakers recognize that aggressive money creation can weaken the dollar, but that is not perceived as entirely objectionable. After all, a weaker dollar should increase U.S. exports, and that could be just the necessary spark to get the U.S. economic engine up and running. Those increased exports should cause the balance of payments to improve, which in turn should allow any decline in the dollar to stabilize. When the dollar stabilizes and tax revenues increase, that is the opportune time for the United States to focus seriously on fiscal responsibility. Such is the plan. Unfortunately, it’s no longer the 1980s, when the global foreign exchange market was still being defined and the U.S. dollar was the premier currency without exception.
As the European Union’s economy improves, so improves the odds that there will be a sudden decline in the value of the U.S. dollar. Such a sell-off is unlikely to even be opposed by U.S. policymakers since it presumably fulfills a desirable objective. However, any such sell-off of the dollar in today’s market could happen harder and quicker than U.S. policymakers expect due to the structure of the global currency markets. That does not mean that there is likely to be a continuous decline into a bottomless pit; however, a sudden sharp fall could be hard enough to attract a lot of attention. Profit-taking by short sellers presumably would enable the dollar to stabilize momentarily, but the success of those sellers could become blood in the water for the rest of the foreign exchange community.
A more noteworthy consequence of such a sell-off is that it will be evidence to investors that U.S. interest rates will soon go up. A positive result of changing perceptions about the prospects for higher interest rates is that it could expedite business investment and that should improve near-term economic conditions.
Improved economic conditions and evidence that the days of the virtual zero-rate bond are about to end could cause a pronounced decline in existing bond prices. (Bond prices go down when interest rates go up.) The problem with such a sell-off in bond prices is that it applies pressure on the Fed to increase interest rates. However, the Federal Reserve recognizes that increasing rates by any significant amount will push the United States debt up to Greece’s debt levels. Thus, the Fed will be tempted to continue its current program of offering low-interest bonds and remain the largest buyer of U.S. government debt. But such action could lead to a more serious problem.
Any evidence that the Fed is artificially holding down interest rates is likely to cause bond prices to fall even further. Of course, the Fed could step in and start buying bonds more aggressively, but it will be unable to hide the price distortion displayed in the bond futures market that stretches out years into the future. Of course, the Fed could enter that market as well, but global investors already know that the Fed is holding a gargantuan bag of unattractive investments. Such action could further diminish investor confidence in U.S. economic conditions, which would weaken the dollar more. Consequently, this would be more proof that interest rates need to increase, which would cause bond prices to decline further and then require the Fed to buy more of what it cannot afford, thus weakening investor confidence even more. (Now consider such events happening in the modern electronic market where stock index futures now represent a larger dollar volume in trading than what occurs on the actual New York Stock Exchange.)
A decline in the dollar can eat away any returns that foreign investors have from U.S. stocks. Such investors are normally not overly concerned about a limited sell-off of the U.S. dollar because most of them are in for the long-term. However, global money managers know the importance of wealth preservation. There is a real tipping point at which investors will increasingly lose interest and decide to exit their long-term positions in U.S. dollar denominated stocks and bonds, and convert their liquid wealth back into a different currency. Such actions by foreign stock investors may not be enormous, but there are huge pools of U.S. dollars held by investors in Asia, the Middle East and South America precisely because the dollar has proven consistent in value; they also are assumed to have a similar tipping point. Moreover, U.S. investors can easily switch into another currency in today’s world of internet and electronic trading.
Any attempt by the U.S. government to even discourage the outflow of capital could quickly turn into a situation where seemingly unrealistic conditions appear to have materialized out of the blue. The prospect of such events can be scoffed at and discounted as “the sky is falling,” but such circumstances have already happened multiple times to other nations in just the past 40 years. Americans can step across the southern border and ask their Mexican neighbors about currency devaluation. In 1994, Mexico’s peso lost 45 percent of its value in a week after a period of protracted government spending that attempted to stimulate the economy. Fortunately for Mexico, the United States was there to quickly step in and rescue the situation. No one will be able to offer similar help to the United States, and threatening to throw U.S. policymakers out of office afterward will be no solution. May we all express the seasonal saying to America’s policymakers: “Bah, humbug!”
– David Poe of World Perspectives, Inc.
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