Thursday, May 26, 2011

Dollar Declining Amid Mix Of Bad Long Term Trends & Uncontrollable Events

Axel Merk, the manager of the Merk Funds, is very bearish on the dollar. The greenback has been declining in value and Merk sees the problem getting worse. The issue is the the structural deficit problems in the U.S.

So Merk is steering his currency-focused mutual funds away from the U.S. in favor of countries with greater fiscal discipline and a commitment to getting their budget affairs in order

“In the U.S., we’ve lost the will to engage in reform,” Merk told Market Watch. “We have not fixed the underlying structural issues. It may require our bond market to get derailed before policymakers engage in the reforms that Europe is making.”

Merk questions how much longer the dollar can keep its status as the world’s reserve currency.

“The U.S. dollar is no longer risk-free,” Merk said. “The balance sheet of the U.S. is deteriorating at a faster pace than other countries."

Merk is particularly bearish on the dollar because he foresees deeper and more serious economic struggles ahead for the U.S.

“The U.S. is trying to weaken the currency intentionally and get a recovery through that,” Merk said. “We’re going to keep the printing machine in full gear until and unless the bond market tells the Fed to change course, and at that stage it’s very late to change.”

Merk is not alone in his view that the dollar is no longer a good store of value. Hedge fund managers, currency traders and analysts around the world have taken the same view.

Bill Gross of PIMCo., the world's biggest bond fund, made global headlines when he dumped U.S. government-related holdings in February and began shorting them in March.

According to Gross, the reason was simple.

“There is really no way out of this [debt] trap and this conundrum at this point,” he said.

That seems to be the growing consensus.

Last month, the People's Bank of China announced that the country's excessive stockpile of US dollar reserves needed to be urgently diversified. China's foreign exchange reserves included more than 3 trillion in US dollars at the end of March.

Subsequently, the Xinhua news agency reported the following:

Xia Bin, a member of the monetary policy committee of the central bank, said on Tuesday that 1 trillion U.S. dollars would be sufficient. He added that China should invest its foreign exchange reserves more strategically, using them to acquire resources and technology needed for the real economy.

This was a clear indication that China plans to "diversify" (read: liquidate) itself of $1 trillion in US holdings. It was bad news for the U.S. and the exact opposite of what it is seeking, whIch is buyers — not sellers — of its debt.

China didn't wait long to begin its diversification plan.

The Financial Times newspaper reported late Wednesday that China is interested in buying Portuguese bailout bonds when the European Financial Stability Facility starts auctioning the securities next month.

The New Zealand press also reported that the China Investment Corp., a huge sovereign wealth fund, may have set aside up to 1.5% (or 6 billion New Zealand dollars) of its foreign-exchange reserves to invest in New Zealand assets, including government bonds, companies and, potentially, dairy farms. The same report noted China is also thought to have allocated 2% of its reserves to invest in Australia.

This clearly indicates that China, a primary creditor of the U.S., intends to make good on its well-reported plan to buy fewer U.S. Treasurys.

Such moves will hurt the dollar and affirm the bearish sentiments of Axel Merk and others like him around the world.

The U.S. dollar has been in long term, or secular, decline. In fact, the dollar has recently been trading near it's all-time lows, established during the 2008 financial crash.

Low interest rates, concerns about inflation and the massive federal budget deficit are all to blame.

Investors can find higher interest rates abroad. The Federal Reserve is fighting like hell to maintain low rates to encourage capital investment, but it isn't helping the U.S. economy much at all. It's also hurting savers and discouraging new savings.

Inflation has built up a head of steam in the commodities sector and is affecting oil and food prices. Any consumer can affirm this. The culprit is the dollar's declining value. Simply put, it's purchasing power is falling.

And the U.S. budget problem is so bad that Standard & Poor's recently threatened to take away the U.S. government's coveted AAA rating status. That would be a first in our history.

All of these things are undermining the dollar and the solutions will produce their own ugly results.

Though the Fed has been remarkably effective in setting and controlling interest rates, a worried bond market may soon begin setting those rates for the U.S. Buyers may need heavy inducements to continue allowing the U.S. to pile up such interminable debt.

This is a tough position for the U.S. to be in, but one it will have little control over. After all, beggars can't be choosers.

Higher rates will affect businesses and consumers alike, thwarting investment and making things like mortgages, auto loans and credit card rates all spike.

The Fed actually wants, and is encouraging, inflation. The opposite is deflation — an economic contraction, or recession. No one wants that. The question is, when do events (inflation) spin out of control and beyond the Fed's reach?

The Fed's massive currency printing schemes, such as QEI and QE2, have undermined the value of the dollar, and the longer term outlook is especially ugly. The Fed has crossed the great divide and there's no going back. All that's left to do is print, print, print away!

The budget deficit is the prime example of how political problems can become fiscal and economic problems.

Congress is hopelessly divided and recently engaged in huge battles to cut just $38.5 billion from a $1.6 trillion deficit. It amounted to just 2.4% of the deficit. Now they just need to cut another $1.56 trillion to eliminate that deficit.

The battles over raising the federally mandated debt ceiling and the fiscal 2012 deficit will be epic, and they will be nasty. They are sure to worry the bond markets and further undermine the dollar.

Cutting the budget will shrink the U.S. economy, which is totally dependent on federal spending at this point. Budget cuts may poll well, but when Congress actually gets down to brass tacks and begins hacking away, Americans will hate it. That's because their quality of life and standard of living will begin falling.

The problem for the U.S. is that so many of its problems are now beyond the control of the fiscal authorities in Congress and the monetary masters at the Fed. In some cases their hands are tied, while in others their control is simply slipping away.

The long term outlook for the U.S. dollar and Treasuries and interest rates and inflation just isn't good. The U.S. is facing a panoply of concerns that will have the effect of slamming the emergency brake on our economy.

There's no getting around it; there are some very tough times ahead, the likes of which most Americans have never seen.

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