The Day the Markets Crashed

(To fully understand this story, refer to 2012:The Other Prediction , where I explained why the US dollar would crash on 21 December 2012)

It was the morning of Friday, 21 December 2012, and the bell at the New York Stock Exchange was about to ring. Gloom and a sense of foreboding hung over the trading floor. Outside, there were hundreds of ‘Occupy Wall Street’ protesters rallying against the abuses of the 1%.

It was not only ‘triple witching’ day (the day when all kinds of option contracts expire), but also only three full days before the trading year ends; and many traders were still holding more US stocks than they wanted. The Dow Jones stocks that they still held no longer seem to be safe anymore, and they had to have ‘safe’ stocks in their portfolio by year-end. Thus, many traders were set to sell off the rest of their Dow Jones stock holdings that day.

2012 had been a disastrous year. Till February, the Dow Jones was above 12000 points, but by March the tide had turned and prices drifted downward the rest of the year. Nothing could cheer people enough to take prices higher. The reelection of Obama and the Democratic sweep of Congress had not helped. On the contrary, Wall Street was depressed after the elections. There are now bills pending in Congress that will force an increase of taxes on Chinese goods come the New Year. And this will surely cause a Chinese reaction and a trade war at the worst possible time. And to make things worse, oil prices had drifted upwards all year – Brent was now at $150/barrel (and WTI at $130).

Today, the Dow Jones was just above 10,000 points. For the first time in history, foreign traders have dumped their US stocks in their year-end ‘window dressing’ operations. Apparently, they no longer considered Dow Jones stocks as ‘good’ stocks to hold.

After the Bell
Right after the opening bell, share prices plummeted. Within the first hour, stock trading had to stop for 15 minutes because the Dow fell more than 10% below the average of the previous quarter (the trading curb, at approximately a 1000 points drop), triggering the automatic stop.  After trading resumed, the Dow reached 9000 points, and a whole series of stop-loss orders to sell stocks hit the exchange.  In contrast to previous crashes, investors were no longer rushing into Treasuries. They were in fact dumping US Treasuries almost as fast as they were dumping stocks. This meant that the effective interest rates on US debt rose from 3% to 5% in a couple of hours.

The US dollar suffered accordingly. It was at $1.60: 1 Euro by 1 pm. At 2 pm, there was concerted action by a number of Central Banks (most of them were limited in their response because their home markets were already closed by this time), which buoyed the dollar to $1.55: 1 Euro. It was the middle of the night in Asia, and the Fed was mainly alone in intervening to save the dollar.

The market dipped even lower by the close of trading, as a whole swath of put options were exercised (which involved the sale of a lot of stocks and currency); the Dow closed at ‘only’ 8500 points (it had gone below 8000 points during the day), and with the exchange rate at $1.60: 1 Euro. It was terrible, but everyone was sure that concerted Central Bank action scheduled for Monday will calm the markets.

It was not to be. Middle Eastern markets were opened on the 22nd and 23rd (Saturday and Sunday), and stocks and the US dollar continued their slide, reaching $1.70:1 Euro at the end of Sunday trading. In the morning of Monday, the Bank of Japan  intervened heavily to support the dollar; but by midday, it stopped. At the same time, the Peoples Bank of China started dumping dollars. This was followed by Russia, and then a host of Third World countries.

The ECB, the Bank of England, the US Fed and the Central Banks of Canada and Switzerland furiously bought dollars all day. Together they bought more than a trillion dollars on that day alone. It did not help. Middle Eastern, other Third World sovereign funds and many Third World Central Banks dumped their US$ bonds and stocks all day. The Euro remained at $1.70:1 Euro all day.

It was a gloomy Christmas in most US households, who saw their 401k balances evaporating, and who realized that the prices of goods will go up a lot in January.  On the 26th, ordinary Americans dumped their holdings in Dow Jones stocks, and bought Japanese and European mutual funds. Oil (WTI crude) hit $200/barrel, and gasoline rose to $6/gallon.  The US government announced that it was monitoring to see that no gas station will sell gasoline above that level. The government warned against price gouging by retailers, and issued an order that prices were to remain at the present levels for the meantime, unless explicit permission was given to raise an item. But this set off a stampede of people buying what they can while the prices were relatively cheap. By the end of the year, grocery stores reported that their stocks of food had been all sold out; panicky people were stocking up.

By the first trading days of the new year, the US dollar had gone to $1.90: 1 Euro, and it was steadily deteriorating. Interest rates on US treasuries hit 7%, and kept climbing. By 15 January, the US government formally called on the IMF for help. The US government could no longer finance its debt, with the interest rate on Treasuries at 9% and climbing. The IMF put together a rescue package of about 1 trillion SDRs. But this would only be given if the US reduces its deficit from $1.3 trillion yearly to only $100 billion in 2012. Obama then forwarded a budget proposal which specified: a 50% cut of defense spending, a tax on luxury houses, cars and yachts, a national Value Added Tax of 15% (and abolition of state sales taxes), etc.

The IMF declared that it was making the SDR the new international reserve currency, and that it would exchange dollars held by Central Banks at $2: 1 SDR. This provided a floor for the value of the US dollar, and stabilized the currency markets. For cash, people used the Euro or the Yen.  After the IMF action, the US dollar was removed as the reference currency for oil (which changed from dollars/barrel to Euros/hectoliter), gold (to Euros/gram) and other commodities.

(this is a depressing story, but it will actually end up well. In another blog, Two Years After the Fall    I show what would happen two years after the crash.)

Americans Inflating Euro Crisis

Americans are aggravating the Euro crisis for their own ends. While there is indeed a problem with the Greek economy, America has made sure that it has developed into a full-fledged Euro crisis.

Euro Crisis?
If the news stories are to be believed, it seems as if the Euro is about to fall apart, and countries will have to revert to their own currencies. This is a myth. In the first place, Greece (and Ireland & Portugal) are small fish compared to the Euro area as a whole, and their problems could not bring the whole currency down. But the main reason why the Euro won’t fail is the strength of the German-France commitment to the Euro. This is something that no American can really understand.

Germany and France see the Euro as the embodiment of their European project, and this means they are committed to it fully. Germany felt the same way about German reunification, and it poured trillions of Euros (then DMs) to make East Germany catch up with West Germany. People were willing to even pay an extra tax just to finance this. The European project is seen by Germans as the thing that ensures the peace and stability of Europe, literally. If the Euro falls, the EU will break up, and a depression and even civil wars may ensue. Germany and France had fought 3 wars with each other, in rapid succession, before the European Community was formed. No sacrifice is too big to prevent this from happening yet another time. There is absolutely no way that the Germans and French will allow the Euro to fail.

Ignorance
America has been doing its best to inflate the Euro crisis. This is due to ignorance, self-interest, and in some cases even malice. Americans are ignorant in that they don’t understand how the EU works. The EU works slowly; but is capable of making huge changes if necessary. EU decision making is a very public affair, with many negotiating positions discussed in the various parliaments and the media. In the end, though, Europe is very pragmatic, and it is actually easier to decide among the 17 members of the Euro-zone, or the 27 EU countries, than it is in the US with its two feuding parties.

In  a sense, the Germans are using the ‘crisis’ for their own ends. The crisis is convenient to force the Greeks to give concessions. But this is part of the public way in which the EU decides on policies. The Germans, and everybody else in the EU, have been using tactics like this since the beginning.

Many Americans, who depend on their 401k funds for their pensions, do not understand the EU dynamics. And they are driven to panic by US  ‘analysts’ and even political leaders who have done their best to inflate the problems with the Euro.

Self Interest
The US government is consciously undermining the Euro in order to stabilize the US Dollar. Because, in the face of the dollar’s instability, to have a stable Euro that could function as a safe haven and even alternative reserve currency would cause a flight away from the dollar. Thus, US government officials are constantly reminding the public (mainly the panicky holders of 401k accounts) that the Euro is in crisis. Obama would say something like: “European countries are as able to repay their debts as America is” – which on face value may pass as some kind of support for the Euro, but which is calculated to remind Americans that investing in the Euro is risky.

Geithner’s supposedly unfortunate comments during the recent EuroFin meeting in Poland (16 & 17 September) is passed as a gaff, but it was perfectly consistent with their policy of overly emphasizing the Euro’s problems. The Euro crisis is just what Washington ordered – as far as they’re concerned, the Eurozone’s crisis should extend at least till after Obama is reelected.

Malice?
There are also those in America who are actively sabotaging the Euro for financial gain. Hedge-fund managers buy CDSs (Credit Default Swaps, financial instruments that ‘insures’ against sovereign default) on bonds from countries such as Spain, Italy or France or sell their bank stocks short. Then they spread rumors that that country’s banks are overexposed to Greek debt.  As a result, the price of the CDS skyrockets and bank stocks fall, and the hedge funds cash in.

Hedge funds have been rightly blamed by European governments for undermining the Euro. Some EU governments have prohibited short selling of bank stocks. The EU and specific countries are investigating the speculation in CDSs. But hedge funds are nimble, and are very difficult to pin down. Hedge funds love doing their dirty techniques against the Euro because they can get away with it. The American public is nervous enough that even small rumors are picked up and could have big effects. Another reason is that hedge funds fear EU investigators much less than US monetary authorities. If they attacked the dollar similarly, they would face far harsher punishment than if the EU catches them.

What Now?
There is now a real Euro crisis, thanks to the Americans. This crisis has depressed the value of the Euro and stock prices. Even though the Euro will not fall, EU governments now have to scramble to control the immediate problems.

While the France-German commitment to the Euro is absolute, this does not mean that they will bankroll Greece forever. They just might opt to have an ‘orderly default’ of Greece, or even kick Greece out of the Euro-zone. After all, Greece didn’t properly qualify to enter the Euro-zone; it had doctored its economic figures to qualify.

But Americans are now being bitten back for their anti-Euro efforts.  Their stock markets (and thus the pensions of millions of Americans) have declined dramatically. International investors and even Central Banks are buying gold at an alarming rate, pushing the gold price ever higher. And the relatively cheap Euro means that the US trade deficit with Europe will only continue to grow. American trashing of the Euro is proving to be only a temporary solution to the US Dollar’s problems. It has led to the US losing precious time that it could have used to decisively address its own problems.

Is US Dollar About to Fall?

The US Congress will have to raise the Debt Ceiling from the present $14.3 trillion by August 2, or else the country would face technical default. But the Republicans are demanding budget cuts be done first; and Democrats are demanding that measures should include increased taxes for corporations and the rich. Both sides are standing their ground, and there is a real danger that the country will indeed default by August 2.

Most probably, a deal will be made at the last minute, and the US can go on merrily increasing its national debt for a few more years. But the question remains: can the US dollar’s credibility withstand such a strain? Will the US dollar fall while Congress debates over raising the Debt Ceiling?

I think that sooner or later, within the next 5 years or so, the US dollar is going to “fall”.  The national debt limit is only part of the problem; the main problem is that the US has a triple deficit – of the budget, trade balance, and payments. And that it has accumulated a huge amount of “unbacked liabilities” in the world – to the staggering amount of $75 trillion.

All proposals on the table will help to reduce the budget deficit, but it will even not be enough to get a balanced budget.  Since there will continue to be a deficit in the coming years, the national debt will continue to grow. And then, there is the trade deficit which also grows from year to year. Thus, all plans now being considered will not improve the US’ capacity to repay its debt.

The world is getting impatient with the dollar, and it seems that US politicians are taking their time at solving it, not realizing that the problem is really urgent.

Signs of Trouble
The problems in the Middle East are all in the news. But the biggest problem with it lies not in Libya or even Yemen – but in the fact that the US dollar has not strengthened in the face of all these problems. Almost always before, when there is political turmoil somewhere, the US dollar gains in value, as money exits that country and goes to the safety of the US dollar. Now, the whole Middle East is ablaze, and the dollar, instead of strengthening, has weakened considerably.

Another sign of impending trouble is that the US, even with “QE2” (the program of the Fed for creating $ 600 B by buying government treasuries) and the extremely low Fed interest rate, faces rising commercial interest rates. QE2 was instituted in the first place to REDUCE interest rates. What will happen after June, when the QE2 program is over? Will interest rates rise substantially, resulting in a rise in unemployment? Will there be a double dip recession? If the Fed makes a “QE3” program instead, will this be enough to hold interest rates down? or will foreign fund managers dump US treasuries instead?

A third sign of trouble is the news that PIMCO, the world’s biggest holder of bonds, has entirely stepped out of US Treasuries. Even worse, PIMCO has resorted to selling US Treasuries short – which means that it even has negative ownership of Treasuries. This shows that US Treasuries are no longer attractive to the wiser international investors. I doubt that many hedge funds keep Treasuries in their portfolios either.

A fourth sign is that when Osama bin Laden was killed, he had with him 500 Euros. He had Euros, not US Dollars, which means that he considered Euros more useful in case he had to escape capture in Pakistan – Euros seem to be more useful in bribes etc. in Pakistan. This shows that even in the underworld, the US dollar is not considered a good currency anymore.

Roots of Crisis
The present crisis has its roots way back in the Bretton Woods agreement, made after the Second World War, to have the US dollar as the world’s reserve currency. Until 1971 the dollar’s value was pegged to the US supply of gold, keeping the US currency in “control”. In 1971 President Nixon let loose the gold peg, making the dollar itself as the only thing in reserve.

The US dollar as reserve currency meant that countries were willing to run a trade and exchange imbalance with the US, since this would mean that they would accumulate US dollars in their reserves. This meant that the US tended to have a structural trade and payments deficit with the rest of the world. This  effectively overvalued the dollar, making its imports cheaper than they otherwise should be. And this contributed to the very high standard of living in the US.

Over the decades, the US steadily accumulated a big debt burden. It is now at $14 trillion, or more than 90% of the US’ annual GDP. Among developed countries, it is only Greece and Japan which have higher debt/GDP ratios. Greece has had its debt crisis, and is now forced to undergo a strict program to get rid of its deficit. As for Japan, most of its debt is to Japanese citizens – and thus the impact of the debt is less than if it was held by foreigners.

The US debt is only part of the “US dollar overhang” in the world economic system; because the bigger part (approximately $60 trillion)  is simply the dollar reserves that countries have accumulated, due to the US trade deficit.  The national debt, in the form of US Treasury Bills, is the smaller part of the problem; but it is the more worrisome part of it, since the US has to pay interest on this.

Stumbling into Dollar Fall
The danger is always present that a country would decide to dump their US treasuries, leading to a chain reaction that sees other countries dumping treasuries, a spectacular rise in interest rates, and the dumping of US dollars from national reserves, and the fall of the dollar. This has not happened so far, since no country will do that consciously and devalue their own reserves. But we cannot depend on this not happening in the future. In fact, I think that the chance of this happening is getting bigger with time.

As more and more dollars are sent abroad, in the form of  US Treasury bills or simply “cash”, the danger that they will no longer be accepted by other countries increases. Already, many countries are calling for an overhaul of the international currency system. Countries have to continuously weigh the advantages of holding dollars against the cost due to the continued watering down of the dollar’s value.

Even if no country would willingly cause the dollar to fall by dumping it, a series of smaller events could push things so that even  minor players could accidentally cause such a fall.  The recent intervention against the Japanese Yen had the inadvertent effect of increasing Central Banks’ reserves of dollars. Central Banks all over the world had to subsequently find ways of restoring their dollar reserves to normal levels. The BRICS agreement to use their own currencies when trading with each other means that less dollars need to be kept as reserves. Eurozone countries intervention to support weaker Euro countries’ finances is another measure that strengthens the euro against a potential fall of the dollar. All these make the dollar weaker. A disruption of the scale of the 2007 sub-prime crisis happening now would surely topple the dollar.

Perhaps it won’t even be a single country or investor which would precipitate the dollar’s fall. It could be simply an accumulation of small steps that would push it over the edge. The US high unemployment rate has “forced” the Fed to keep the Fed Funds rate low, but this at the same time increases consumption and imports, and to further trade deficits.

The US dollar is undergoing something like a game of international “musical chairs”. US-based investors buy securities in other countries, effectively moving dollars abroad; Central Banks sell dollars to prevent their currencies from appreciating; the continuing US budget deficit means that the government has to issue more Treasuries;  foreigners buying US equities or Treasuries effectively returns dollars to the US;  too much incoming dollars could cause inflation, and increase unemployment. The cycle continues, and dollars are passed back and forth from the US and abroad.  A growing number of Central Banks are wary of keeping too much dollars, and this cycle would eventually break down at some point.

Tipping Points
There are a number of occasions or events which could push the dollar over the edge. The Debt Ceiling of the US has been reached, and by August 2 the US Congress has to agree to raise the limit. Not to do so will surely bring about a loss of trust in the dollar, and its subsequent fall.

And then will come the budget discussions later in the year. This is another occasion when confidence in the dollar may be critically damaged.  This will be followed by the Presidential election campaign and possibly a new administration.

At any time, Congress may pass a law imposing a tax on Chinese imports. This will cause Chinese countermeasures, including a stop to buying US Treasuries. And this will be enough to precipitate a chain reaction that will cause the fall of the US dollar.

The US dollar will fall within the next 5 years. While it will cause a deep crisis, it won’t be that bad, in the long run. I wrote a blog post about how it will be Two Years After the Dollar Fall

Two Years After the Fall

It is now March 13, 2014. America has undergone a huge shift in its economy in the last two years. On this day, in 2012, the dollar “fell” in value, by about 100%; and more importantly, it “fell” from its position as the world’s reserve economy.

The Dollar Falls
It all started in November 2011. Riots had broken out in Saudi Arabia, and the government was frantically trying to restore order. The Saudi government had bungled in its handling of a relatively small disturbance among Saudi Shiites in Qatif, in the Eastern province. In November 2011, the disturbance had escalated into a nationwide protest movement. By December, workers in the vital oil industry and in the ports had gone on strike. And the demands had hardened – where before they had merely asked for the release of arrested Shiite leaders, protesters had now gone on to demanding a Constitutional Monarchy, some even wanted a republic, while others were calling for the independence of the Eastern province. All of this caused the price of oil to go through the roof. By the end of December,  oil had reached $200/barrel.

To make matters worse, the US response to it was also wrong. Congress passed a new Stimulus Bill of $500 billion, and the Fed proclaimed QE4 – a program to pump $1 trillion into the economy, as a response to the new recession. Unlike what happened during the 2008 recession, however, the US was now alone in pursuing an expansionary policy. This caused a lot of misgivings in other countries regarding the value of the US dollar.

Oil producing countries responded by demanding that they be paid in “hard” currencies – e.g. Euro, Yen, even the Chinese Yuan – and NOT in US Dollars. By January 2012, Central Banks all over the world decided to cut the US dollar component of their reserves, by a modest 1/4. Thus, from an average of 80% of reserves in US dollars, to 60%. This seems to be a modest change in policy; but when it is done by ALL Central Banks at the same time, it had a devastating effect. This policy meant that the Central Banks would gradually replace their dollars with other currencies in the course of a number of months, eventually ending with the target percentage of US dollars in reserve. By the end of February, however, the value of the US Dollar had gone down to the point where Central Banks holding lots of dollars (mostly in the form of US Treasury Notes) became nervous. They stood to lose a lot, if the dollar lost value.

So, it finally came on Tuesday, March 13, 2012. The Saudis were the first to dump their US dollar holdings. This was followed by Russia, Japan, and then China. After this, everybody else dumped their dollar holdings. You could probably speak of an “oversold” situation with the dollar then, but Central Bankers didn’t care anymore – they just wanted out, as quickly as possible.  As a result of all this, the dollar sunk to $4: 1 Euro on March 16, 2012. In the months following, the dollar regained some strength, finally stabilizing at $3:1Euro by December 2012.

Picking up the Pieces
The US was left to pick up the pieces. It still had a big budget deficit, and a huge payments deficit, and a 16 trillion national debt. The only good news in all this was that the national debt remained at 16 trillion dollars, even though the dollar was half its former value (thus, effectively the national debt was reduced by half).

The US had to go to the IMF to borrow money to finance its budget deficit. Nobody else was willing to lend the US money at that time. The US got a 500 billion SDR loan from the IMF (roughly equivalent to $500 billion at the old exchange rate). But the IMF loan came at a price: the US government had to cut spending, and increase taxes, and it had to have a concrete program to balance the budget by 2015. The US also had to open up its economy to foreign investments (thus, the airline, oil, banking etc. industries were opened to 100% foreign ownership).

Recovery
The IMF conditions were tough, but now, 2 years after the fall, the economy is on its way to recovery. US labor costs had dropped in relation to the rest of the world (while the US dollar’s value was halved, prices rose 30% and wages rose only 10%). This has led to a huge expansion in US-based manufacturing of products which used to be imported from China. (Another large chunk of the production had gone to Mexico, from which it is cheaper to ship to the US.) Automobile production has greatly expanded, with so many people buying smaller cars, hybrids and EVs (Electric Vehicles). And there is now a huge demand for buses, as local governments expand their public transportation services.

Tourism is now booming, with Asians and Europeans making the most of  “cheap” US vacations – tourism revenues have quadrupled since 2012. There is also a surge of “medical tourism”, with Europeans and Asians coming for elective surgery (which are not covered by their country’s health insurance).

American university enrollment has surged; while the number of American students has lessened, foreign students have more than made up the loss. Foreigners find that the US is offering quality education at bargain prices. And while foreign graduates are now in demand in the US, a bigger percentage of them opt to work in their home countries about graduation.

The stock market is enjoying a bull market of sorts – the Dow Jones just topped 20,000 points last January. Some companies are having a hard time: Walmart’s sales suffered as a result both of the lower purchasing capacity of people and the higher prices of goods. It is now repositioning stores to city centers, since people now find their suburban locations “too far away” (due to high gasoline costs). Starbucks has suffered because people have decided en masse that Starbuck’s coffee is a “luxury that they could live without”. Airlines are suffering from people cutting back on air travel.

But more companies are thriving: McDonalds has noted an increase in sales, even in the face of 30% higher prices; Amazon has seen a boom in the sale of Kindles and e-books (paper prices have also spiked); IT companies are profiting from people spending more time at home (people are also working more from home).

People have developed new habits. The magnetron is still all important; what’s new is that companies are now selling magnetron meals in reusable containers. Children often go to school now on bikes (leading to a reduction in child obesity). People are consuming more (local) vegetables, and eating less meat.

Many more people are employed than at any time in the past few decades. The unemployment rate is now at 5%, and is still dropping. There are less illegal Latinos now, since many Mexicans now prefer to work in the new Mexican factories. Americans are now more willing to take on farm jobs that were formerly done by Latino migrants. There is a marked reduction in the drug trade, with lower US buying power and prosperous Mexican workers.

There are now plans to build a nationwide rapid rail network. Ordinary rail lines are more intensively used for carrying products (replacing trucks), and a lot more products are transported by water. Solar farms are being set up in the Southwest; in Hawaii, the government is feverishly building solar and wind power plants (Hawaii was the worst hit by the oil price rise).

The “fall” of the dollar has caused a lot of suffering in America. But the American people are not only adapting well to the change, they are actually thriving. The resilience and hard work of the American people is now showing that a new economy could be fairer, greener, more equal, and eventually, more prosperous.

Some people say that the “fall” may have been the best thing to happen to America. They’re probably right. The future indeed looks quite bright.

$1.45: 1 Euro by the end of 2011

The year 2011 will be marked by a very significant deterioration in the dollar exchange rate. I think that the exchange rate by this time next year will indeed be $1.45: 1 . Why do I think so?

Why?
Well, the most obvious reason is that the US is printing too much money, accumulating too high budget and trade deficits, and borrowing too much. The US Fed is stimulating the US economy as if it was the only economy in the world. They don’t see the international effects of US economic policies. Well, I think that 2011 will show that there is a limit to the amount of US dollars the world can take. At a certain point, people from other countries will have to be convinced by high interest rates to invest in US treasuries. And this would mean a devaluation of the dollar.

Even without “Quantitative Easing 2” and the extension of the Bush tax breaks, I think the US dollar will be in trouble anyway. At the beginning of the year, Central Bankers (Central Bankers are very “neat” in that they make policies that start at the beginning of the year, or half year, or quarter) will most likely set their policy regarding the amount of US dollars they will keep in reserve for the coming year. And I think that they will set the target percentage for dollars at either the same or at a lower level than that for 2010.  The dollar is a declining component in world trade, and it is also expected to devalue, so prudent Central Bankers will aim to have a lower percentage of dollars in their reserves. This, together with the rise in the amount of dollars that go around the world’s financial system, would mean that there will be a growing amount of dollars that are dumped by all these Central Banks. All these extra dollars means that the US dollar will devalue.

What about the Euro and its crisis? Well, to make the long story short: the Euro crisis is over. 2011 will be the time of the dollar crisis; and as a result, the problems of the Euro will be overlooked or actually get solved. Investors are sure to notice that the US economy is heavily indebted, and that the dollar is devaluating; so, they will think twice before buying US treasuries. After all, the US economy is worse off that either the Portuguese or Spanish economies. People will see that, and will eventually have to act accordingly.
This will bring about a domino effect: lower demand for treasuries; speculators betting (through Credit Default Swaps e.g.)that the interest on treasuries will rise; interest on treasuries actually rising as a result, etc. If speculators get the idea of dumping their other US dollar denominated assets, then devaluation will surely result.

The US can still stop this trend of a devaluating dollar. However, I think it won’t, and for the simple reason that they want the dollar to devalue. US economists seem to think that this is a good idea – that devaluation will stimulate exports and lessen imports. So, the Fed will not do anything to defend the dollar; and thus the dollar will devalue in 2011.

Is Devaluation a Good Idea?
For a small economy, it indeed could be a good idea to devalue its currency in order to restore its balance of trade. Devaluation will make that country’s exports cheaper and make imports more expensive, forcing the market to restore the trade balance after a while.

For the US dollar, however, it will be a bad thing if it devaluates. And this is because it is the world’s main reserve currency. Devaluation will not only lower the price of the US’ exports, it will also lower the value of reserves other countries have built up. For many countries, holding US dollars becomes a game of chicken: they would keep it as long as possible, but dump it before everybody else does. But when the Central Banks start dumping dollars, there will be no stopping the trend.

So, devaluation will not only affect the trade balance. It will affect how other countries view the dollar. And this means that if they sense a trend of devaluation, they will  dump their dollars in the hope of preserving the value of their reserves.

Devaluation will also be bad for the US itself. When the dollar loses value, the amount of imports will take 6 months or longer before it starts going down. This means that oil and other commodities will sap the US trade balance for some time before going down.  And it will take some time before exports get a boost. There is a lag time before companies are able to increase production accordingly.  And there is China: if present trends continue, China’s yuan will maintain its value rate relative to the dollar. This means that imports from China will not be affected, and exports to China will also not increase.

Devaluation will mean that people will pay a higher price for oil. I would estimate it to reach $4/gallon in 2011, at least. Other commodities will also rise in price: from iron ore to rubber, copper, aluminum. And this will cause the price of goods produced in the US to rise accordingly.
Devaluation means that consumer prices in the US will rise. It may not rise by the same percentage as the devaluation, due to importers absorbing part of the loses, but it will surely rise.

Devaluation of the US dollar, if it goes beyond a point, would mean that other countries would consider dropping the dollar as the currency used to price certain commodities. Take for instance oil – it is still denominated in dollars. But if the dollar devalues too much, OPEC may just decide to drop the dollar/barrel measurement, and revert to perhaps a Euro to metric ton pricing.

It could be worse
That the dollar will devaluate, is practically a given. But a depreciation of 10% is not the worst possible case. It could indeed be worse. Here are some things that could make the scenario even worse for the dollar.

Germany Agrees to ECB Issuing Euro Bonds. So far, the Germans are holding back on this, for the reason that it pays much lower interest rates with the present system of each country issuing its own bonds. However, if for whatever reason, the Germans (and other “Northern” countries, e.g. the Netherlands) agree to let the ECB issue common bonds for the whole of the Euro zone – which would then have an “average” interest rate; then it will forever get rid of any reason for a Euro crisis. And this would mean that international investors will more enthusiastically tear down the price of US treasuries.

China Shifts Its Peg to a “Basket of Currencies”. If China lets go of its dollar peg, it will not be good for the US. It’s funny – the US has been insisting for years that the Chinese should revalue its currency. But if China does so, even if only a little, it will mean a lot of trouble for the dollar. Changing the peg for the yuan will mean almost certainly that China will stop buying US treasuries. This means that the price of treasuries will drop, and effective interest rates on them will rise.  And China’s dumping of US treasuries will be sure to trigger similar actions by other countries.

Big Disruption in the Supply of Oil. The price of oil is now at about $90/barrel.  It will slowly rise to about $100/barrel by the end of the year, given present supplies.  If there were to be a major disruption in the supply of oil – perhaps a total stop of Nigerian or Venezuelan exports – the price will rise to even $150/barrel.  While the world has seen these price before, it is now less able to cope with it. So, a big rise in the price of oil will be greeted by a return to recession for the US, and a big drop in the value of the dollar.  The dollar will lose more than 10% of its value, as a result of this.

I don’t think that these “worse case” scenarios will happen in 2011 (well, 2012 is another story altogether). So, this means that the US dollar will devalue by “just” 10%.

Unfortunately, I think that this trend is inevitable. The dollar will devalue by about 10% in 2011. It may devalue by the same amount in 2012. And if this continues, the dollar will cease to be the main reserve currency soon after. Only the Fed can stop this. But it won’t. It is not politically expedient for the Fed to do so.