The Budget Deficit's Effect on the Dollar
(November 30, 2006)
Dear Subscribers and Readers,
Over the last few days, the talk about the “imminent crash” of the dollar has grown quite deafening – as can be seen via the mainstream press, various financial blogs, and financial newsletters alike. I am even now hearing comments such as about being “super bullish” on the Euro from currency strategies of major investment houses. Moreover, many European finance ministers did not seem to be too bothered with the relentlessly rising Euro despite the fact that the European stock markets clearly did not like it. We are now clearly at the “breaking point” – but are all that talk about the “imminent crash” of the dollar really that valid? We again examine that issue today, as this author is still looking for a rally in the U.S. dollar index going into the end of this year.
First of all, it is interesting to note that the most recent decline of the U.S. Dollar Index can be attributed (at least initially anyway) to talk about the People's Bank of China (or the Chinese Central Bank) further diversifying their reserves. As noted by the most recent daily commentary from the Bank Credit Analyst, however, the impact of any further diversification away from U.S. Dollars by the Chinese may be exaggerated. To put it in perspective, Chinese reserves of U.S. Dollars as a percentage of total reserves are already at the 70% threshold – down from a high of over 90% in 2003. More importantly, the 70% threshold also represents approximately the percentage of total trade that the Chinese does with the United States. Following is the relevant chart from the Bank Credit Analyst showing the amount of U.S. Treasuries and Agency Bonds held by the Chinese as a percentage of total Chinese foreign reserves:
Quoting the Bank Credit Analyst: “China will park the majority of its foreign reserves in U.S. dollar assets for years to come. It is estimated that more than 70% of China's total trade is quoted in U.S. dollars, which explains why China parks almost the same percentage of its reserve assets in U.S. government paper. Indeed, the share of U.S. government paper as a percent of Chinese reserves has already declined from more than 90% to 67 % - a normalization effort to reflect China's trade structure. Going forward, China's reserve management strategy will have little impact on the U.S. dollar's exchange rates against other majors.” In other words, whatever the Chinese does with its foreign reserves going forward should have negligible impact on the U.S. Dollar index.
Moreover, it is important to note that there has been no meaningful empirical relationship observed between the trade deficit and the concurrent or the subsequent performance of the U.S. Dollar Index. There are many reasons, with the major ones being:
- The trade deficit is a number that is very difficult to measure – and each country has a different number of its own. For example, the Chinese measurement of the U.S.-China trade deficit results in a number that is about half the size of the U.S. measurement! Moreover, given that a significant amount of commerce is now done online, any measure of the U.S. trade deficit just continues to get harder every year.
- The U.S. Dollar is the world's reserve currency and thus the preferred currency of world trade. Given that this is the case, there is inevitably a need for the U.S. to run a trade deficit in order to provide the necessary dollars for other countries to trade with. Interestingly – whenever the U.S. current account deficit has declined in a substantial way – some major exporter or financial institution usually goes bust.
- Speculative or investment flows of funds have historically had more of an impact than trade flows – and with the worldwide proliferation of hedge funds (and given that pension funds are now getting into the “currency overlay” game), the impact of speculative flows vs. the impact of trade flows is getting higher by the day.
If anything, the “deficit” that has been more historically reliable in “predicting” the subsequent performance of the U.S. Dollar is the U.S. Budget Deficit. Without further ado, following is an annual chart showing the year-over-year change in the budget deficit (as a percentage of GDP) vs. the annual change in the U.S. Dollar Index from 1986 to 2006 (note that both the 2006 budget deficit and the USD Index numbers are not final at this point):
Note that the U.S. budget deficit this year is expected to come in at $296 billion, or 2.3% of GDP. This estimate is down from nearly a $425 billion deficit in the 2006 budget that was estimated in the beginning of this year – and down from a deficit 2.6% of GDP hit in the 2005 budget (hence the 0.3% year-over-year change in the budget balance during 2006 in the above chart).
As mentioned on the above chart, the correlation from 1986 to 2006 is 30% - a respectable correlation but not overly significant. However, it is interesting to note that the correlation between the year-over-year change in the budget surplus/deficit and the annual change in the U.S. Dollar Index has increased significantly in recent years – rising to 67% if the study period is narrowed down to the last ten years! Given this historical relationship, the U.S. Dollar Index (based on the close as of yesterday, the annual change in the USD Index is now at negative 8.5%) should be performing much better than it has over the last 11 months. It is also interesting to note that the UK, France, and Germany are also running similar budget deficit numbers – with the former two actually projected to run a higher budget deficit amount (as a percentage of GDP) than the U.S. In other words, the major Western European powers hold no advantage when it comes to the state of the budget. Finally, the incoming Chairman of the Budget Finance Committee, Senator Kent Conrad of North Dakota, has in the past been very committed to balancing the U.S. budget – and there is no reason to doubt that this is still his goal going forward.
As far as timing-wise, now is as good a time to get into the U.S. Dollar Index – as the U.S. Dollar Index is now very much oversold, as shown by the following daily chart showing the value of the U.S. Dollar Index vs. its percentage deviation from its 50-day moving average from December 1985 to the present:
As of the close on Tuesday evening, the percentage deviation of the USD Index from its 50-day moving average hit a low of negative 2.97% - representing the most oversold level since May 23, 2006. Can the USD Index continue to decline from current levels? As our subscribers should know, anything can and has historically happened in the financial markets, but probability now suggests that it is more prudent to buy the U.S. Dollar Index than to sell it. Finally, all my arguments for a major rally in the U.S. Dollar Index that I have discussed in previous commentaries (such as slower economic growth in the Euro Zone next year, etc.) still hold.
A Quick Update on the Stock Market
It certainly took a while for the NYSE to do this – but the October margin debt data has finally been released. Following is a chart showing the Wilshire 5000 vs. the change (over a period of 3, 6, and 12 months) in margin debt from January 1998 to October 2006 (note that margin debt outstanding on the NASD has been estimated since it typically is not released until a few days later):
The increase in margin debt has come back with a vengeance during the September to October 2006 period. This is perfectly normal in a bull market – especially given that margin debt declined substantially (three out of the four months) during the May to August 2006 period. While November data may show differently, it is important to note that – at this point – both the increase and the amount of margin debt outstanding are still not at a level that is high enough to be alarmed just yet. I will inform our subscribers of the November data as soon as that is released (hopefully by the middle of December).
Finally, the most recent NASDAQ short interest numbers have been released – and just like the most recent NYSE short interest data, this does not appear too good for the bulls, at least in the short-run anyway. Following is a monthly chart showing total NASDAQ short interest vs. the value of the NASDAQ from September 15, 1999 to November 15, 2006:
As mentioned on the above chart, NASDAQ short interest declined a substantial 410 million shares for the month ending November 15, 2006. While the long-term impact is not overly high, there is no doubt that short-covering on the NASDAQ should take a breather over the next few weeks. In other words, do not depend on the shorts to take the market up for the rest of the year. Instead, any further rally in the NASDAQ will be very much dependent on new money coming in – whether it is from hedge funds, company buybacks, or retail investors.
Henry To, CFA