U.S. Dollar Feels Pain as Loonie Flies High

UNDERLYING RISKS
Gold soars as investors shift bets

ALEX ROSLIN
SPECIAL TO THE GAZETTE
Monday, September 24, 2007
The Montreal Gazette

All eyes were on the loonie last week as it reached parity with the U.S. dollar for the first time since 1976.

The leaping loonie has provoked squeals of pain from Canadian manufacturers and exporters, who have beseeched the Bank of Canada to lower interest rates in an attempt to slow the dollar’s ascent.

Less noticed amid the hoopla are the travails of the U.S. buck. The housing meltdown and credit crisis south of the border have sent the U.S. dollar crashing like a stone, not just against the loonie, but also other major currencies like the euro, which broke to record highs in mid-September.

Even the sickly Japanese yen has ended an 18-month downtrend against the U.S. dollar, shooting up seven percent since June.

In fact, in early September, the benchmark U.S. dollar index—a closely watched average of the U.S. currency’s value against that of six major trading partners, including Canada—closed below 80 for the first time since 1992.

Last week, the dollar index hovered a hair above its 1992 intraday low of 78.43 for much of the week, then briefly pierced that low late in the week.

The 78-to-80 zone has been a highly watched psychological level of support for the U.S. dollar for years.

Until this month, it’s acted as a kind of trampoline for the index five times since 1991. Each time this floor was touched, the dollar ended up bouncing smartly back up.

But as the U.S. Federal Reserve Board sought to resuscitate the financial system by lowering interest rates last Tuesday, that put still more downward pressure on the dollar.

One reason: lower interest rates make U.S. government bonds less attractive to foreigners. That’s a problem for the dollar because about half of the $4.4-trillion U.S. federal debt is held by non-Americans, up from a third in 2001.

Why does any of this matter, especially to Canadians?

Some analysts have argued for years that the world’s chief reserve currency is headed for a collapse as the U.S. economy suffocates under mounting housing debt.

A dollar panic could force the Fed to reverse course on interest rates and hike them back up to stem any sudden capital flight from the United States.

That, of course, could kneecap the global economy as it struggles to emerge from a liquidity crisis that has rapidly spread beyond U.S. borders to Canada and other countries.

Underlining the U.S. vulnerability, Chinese government officials last week said Beijing would sell off its $900 billion in U.S. bond holdings if Washington imposes sanctions over Chinese trade practices.

Another blow to the dollar was struck last Thursday when Saudi Arabia refused to cut its interest rates in lockstep with the U.S. for the first time, saying it didn’t want to ignite domestic inflation.

The move ignited speculation that the Gulf kingdom would break its currency’s peg to the dollar, which some analysts said could provoke a stampede out of the American buck.

The dollar’s troubles were further underscored last week by the soaring price of safe-haven gold, which hit a 28-year high above $735 U.S. an ounce.

The developments had one analyst predicting a gold mania unseen since the attempted French invasion of Britain in 1797, which sent bullion prices into orbit.

In a Times of London story last week, analyst Christopher Wood, of Hong Kong brokerage firm CLSA, said gold would quadruple to above $3,400 within three years, spurred by a U.S. dollar collapse.

But some currency and gold analysts said the apocalyptic scenarios are overblown.

“Unless we see a vicious economic contraction in the U.S., the doomsday scenario of dollar weakness is not inevitable,” said Boris Schlossberg, chief currency strategist at DailyFX.com, a foreign exchange news website and brokerage.

U.S. Fed doctrine is to let the greenback slide when faced with economic turbulence, even if it means higher inflation, Schlossberg said from his New York office.

“That’s the bet the Fed has made for the last 25 years. The key thing central bankers have learned is if they can monetize these crashes, that’s better than deflation like we saw in the 1930s,” he said.

“People would rather see high prices than high unemployment.”

But Schlossberg said the U.S. isn’t the only country facing economic weakness, and when other countries start lowering interest rates, that will buoy the U.S. dollar. “The economic fundamentals in the Euro zone are not as sound as everyone believes,” he said.

“It’s quite likely the Euro is peaking here.”

As for the Canadian dollar, Schlossberg said it “has become the darling of the currency market. The market is telegraphing that the Canadian economy has decoupled from the U.S. economy because it’s the only safe liberal democracy that contains a huge amount of resources.”

However, Schlossberg also cautioned that the Canadian dollar has shot up too far too fast, and a decline in oil prices or further bad U.S. economic news could send it into a tailspin.

“The Canadian dollar tends to have very sharp reactions,” he said. “It is obviously, clearly, grossly overbought.”

Gold analyst Jon Nadler also doesn’t expect the doomsday scenario to unfold any time soon.

“The call for the death of the dollar is mostly premature,” sad Nadler, who works for Montreal-based bullion dealer Kitco.

“People wishing for four-digit gold (prices) should examine the reasons for their wish. (Such a scenario) means everything else we own has gone sour,” he said.

Nadler expects the greenback may fall a little further to 78.50, fueling a possible rise in gold to $775. But he cautioned anyone investing in gold to be ready for a vicious pullback. The historic post-war equilibrium price of gold is $400, he said, which means ample room to the downside.

“These markets move very fast,” he said. “The volatility can be expected to excite and disillusion.”

[AR: The published version of this story included charts of the U.S. dollar index, Canadian dollar, crude oil and gold since 1990.]