A U.S. Dollar Collapse Timeline
The U.S. dollar started 2017 by making some bullish moves against its main rival currency, the euro. But, given the European political and economic risks at stake, the Greenback should have shown far greater strength. Instead, it has never managed to reach the parity that so many had expected, because of the Federal Reserve’s nominal interest-rate increases. A U.S. dollar collapse has started to become a real possibility.
Any dollar collapse predictions naturally raise two questions: 1) When will the dollar collapse happen? and 2) What will make it happen? Indeed, you would be right to worry about a dollar collapse in 2017. In January, anyone suggesting that the dollar would crash in 2017 would have faced skepticism, if not outright derision.
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The weakness of the euro and the mountain of existential risks that it faces simply in staying afloat acted as an injection of confidence in the dollar. Brexit is proving to be complicated. The United Kingdom, which is not even part of the eurozone, will have to pay a huge bill to divorce the European Union (EU).
The U.K. also faces an uncertain future. That’s regardless of how confidently British Prime Minister Theresa May presents herself in meetings with her European counterparts. The U.K. will have to pay anywhere from $65.0 billion to $88.0 billion, said European Commission (EC) President Jean-Claude Juncker. (Source: “Brexit’s Costs and Whether Britain Will Pay Up: QuickTake Q&A,” Bloomberg, May 4, 2017.)
You might be wondering what the U.K. and the eurozone have to do with the dollar. It turns out they have quite a bit to do with it.
Surely, the two countries that have the highest reserves of U.S. dollars, Japan and China could make a U.S. dollar collapse happen tomorrow, even today. They can simply sell large chunks of their holdings of U.S. treasury bonds.
China owns over a trillion dollars’ worth of U.S. treasury bonds, but Japan owns even more: $1.2 trillion. China does not want the U.S. dollar to go too high, because it would exacerbate the country’s capital outflow problem. China’s yuan is pegged to the U.S. dollar, and its central bank is trying to keep the yuan from going too high, in order to encourage exports. China has long ago stopped being the most advantageous place to do business. It has to contend with competition from other emerging Asian economies that offer even lower production costs.
Japan, on the other hand, does want a high dollar, to make its high-quality products as competitive as they are attractive to American consumers. Japan has become far less dependent on a weaker yen than in the 1980s or 1990s. Japanese companies make a number of products in the United States, thus reducing the dollar’s impact. As a U.S. ally that is at a heightened level of security—given the situation in North Korea—Japan might be less inclined to prop up the dollar. This puts it in a rare situation of agreement with China.
Therefore, the two largest holders of U.S. debt have few incentives to see the dollar go higher. A U.S. dollar collapse scenario would benefit neither China or Japan. For starters, a dollar collapse would represent the symptom of a wider financial crisis or outright economic collapse. The trouble is, that’s just what could happen.
Will the U.S. Dollar Collapse Despite Widespread Optimism?
A dollar collapse is starting to look likely, if not inevitable. Considering the political turmoil in Europe, including the difficult Brexit proceedings in the U.K. and the various elections on the continent, the Greenback should be propped up. At the time of writing, however, the dollar was trading at about 1.09 to the euro. The dollar had a chance at parity, but it’s slipping away.
At the beginning of 2017, the prophets of a weak euro and high dollar appeared to have made the right call. On January 1, the European currency sagged temporarily, to a record low of $1.0339! Parity (1:1 euro to dollar) seemed to be just an inch away. All factors were playing in favor of it. But it did not happen. President Donald Trump has simply created too much uncertainty.
The euro is now trading at its highest level since the dollar rally after the U.S. election, and the forecasts for future price developments have changed. The euro is rising again, as the British pound has also done. A cloud of fear has arrived, inspiring doubt in the U.S. economy. Surely, Trump scored some political points on May 4. The House of Representatives voted to repeal Obamacare.
Americans, however, started to like Obamacare. More of them (55%) approved Obamacare than those who approved the performance of Trump in his first 100 days in office. The repeal of Obamacare still has to pass through the more-combative Senate and, by then, it may prove to have been a major political mistake.
By the end of 2016, Goldman Sachs Group Inc (NYSE:GS) expected the dollar to continue to appreciate in 2017, reaching parity with the euro by the end of the year. The strength of the U.S. currency was predicated on the interest-rate differential between the U.S. and Europe, as well as Japan. But, even more so, the dollar’s rise was predicated on the perception of political weakness in the EU.
Major Turnaround of Expectations: Upcoming Dollar Collapse
Many analysts had expected the dollar to reach parity with the euro. In fact, all the signs pointed to the U.S. dollar surpassing the euro before the end of 2017. The elections in Europe were supposed to have brought in a series of anti-eurozone governments. But, one by one, fear of letting go has stopped this from happening. The anti-euro parties remain strong, however. They have lost election battles, but they still believe they might win the war.
The euro has stabilized after weeks, if not months, of uncertainty. Meanwhile, the dollar has started to reflect the uncertainties of the current U.S. administration. The European currency has gained back some six months’ worth of losses against the dollar. The stronger the euro, the weaker the dollar shall be, as the current macroeconomic and geopolitical situation stands.
Meanwhile, the Greenback has also been losing ground to the Japanese yen. In the meantime, the European currency could jump to US$1.15 by the third quarter!
Interestingly, the dollar-euro parity advocates justified their opinion with rising interest rates in the United States. This is because the fundamental relationship between interest rates and currencies is the following. If interest rates rise in a country, investment in the capital market becomes more attractive for both domestic and foreign investors. This results in a higher demand for that country’s currency. Conversely, the process reverses when the interest rates of a country fall.
The expectations of pro-EU political parties going under the proverbial bus in 2017 were deeply entrenched. Analysts failed to consider the alternative: the pro-euro governments surviving. And there are more shocks ahead. Thanks to favorable economic data in Europe, the European Central Bank (ECB) might start raising its own interest rates. (Source: “Europe’s Central Bank Sounds a More Upbeat Tone,” The New York Times, April 27, 2017.)
Until just months ago, the idea of the ECB raising interest rates and easing up on its quantitative easing mantra would have provoked a flood of spit-takes on Wall Street. The European Central Bank raising rates was, to put it mildly, taboo, but there are signs of life coming from the Spanish, Italian, and even the Greek economies.
The ECB appears ready to taper off its bond purchase program. At the end of 2016, the ECB had extended it by nine months, to at least December 2017. Now, the ECB President Mario Draghi is starting to see the end of the tunnel.
The Fed Could Hold Back on Raising Interest Rates
While the ECB considers raising interest rates, there are doubts about just how far the U.S. Federal Reserve can continue its program of interest rate hikes in the United States. Rate hikes are intended to control inflationary pressure, which is a byproduct of real economic growth. That is to say, higher employment and higher wages.
Yet, even Donald Trump might have been surprised as he celebrated his first 100 days in power. The U.S. economy has not grown in an especially stellar manner in the first quarter. After enjoying very solid growth in recent years, the United States may be reaching another plateau. GDP growth in the first quarter was the lowest in three years.
Trump, for his part, has fueled uncertainty. He has done the opposite of what he explained was going to be the “America First” program. At no point since the 1980s has the U.S. experienced the current level of tensions with other nuclear powers, Russia foremost. Now the Trump administration, which has proven shaky and inexperienced, faces a tough trial.
Trump has graded his first 100 days’ presidential performance as A+. He is probably right that the 100-day standard is pointless, but it has shown that the president is facing a steep learning curve. (Source: “Trump: ‘ridiculous’ to grade my 100 days, but he gives himself an A+,” The New Daily, April 25, 2017.)
The slower-than-expected U.S. economic growth will mark the Trump administration’s first major challenge on the economy. This will involve careful policy decisions that cannot be initiated through executive orders like Trump’s immigration bans. The United States grew at 0.7% in the first quarter on an annualized basis. It’s still better than the EU’s performance, but the latter is catching up. Moreover, that U.S. economic growth was the result of Barack Obama’s administration. Trump’s policies have not kicked in yet, and his ambitious tax reform could crash in Congress.
Not surprisingly, then, the Federal Reserve did not raise interest rates, taking a wait-and-see attitude. It maintained its key policy rate, the Federal Funds Rate (FFR), in a range of 0.75% to 1.0%.
One major factor has drastically affected growth. It’s a troubling sign. There has been near-stagnation in consumer spending. The consumer spending rate was 0.3%, compared with 3.5% in the fourth quarter of 2016. The labor participation rate, despite the unemployment rate at 4.4%, is at 30-year lows. It’s the weakest growth since the last quarter of 2009. Fed Chair Janet Yellen might want to hold back on interest rate hikes, because the United States could be heading for another recession.
