Real Estate Grounds The Dollar

Real estate grounds the dollar

We are all aware of the sub prime lending led real estate crisis that the US is currently going through. But what has this got to do with the value of the dollar, which seems to have displayed persisting weakness for sometime now?

Let’s try and understand what currency values indicate. In general, like common stocks reflect the health of a corporation, the value of a nation’s currency is indicative of the economic health of the nation.

The value of a nation’s currency is measured relative to that of other select nations. Thus, the value of the US dollar is usually measured against the Euro, Yen and the Pound amongst other currencies.

Having understood that there is a general relationship between the economic health of a nation and the value of its currency, let’s analyze how the current real estate bust is affecting the value of the dollar.

The value of a currency is primarily affected by the level of inflation in the economy and the prevailing interest rates. Inflation and interest rates are themselves closely interlinked, with interest rate being a key tool that central banks use to manage the former, as well as the health of the economy.

The past few years of low interest rates and easy loans for home buyers fuelled property prices. A large part of these loans were sub-prime loans, given to buyers with poor credit history. Some of these loans were flexible loans and carried low mortgage payments for the first few years after which they were to reset in line with market interest rates. From the time these loans were given out until the time they were ready to reset, market interest rates moved up considerably due to Fed having raised its benchmark rate. This implied that the borrowers were to suddenly face huge monthly mortgage payment liabilities, which they could possibly not manage to pay. Defaults started and a large number of properties came up for sale. This led to prices stagnating or moving downwards as new buyers were far from few, with interest rates having shot up. Due to rising interest rates, these flexible loans led to a situation where the fixed payments made did not even cover the interest liability and the outstanding interest for the period got added up to total outstanding liability. In several cases the total outstanding after the reset period added up to greater than the purchase/present value of the property leading to the situation called ‘upside down’ in the loan. Imagine the plight of the buyer who had thought that he could always sell the property and make some money. He now faced a situation, where the outstanding loan was higher than what he could sell the property for.                                                          

Fed’s dilemma
           
If the Fed were to significantly lower interest rates, it might become possible to shore up the sagging real estate market. However, policy does not permit such knee jerk reactions and moreover, interest rate change also have to take into account inflation levels and projected inflation. The news on the inflation front is not very heartening. U.S. consumer prices rose the most in more than two years in November on record energy costs, reinforcing the Fed’s concern that inflation will erode confidence in the economy. The consumer price index rose 0.8 percent in November, up from 0.3 percent the previous month, according to the U.S. Labor Department statement on December 14, 2007. With, crude prices showing no signs of relenting, inflation will continue to pose a threat to the US economy. This implies that the Fed’s hands are tied. If it lowers interest rates, it may push liquidity into the system leading to a higher inflationary pressure, a condition the Fed is completely averse to. Thus, the Fed needs to be very careful in crafting its interest rate movements.

Early last month, the Federal Reserve cut interest rates for the third successive time in order to prevent the rapidly deteriorating US housing market from dragging the world’s biggest economy into recession. The cut was a marginal 25 basis points. However, these successive cuts have led to a depreciating dollar and thus our corollary, ‘Real estate grounds the dollar’.

4 comments

  1. akeakamai

    Thanks for going over the sub-prime issue, and then tying it back into Forex. Great read for someone like me who didn’t fully understand what all the fuss was about!

    Reply
  2. akeakamai

    Thanks for going over the sub-prime issue, and then tying it back into Forex. Great read for someone like me who didn’t fully understand what all the fuss was about!

    Reply
  3. rdquintas

    Excelente Post!!

    I would like to add this excelente article from The Economist:

    ——————————————
    The dollar and the world economy
    Dec 19th 2007
    From the Economist Intelligence Unit ViewsWire

    Why the dollar should stabilise next year

    The global economy, already beset by financial market turmoil and slowing US growth, is now confronted by the risk that the gradual decline of the US dollar could run out of control. In addition to the weakening outlook for the US, there are fears that central banks could suddenly move to dump their huge dollar reserves or that Middle Eastern countries could abandon their pegs to the dollar. Our baseline scenario is for the dollar to stabilise in 2008 before beginning to appreciate. But a US recession or other factors that could lead to a loss of confidence in the dollar pose major risks to this scenario. A dollar crisis would be very damaging for the global economy, making the expected slowdown much deeper and more protracted.

    Dollar decline
    The financial market turmoil that begun in August has put serious pressure on the US dollar: by end-November the dollar had fallen by some 6% since August against a trade-weighted currency basket tracked by the US Federal Reserve. Dollar weakness is not a new issue: the currency has lost a quarter of its value against a broader range of currencies over the past five years. However, there are fears that, in the current environment, the dollar’s decline could turn into a rout.

    Much of the reason for the dollar’s decline lies in economic fundamentals: notably the large US current-account deficit, which reached 6.2% of GDP in 2006. Dollar weakening has been accelerated partly by the cyclical divergence between the US (where growth is weakening owing to the fallout from the subprime mortgage mess) and the rest of the world (where growth remains robust), and by the associated widening of interest rate differentials following cuts by the US Federal Reserve. The subprime debacle and ensuing turmoil on credit markets have also hit the dollar because uncertainty centres on dollar-denominated assets and confidence in the resilience of the US financial system has been shaken. Net private capital inflows into the US have weakened sharply since August.

    Finally, current difficulties have reinforced some investors’ worries about the longer-term role of the dollar as a reserve currency in the global economy. Immediate concerns are that central banks and sovereign wealth funds (SWFs) sitting on huge piles of dollars, such as China and several oil producers, could dump their dollar assets out of fear of capital losses from dollar depreciation. Similarly, there are concerns that the dollar could be hit if those central banks that currently peg their currencies to the dollar shift to different exchange-rate regimes. One reason for this, particularly for countries in the Middle East and for China, would be to ease inflationary pressures that are building as the US currency weakens.

    Road to recovery
    In our baseline scenario for the global economy, the dollar is likely to stabilise in 2008 before beginning to recover later in the year–we forecast an average rate against the euro falling from US$1.37€1 in 2007 to US$1.46:€1 in 2008, before recovering to US$1.33:€1 in 2009. The US currency is likely to continue to weaken against the yen into the medium term, but this is mainly because the yen will appreciate strongly as Japanese interest rates rise and the carry trade unwinds.

    The main reason to expect the dollar’s fortunes to improve is that by late 2008 the current hysteria on global markets should have abated, and US growth should be beginning to emerge from a period of weakness, allowing for calmer consideration of the relative strengths of the US economy. Robust productivity growth in a global context (even allowing for concerns over weaker US productivity growth in the coming years) and comfortable demographics support the case for a relatively bright long-term outlook and hence provide good grounds for the dollar to strengthen. Once the US’s economy’s downturn and weaker dollar have reduced the US external imbalance, we expect the currency to appreciate into the longer term.

    It is likely to be supported in 2008 by interest rate dynamics. We believe that markets exaggerate the case for monetary policy easing in the US next year and the Fed funds rate will still stand at 3.75% at the end of 2008. This would lead to some strengthening pressure for the dollar, as investors readjust their interest rate expectations. The US currency may also be supported against the euro by an interest rate cut by the European Central Bank, although the uncertainty about this is high.

    Finally, we believe that a large-scale shifting of public foreign reserves out of the dollar is highly unlikely. The investment horizon of these entities tends to be long-term, and, as we have argued, over the longer-term the dollar should appreciate. Even in so far as central banks and SWFs with large US dollar assets are concerned about short-term losses, they will be held back by concerns that any disposal of the currency would trigger even bigger capital losses on their remaining stock of US dollar assets. Moves away from a dollar peg should also have only a limited impact on demand for the dollar—we currently do not expect the Gulf states to re-peg—and even if they did, they would probably move to a basket of currencies dominated by the dollar, mitigating the impact on dollar reserve holdings.

    Considerable risks
    Nevertheless, the risks of the dollar’s decline into 2008 turning into a rout are high. Most importantly, there are downside risks to our US growth forecasts, notably from a continuation of the recent financial market turmoil beyond what we currently expect, or from a greater-than-expected impact on consumer demand from the correction in the US housing market. The dollar will also remain exposed for much of 2008 to nervousness among investors about the US current-account deficit and about shifts in central bank and SWF holdings and in exchange rate regimes.

    These factors could easily lead to a further sharp fall that could see the dollar clear the US$1.60:€1 threshold. Co-ordinated countermeasures by the G7 would probably put a floor under the dollar. Nevertheless, a full-blown dollar crisis, coming on top of the credit crunch and a weakening US economy, would be disastrous for the global economy.

    A dollar slump would hit financial markets hard, and could force the Fed to raise US interest rates just as the economy was slowing, pushing the US into a protracted recession. At the same time, the euro would bear the brunt of the dollar’s weakening: further euro appreciation would substantially reduce growth in Europe (we estimate that a 10% rise of the euro in nominal effective terms would cut growth in th euro zone by a third of a percentage point). The downturn for the global economy already expected as a result of recent financial market turmoil would therefore be much deeper and more protracted.

    De-dollarfication
    Even under our baseline scenario, in which the dollar avoids a sharp slump in the short term, there are substantial risks to the currency in the medium to long term. A period of below-potential domestic demand growth in the US will contribute to a moderate shrinking of the external deficit to around 4% in 2010 followed by a stabilisation in subsequent years, but this will still leave the deficit at a high level. Foreign investors will not accept low returns on their US holdings for ever, particularly as the US becomes a smaller part of the global economy and the supply of financial assets from emerging markets continues to develop, raising investment opportunities outside of the US. The dollar will therefore remain exposed to shifts in sentiment into the medium term.

    Moreover, given structural shifts in the global economy, an end to the dollar’s hegemonic status (as an international means of exchange and reserve currency of choice) may be inevitable in the longer term. This shift could be stable or disorderly—but it could yet occur gradually, and certainly need not imply a slump in the dollar in the short-term.
    ——————————————

    Reply
  4. rdquintas

    Excelente Post!!

    I would like to add this excelente article from The Economist:

    ——————————————
    The dollar and the world economy
    Dec 19th 2007
    From the Economist Intelligence Unit ViewsWire

    Why the dollar should stabilise next year

    The global economy, already beset by financial market turmoil and slowing US growth, is now confronted by the risk that the gradual decline of the US dollar could run out of control. In addition to the weakening outlook for the US, there are fears that central banks could suddenly move to dump their huge dollar reserves or that Middle Eastern countries could abandon their pegs to the dollar. Our baseline scenario is for the dollar to stabilise in 2008 before beginning to appreciate. But a US recession or other factors that could lead to a loss of confidence in the dollar pose major risks to this scenario. A dollar crisis would be very damaging for the global economy, making the expected slowdown much deeper and more protracted.

    Dollar decline
    The financial market turmoil that begun in August has put serious pressure on the US dollar: by end-November the dollar had fallen by some 6% since August against a trade-weighted currency basket tracked by the US Federal Reserve. Dollar weakness is not a new issue: the currency has lost a quarter of its value against a broader range of currencies over the past five years. However, there are fears that, in the current environment, the dollar’s decline could turn into a rout.

    Much of the reason for the dollar’s decline lies in economic fundamentals: notably the large US current-account deficit, which reached 6.2% of GDP in 2006. Dollar weakening has been accelerated partly by the cyclical divergence between the US (where growth is weakening owing to the fallout from the subprime mortgage mess) and the rest of the world (where growth remains robust), and by the associated widening of interest rate differentials following cuts by the US Federal Reserve. The subprime debacle and ensuing turmoil on credit markets have also hit the dollar because uncertainty centres on dollar-denominated assets and confidence in the resilience of the US financial system has been shaken. Net private capital inflows into the US have weakened sharply since August.

    Finally, current difficulties have reinforced some investors’ worries about the longer-term role of the dollar as a reserve currency in the global economy. Immediate concerns are that central banks and sovereign wealth funds (SWFs) sitting on huge piles of dollars, such as China and several oil producers, could dump their dollar assets out of fear of capital losses from dollar depreciation. Similarly, there are concerns that the dollar could be hit if those central banks that currently peg their currencies to the dollar shift to different exchange-rate regimes. One reason for this, particularly for countries in the Middle East and for China, would be to ease inflationary pressures that are building as the US currency weakens.

    Road to recovery
    In our baseline scenario for the global economy, the dollar is likely to stabilise in 2008 before beginning to recover later in the year–we forecast an average rate against the euro falling from US$1.37€1 in 2007 to US$1.46:€1 in 2008, before recovering to US$1.33:€1 in 2009. The US currency is likely to continue to weaken against the yen into the medium term, but this is mainly because the yen will appreciate strongly as Japanese interest rates rise and the carry trade unwinds.

    The main reason to expect the dollar’s fortunes to improve is that by late 2008 the current hysteria on global markets should have abated, and US growth should be beginning to emerge from a period of weakness, allowing for calmer consideration of the relative strengths of the US economy. Robust productivity growth in a global context (even allowing for concerns over weaker US productivity growth in the coming years) and comfortable demographics support the case for a relatively bright long-term outlook and hence provide good grounds for the dollar to strengthen. Once the US’s economy’s downturn and weaker dollar have reduced the US external imbalance, we expect the currency to appreciate into the longer term.

    It is likely to be supported in 2008 by interest rate dynamics. We believe that markets exaggerate the case for monetary policy easing in the US next year and the Fed funds rate will still stand at 3.75% at the end of 2008. This would lead to some strengthening pressure for the dollar, as investors readjust their interest rate expectations. The US currency may also be supported against the euro by an interest rate cut by the European Central Bank, although the uncertainty about this is high.

    Finally, we believe that a large-scale shifting of public foreign reserves out of the dollar is highly unlikely. The investment horizon of these entities tends to be long-term, and, as we have argued, over the longer-term the dollar should appreciate. Even in so far as central banks and SWFs with large US dollar assets are concerned about short-term losses, they will be held back by concerns that any disposal of the currency would trigger even bigger capital losses on their remaining stock of US dollar assets. Moves away from a dollar peg should also have only a limited impact on demand for the dollar—we currently do not expect the Gulf states to re-peg—and even if they did, they would probably move to a basket of currencies dominated by the dollar, mitigating the impact on dollar reserve holdings.

    Considerable risks
    Nevertheless, the risks of the dollar’s decline into 2008 turning into a rout are high. Most importantly, there are downside risks to our US growth forecasts, notably from a continuation of the recent financial market turmoil beyond what we currently expect, or from a greater-than-expected impact on consumer demand from the correction in the US housing market. The dollar will also remain exposed for much of 2008 to nervousness among investors about the US current-account deficit and about shifts in central bank and SWF holdings and in exchange rate regimes.

    These factors could easily lead to a further sharp fall that could see the dollar clear the US$1.60:€1 threshold. Co-ordinated countermeasures by the G7 would probably put a floor under the dollar. Nevertheless, a full-blown dollar crisis, coming on top of the credit crunch and a weakening US economy, would be disastrous for the global economy.

    A dollar slump would hit financial markets hard, and could force the Fed to raise US interest rates just as the economy was slowing, pushing the US into a protracted recession. At the same time, the euro would bear the brunt of the dollar’s weakening: further euro appreciation would substantially reduce growth in Europe (we estimate that a 10% rise of the euro in nominal effective terms would cut growth in th euro zone by a third of a percentage point). The downturn for the global economy already expected as a result of recent financial market turmoil would therefore be much deeper and more protracted.

    De-dollarfication
    Even under our baseline scenario, in which the dollar avoids a sharp slump in the short term, there are substantial risks to the currency in the medium to long term. A period of below-potential domestic demand growth in the US will contribute to a moderate shrinking of the external deficit to around 4% in 2010 followed by a stabilisation in subsequent years, but this will still leave the deficit at a high level. Foreign investors will not accept low returns on their US holdings for ever, particularly as the US becomes a smaller part of the global economy and the supply of financial assets from emerging markets continues to develop, raising investment opportunities outside of the US. The dollar will therefore remain exposed to shifts in sentiment into the medium term.

    Moreover, given structural shifts in the global economy, an end to the dollar’s hegemonic status (as an international means of exchange and reserve currency of choice) may be inevitable in the longer term. This shift could be stable or disorderly—but it could yet occur gradually, and certainly need not imply a slump in the dollar in the short-term.
    ——————————————

    Reply

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