How Big Is The Risk Of A Dollar Cliff?

As election euphoria settles and the "fiscal cliff" approaches, what are the implications for the dollar? Even as federal deficits may be unsustainable, stocks and bonds are up, and while the dollar may have resumed its long-term downward trend, the greenback has hardly fallen off a cliff. We look at how different tax policies might affect the U.S. dollar.

In our assessment, the fiscal cliff, that is the looming simultaneous tax increases and spending cuts, is mostly a distraction. It's a distraction because, as significant as the short-term impact on GDP may be, "going over the cliff" does not solve our long-term fiscal problems. Indeed, we might as well call it European style austerity, as before factoring any slowdown induced by the cliff itself, the U.S. would continue to face a deficit exceeding 3% of GDP. More importantly, Medicare reform, in our view key to long-term budget sustainability, remains elusive.

The most attractive attributes of the dollar may well be its liquidity. A side effect of issuing record amounts of debt is that central banks have a place to deploy their dollar reserves without impacting markets too much. However, the Federal Reserve (Fed) may be crowding out other investors, as it gobbles up an ever-growing chunk of federal debt, in an effort to keep down U.S. borrowing costs. Still, the Fed has shown its willingness to provide liquidity in times of crisis, providing comfort to many.

And while we take it for granted, the ability to take one's money out of the U.S. is also a key reason why investors put money into the U.S. The best thing that could happen to global financial stability is if emerging markets opened their capital accounts and developed their domestic fixed income markets, making them less dependent on U.S. dollar funding. Instead, policy makers from Brazil to Switzerland that are afraid of speculative inflows impose roadblocks, then engage in ill-fated efforts to manage the fallout from their policies. Countries might be better served preparing their economies for a world where the dollar is no longer the only game in town, rather than deploying billions to provide the illusion of a world order that we believe won't come back.

Like any asset, currencies are driven by supply and demand. Investors buy U.S. dollar denominated assets if they believe they get a worthy return. Because the U.S. has a promoted a value added tax where proceeds are used to pay for national health care coverage. By clearly identifying and capping benefits, high spenders would pay more into the system than they receive. This may well be a back-door way to introduce a national value added tax at some point. And once introduced, it may well morph into something bigger.

As it stands, however, the U.S. tax system is hopelessly out of touch with that of the rest of the world. Europe has learned that individuals can be taxed rather highly before they move, but corporations must be lured with low taxes. As far as the dollar is concerned, we consider the current tax system a negative for the dollar; prudent tax policies could promote the dollar. But the tax system itself may not trigger a "dollar cliff". The bigger concern is on the spending side, as any tax system may fail at some point when spending far exceeds revenue. The fiscal cliff discussion is, in our assessment, about merely tweaking spending. Meaningful entitlement reform is, in our view, the most important factor driving long-term fiscal sustainability.

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However, as Europe has shown us, the only language policy makers appear to understand is that of the bond market; as long as the bond market lets policy makers get away with excessive spending, we see little chance entitlement reform is tackled in earnest. As such, the risk of a dollar cliff may stem from the bond market acting up to provide "incentives" for reform. Because the U.S, unlike Europe, has a current account deficit, the dollar may be far more vulnerable should the "bond vigilantes" impose reform. "Bond vigilantes" is a term used to refer to a bond market selloff that imposes reform. On that note, we don't need horrible news for such a selloff to happen: good news might do the same. Should the economy recover, the bond market may turn into a bear market. In such an environment, foreign investors that historically favor U.S. Treasuries might reduce their holdings, causing downward pressure on the dollar. In our assessment, the biggest threat to the bond market - and with that to the dollar - is neither good nor bad news, but a return to historic levels of volatility in the bond market. A lot of investors that have chased yields might all run for the exit at once should sentiment spread that U.S. bonds might be a bit pricey.

Written By: Axel G. Merk