The Flight from the USD

USD Becomes Funding Currency
Major central banks are keeping liquidity ample in the aftermath of the global credit crisis following the collapse of Lehman Brothers, resulting in a flood of excess liquidity in the capital markets. With perceptions that global systemic risk is essentially eliminated, investors are looking to invest in higher-yielding currencies and riskier assets. Consequently, equity markets around the world hit record highs and emerging market stocks enjoyed even bigger gains. So far this year, the Shanghai Composite Index and the Indian Sensex 30 have risen 62 percent and 73 percent respectively.

Despite improvement in risk appetite, investors are leaving the U.S. to invest overseas. The latest Treasury International Capital (TIC) report showed $97.5 billion in net capital outflows from the U.S. in July, exerting selling pressure on the USD. The dollar had rallied broadly for the most part this year amid a broad liquidation in cross border assets by the U.S. investors, driven by worries about the deteriorating global financial and economic outlook. But as risk appetite returns, investors are selling USD to fund their investments. If risk appetite remains firm in the coming months, capital will keep flowing out of the USD.

Printing Money Is Ineffective In Bringing Recovery
The problem of the USD can be traced to the ineffectiveness of the U.S. stimulus package so far and the expected lag in policy normalization compared to other economies.

Last week, the Fed chairman declared that "the recession is very likely over." While recent economic releases appeared to back up this positive sentiment, U.S. consumers have yet to start spending and incur debt. Consumer confidence still hovers in recessionary levels, unemployment remains high and the labor market continues to contract. Corporations are not buying because the outlook for recovery and government policy changes remain highly uncertain. We might have passed the worst contraction, but the rebound will take much longer to occur. As Bernanke commented, "It's still going to feel like a very weak economy for some time."

The U.S. has thus far avoided a repeat of the 1930 depression by printing money - with a surge in national debt that we have not seen before and a budget deficit in the trillions of USD. But can we really get back to the growth we experienced previously by simply having one agency of the government issuing trillions of dollars of paper money to buy off the debt issued by the government? History indicates that this is a highly doubtful proposition.

USD Cannot Lead the World To Recovery
Policy makers in other economies seem to be doubtful about the effectiveness of the current U.S. monetary and economic policy as well. China has repeatedly indicated that USD should be replaced eventually by a new global reserve currency. Russian Prime Minister Putin also said last week that the U.S. Federal Reserve's uncontrolled role as the world's sole USD printing press is a "problem."

The U.S. is perceived as no longer able to lead the rest of the world back to recovery. Many investors believe that given the depth of the contraction, the ineffective stimulus package and the damage to the credit market, the U.S. downturn could linger much longer than in other countries. As such, USD interest rates will remain suppressed for some time as the U.S. will lag the countries in ending quantitative easing to return to a normalized monetary policy. China or other emerging countries are showing more promising signs of increased economic activity, attracting foreign inflows that are currently parked in U.S. assets. As the Fed is perceived to be the last central bank among industrial nations to withdraw stimulus, investors will sell short USD and buy currencies of economies where central banks are keen to tighten as growth emerges.

However, the flight from USD will not mean that the USD will collapse. USD will likely take on a long gradual slide. It is still the only currency in the world that offers the depth and breath available to investors. There is simply no other investment alternative, although USD selling could intensify once the global economies continue to recover and capital could find investment opportunities in the real sectors.

Watch Gold
Given the lack of alternative investments other than the USD and the fear of continued financial uncertainty, it is logical that investors and central banks will turn to gold. Gold is also viewed as an insurance policy to the potential inflationary pressures as seen in the growth of the U.S. money supply. September U.S. M1 rose about 18 percent year-on-year, while the budget deficit reached a record $1.38 trillion for the first 11 months of the fiscal year that ends September 30. Gold as a real asset will be favored by investors as a hedge to potential future inflation.

It is no wonder China is considering buying gold offered for sale to central banks by the International Monetary Fund (IMF), despite gold trades above the psychological $1,000 per ounce level. China, the world's biggest producer and buyer of gold, revealed that it had lifted its own stock of gold to 1,053 tons from 400 tons when it lasted reported its holdings in 2003.

The prospect of a weakening USD and mounting inflation fear will drive gold higher despite reaching an 18-month high of $1,025.80 an ounce last week. Watch that $1,050, if broken, could indicate further gain to new highs.