The US is by no means the world’s most competitive or strongest economy, though the dollar remains its reserve currency. This intuitively contradictory feature in contemporary capitalism was seen as likely to sap the dollar’s strength, even if there was no clear alternative to it as a reserve currency. The threat to the dollar intensified with the onset of the 2008 crisis and the Federal Reserve’s response to that crisis in the form of an injection of huge volumes of cheap liquidity into the system. With the system awash with dollars, the currency was expected to slide. The evidence too pointed to a medium-term decline of the relative value of the dollar. Countries like China with substantial exposure to dollar-denominated assets were wary of suffering large losses because of the depreciation of the dollar.
What has come as a surprise, however, is the recent sudden rise of the dollar with a parallel fall in the value of a whole host of assets varying from equity to metals and gold which had emerged as the preferred safe havens for investors.
Copper, zinc, steel, silver, platinum and gold, all of which were preferred investment targets for wealth holders and speculators are suddenly being shunned. Silver fell by 34 per cent in value in three days, which was its sharpest fall in thirty years, and copper fell by more than 13 per cent. Gold recently registered its sharpest four-day fall since 1983. There seems to be nothing of substance that is worth holding, even if it is durable. The dollar is the current safe haven, though it may not remain so.
This has occurred in the current atmosphere of fear of sovereign defaults, banking crises and a return to recession. In the midst of that uncertainty, the dollar, which was expected to weaken because of economic circumstances in the United States and was indeed drifting downwards, is suddenly gaining in strength. A host of alternative assets—oil, gold and metals among them—which were targets of a bull run previously are all of a sudden being dumped in favour of the dollar.
The turn to the dollar was particularly sharp after the Federal Reserve announced the launch of its “Operation Twist” in late September this year, which involved selling shorter-term Treasury holdings, and buying long-term debt and mortgage-backed securities to the tune of $400 billion. This move is seen to have sent out two signals. The first is that the Fed was attempting to flatten the yield curve by reducing yields on long-term bonds, with the hope that it would revive housing demand and spur investment. The second was that it was moving away from its earlier practice of quantitative easing, which floods the system with dollar liabilities. These implicit objectives were ostensibly seen as a commitment to act against the slowdown in US growth without undermining the dollar’s value, encouraging a shift to the currency.
This in itself cannot fully explain the fall in the prices of alternative assets, especially gold. What is perhaps happening is that the uncertainty and downturn in equity markets is forcing some investors to sell alternative assets in order to cover losses or meet margin calls. The resulting price decline is possibly forcing those who in herd-like fashion moved into gold, metals and other commodities to book profits or cut losses and exit from these assets. But with nowhere else to go, the shift was to cash. And what form of cash is there to hold other than the dollar, with the euro and the yen in crisis.
In the process developing countries that have been the targets of financial investors and those dependent on commodity exports have become particularly vulnerable. Their financial and commodity markets are destabilised. And their currencies, which were appreciating earlier, have experienced sharp declines. The ultimate source of such volatility is the fact that the world is awash with liquidity as a result of the monetary policies adopted in developed countries. The search for investment opportunities to lodge the capital released by those policies has led not just to the proliferation of “innovative” financial instruments in the developed world, but also to cross-border financial flows to developing country markets, to the speculative acquisition of commodity stocks (see Wise’s earlier post on this), and to investments in a whole range of new asset classes that can serve as stores of value.
The diversification of investment portfolios that this proliferation of assets permits was expected to ensure stability. What the world got instead is an increase in volatility.