Has the Repudiation of the Dollar Begun?

The Fed’s unexpectedly large cut to the discount rate said loud and clear that its priority is domestic growth, not preserving the value of the depreciating dollar.

Yet as we have pointed out, the dollar’s status is a tremendous asset for the US, not to be squandered. It gives us the ability to borrow in our currency, and also lowers prevailing interest rates by making the dollar a favored choice for international investors who wanted a safe place to park excess funds.

Bill Pimco had correctly predicted that Bernanke faced a tough choice between preserving the housing market versus shoring up the dollar, and in the end would capitulate and support housing. But in choosing housing, he may wind up with neither.

Foreign central banks have already been quietly diversifying away from dollars. More recently, foreign institutional investors have become openly disenchanted with the dollar.. Even though Venezuela sells more than half its oil production to the US, earlier this week it announced that it will no longer accept payment in dollars (hat tip The Prudent Investor). While this move may seem to be merely symbolic, it is another sign that the dollar’s days as reserve currency are numbered.

The latest blow came today, when Saudi Arabia refused to cut interest rates to maintain the relationship of its currency with the dollar (hat tip Calculated Risk). As the UK’s Telegraph reported:

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East….

The Saudi central bank said today that it would take “appropriate measures” to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg….

There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries.

The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit — expected to reach $850bn this year, or 6.5pc of GDP.

Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America’s credit and short-term paper markets over the last two years…

The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis.

“If Ben Bernanke starts running those printing presses even faster than he’s already doing, we are going to have a serious recession. The dollar’s going to collapse, the bond market’s going to collapse. There’s going to be a lot of problems,” he said….

Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.

And remember, unlike Chavez, the Saudis are supposedly our friends. Depending on short-term hot money to fund current account deficits is exactly the position that many emerging market economies were in immediately before the 1997 Asian crisis, when that funding was withdrawn.

The final nail in the coffin came as Greenspan, who has shown a propensity to distance himself from losing causes, said that the euro could replace the dollar as reserve currency. That’s as close as you get to it being official.