The Falling Dollar

{Q} Do you think the Fed is justified in supplying liquidity in instances where market participants have taken an imprudent amount of risk, as in the case of subprime mortgages, heavily leveraged hedge funds, and all the rest?

{A} It is not appropriate for them to be bailing out investors who have taken on imprudent amounts of risk. That’s their conundrum: Bernanke realizes that if he improves liquidity, it will ease the pain of those who invested in those areas. On the other hand, if he doesn’t do it, the situation could spill over and affect other parts of the economy, which then really does come under the purview of the Federal Reserve. They have to react once it becomes apparent that it could impact economic activity.

{Q} Do you feel the Fed has acted appropriately in the past four to six months?

{A} I do. But to answer that question, you have to look at what the Fed has been up against. The problem they have right now is that there is a huge pool of liquidity outside of their direct regulatory authority: in foreign hands, in the hedge funds, and private-equity funds. Even though in the past couple years they were trying to slow things down by raising interest rates, this huge pool of money was out there looking for yield. It’s that pool of liquidity that caused the subprime situation.

 

{Q} Why is the value of the dollar so closely tied into all of this?

{A} People need to realize that the value of a currency is not like a stock. It’s a relative value. So if the dollar drops, another currency appreciates in value. In today’s global economy, nobody wants a super-strong currency, because that makes them less competitive on the world market. They’d prefer to have a relatively stable currency. That is one reason why you’ve seen some fairly substantial downdrafts in the U.S. dollar. Central banks worldwide step in to support the dollar and to push down their currency a little bit, just so they don’t price themselves out of the global market.

{Q} What does a weak dollar mean to a U.S. investor?

{A} At some point in time, our imports are going to become more expensive. So far, the only import that has been affected has been oil. But it could eventually affect other goods. For instance, the Asian countries have been very careful to try to keep their prices stable in terms of dollar value. But at some point, that’s going to become an issue, and that in turn will become an inflation issue.

{Q} So how does that help or hurt investors?

{A} If you’re an investor in the United States right now, you should be looking at companies that have exposure overseas, because many economies overseas have greater growth prospects than we currently do. Plus, they also have appreciating currencies, so you get a double whammy there—two hits for the price of one. The companies in the United States that are really under pressure are those really dependent on domestic spending.

 

{Q} You’ve touched on the subprime mess. What about the potential ripple effect? When people aren’t buying houses, they aren’t buying refrigerators, beds, or going to Menard’s either. Do you think that the market’s current level fully reflects this assumption?

{A} It is extremely important to me. I don’t know if it’s fully priced in yet. Now that the Fed has changed its policy from raising interest rates to lowering rates, typically when that happens, the two sectors that perform extremely well are consumer discretionary stocks and financial stocks. Those two areas have eroded. That suggests that ‘ripple risks’ may not yet be fully priced into the market. The bigger question is whether the consumer discretionary stocks and the financial stocks are telling me something more worrisome about our economy.

{Q} Do you think the Fed is worried that this broader potential impact could be a true damper on a big chunk of the economy?

{A} Yes. This subprime situation is really more deflationary than inflationary. Any time you start to have people defaulting on loans, that’s a deflationary phenomenon. Nobody has really talked about that. The core personal consumption expenditure is running at about a 1.8 percent per year increase. It doesn’t take much of an impact to have that figure slip into negative territory. Then you’re talking deflation, and that’s a problem that scares the bejeebees out of the Fed. They know how to control inflation. But how do you control falling prices? It’s like pushing on a string.