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Recession Fear and Dollar Loathing in Las Vegas

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Judging by today's selling frenzy on Wall Street, it looks like the market has finally started pricing in a worst case scenario for the U.S. economy. And the time has come to ask some important questions.

Is it safe to say that the recession is finally here? If we are in a recession, how long will it last? Will heavy consumer debt, a growing federal budget gap, and rising prices make this recession worse than Americans have experienced over the past two decades? Will the situation evolve into the worst financial crisis since World War Two (legendary investor George Soros seems to think so)?

As I mention on ThePanelist.com, sometimes the questions are more important than the answers, especially in the chaotic environment in which we now find ourselves. The right questions can act as a compass to steer us through this turbulent time. I'm not going to pretend I know the perfect questions to ask, but here's the biggest one on my mind:

Will the Fed lose its ability to stimulate the economy during a recession?

After today's doom and gloom, the street is calling on the Fed for another emergency interest rate cut. But there's a problem: rates can't go below zero. The Fed may continue to cut interest rates, but they must be careful not to run out of ammunition. In other words, if the federal funds are lowered beyond a certain point, the ability of the Fed to stimulate the economy comes to an end.

George Soros believes we are entering the greatest financial crisis in 60 years because the Fed is losing its ability to stimulate the economy. Soros explains why this crisis is different:

The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency.

He adds:

The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.

For decades foreigners have been buying U.S. bonds and keeping U.S. interest rates low. It's hard to quantify the impact of foreign investors, but a 2006 study by Professors Francis and Veronica Warnock at the University of Virginia found that U.S. long-term interest rates would be about 90 basis points higher without foreign buyers. In a nutshell, Soros believes the greenback is losing its place as the world's reserve currency. Soros feels that foreigners will stop buying U.S. bonds, i.e. the end of dollar hegemony, which will place upward pressure on U.S. rates. With U.S. yields rising due to foreigners running for the exits, the Fed's interest rate cuts become impotent. It goes without saying that the recession could turn into a multi headed monster if this is the case.

The consensus seems to be that foreigners will turn their backs on U.S. assets, which would validate Soros' argument. I'm not necessarily disagreeing with Soros, but I'm going stick out my neck and suggest the market is too quick to jump to the conclusion that the dollar will lose its place as the world's reserve currency. To read my previous blog on this idea, click here.

Soros' argument makes sense if the market is a cold computer that rationally incorporates every piece of information. Why should foreign governments hold dollar assets when the dollar has lost more than 20% of value against its main trading partners since February 2002? But the market is made up of emotionally-charged humans, and humans suffer from bounded rationality. In other words, humans can't be 100% rational 100% of the time. If humans were 100% rational 100% of the time, Las Vegas would be a ghost town in the desert.

As humans, we suffer from loss aversion. Loss aversion is the tendency for people to strongly prefer avoiding losses as opposed to achieving gains. As an example, choose between these two options:

Option A: A sure loss of $890
Option B: A 90% chance to lose $1,000 and a 10% chance to lose nothing.

In this situation, the majority of decision makers will prefer the risk in Option B, even though the other outcome is more statistically desirable.

The valuation losses of foreign assets due to the sharp decline of the dollar will hurt foreign investors, and I argue here that foreign investors are in no way different from a gambler losing money at a roulette table. Moody's released the following calculations: Assuming the exchange rate of the dollar falls from about 0.67 euro currently to 0.50 euro over the next two years - a very bold assumption - China is expected to lose close to $260 billion in valuation losses, while Japan could lose $190 billion. Is China willing to risk a $260 billion loss by sticking with the dollar?

I admit that I am proposing an unlikely scenario, but it is conceivable that foreign governments will choose to hang on to their losing dollar positions in the same way a gambler would have a tendency to "double down" when things go wrong, rather than admit a loss. At the very least, this argument suggests that governments will take their time unwinding dollar positions, which would limit the medium-term upside pressure on U.S. yields. We are, after all, only human, and there are signs that the dollar could rebound towards the end of 2008. The U.S. current account is improving, fear-motivated bond flows would perversely support the dollar, and investors are focused on relative growth prospects rather than absolute borrowing costs. If aggressive cuts by the Fed can stimulate the economy, then the U.S. will definitely lead the way in terms of economic recovery, and the dollar could rebound. For some evidence of this trend emerging, click here, here and here.

If foreign investors choose to "double down" and stay invested in the dollar, U.S. yields won't rise as much as Soros predicts, and the Fed's interest rate cuts may remain potent, limiting the damage a recession may cause. If only it was so straightforward...