1. A bear raid on the U.S. dollar? (continued) We began this series in WILTW 3/26/09, when the dollar index was selling at 84.16, down from its 2009 high of 89.105, reached on March 5th. Since then, despite a chorus of bullish calls—“the dollar will rally because everyone is bearish”—the dollar keeps drifting lower. In WILTW 9/3/09, we cited the comments of John Roque of WJB Capital Group, who argued it was hard for the dollar to bottom since it was below downward-sloping 50-and 200-day moving averages, similar to the S&P between November 2008 and January 2009.
The dollar is certainly in the news, with front-page headlines this week: “World Tries to Buck Up Dollar” and “Chinese Hint at Stronger Renminbi”. Reportedly, emerging countries may have spent as much as $150 billion on currency intervention in the past two months. This week, Thailand, South Korea, Russia and the Philippines acted to hold down the value of their currencies against the U.S. dollar. As we have written, the prospect of strengthening currencies will cause many fast-growing countries to keep interest rates lower and economic stimulus plans in place longer than otherwise. At the conference of Asia-Pacific Ministers this week, Geithner reiterated it’s “very important” the U.S. maintain a “strong” dollar. Will any of this make a difference? We doubt it.
Of perhaps greater significance is the fact that Japan’s benchmark JGB yields are up 15% in the past month. With the savings rate of Japanese households so low, Halkin Services notes there is “justifiable concern that Japan will be driven to liquidate some of its investments in U.S. Treasuries.”
We recently asked Peter Warburton (see related reports) whether we should be concerned about the declining U.S. money supply growth. Warburton responded that despite the recent weakness in the U.S. money supply measures (M1, M2, M3), it
is important to understand that the aggregate purchasing power of all relevant U.S. financial institutions is still rising. “We can look at this phenomenon either by instrument or by institution, but the conclusion is the same. Taken together, those institutions with access to the Fed’s dirt-cheap funds are standing behind the whole financial edifice. As long as this permissive policy remains, there is a strong expectation that the prices of corporate financial assets (equities and bonds) will rise.”
Warburton notes that the collective retreat of central banks into the “output gap paradigm” is alarming, yet, understandable. Central banks are arguing that ultra-easy monetary policy is not irresponsible because excess spare capacity gives them a “free pass” on monetary policy. By the same token, the rising unemployment rate justifies continued expansionary fiscal policies by the Administration. Both propositions are flawed.
Warburton observes that the latest Fed statement makes the connection between the extension of ultra-easy monetary conditions and the assertion of ample spare capacity explicit, suggesting that policy will not be tightened until there is evidence of rising capacity utilization. In so doing, the Fed has invited risk-takers to short the U.S. dollar more aggressively in pursuit of better returns elsewhere. “While numerous commentators are calling for a sharp technical rally in the U.S. dollar, this overlooks the extraordinary position adopted by the Fed…The Fed is inviting a waterfall scenario for the U.S. dollar and there is a sizeable risk that this will duly occur.”
Warburton points out this risk is obvious to foreign holders of U.S. financial assets, who are heading for the exits, shortening maturities of their U.S. Treasury holdings, exiting other U.S. dollar-denominated bonds, including Agencies and MBS, exchanging U.S. dollar financial assets for U.S. dollar claims on real assets, or non-U.S. dollar claims on real assets.
The logical conclusion is to own or buy commodities that will be in strong demand from Asia. In WILTW 6/4/09, we discussed meeting a man who is one of China’s largest investors in commodities and head of the investment division for one of China’s largest transport companies. This highly-successful investor focuses entirely on investing in commodities that China imports heavily and where he can see Chinese demand increasing radically. In other words, it is well-known that China drives demand for many commodities. In the past, we and many others have focused
on this, but, we have never exclusively studied the Chinese demand for a particular commodity as the single driving force behind making an investment. This was a novel approach, and as he related the investment rationale for copper and zinc, we became intrigued.
Three key developments will fuel China’s copper demand: 1) The electric car is very likely to become a reality in China and their batteries require a great deal of copper; 2) China has an ambitious plan to upgrade its power transmission system which will also mandate massive amounts of copper; and 3) Most of China’s alternative energy projects (solar and wind), built or planned, are located in the western part of the country. Power needs to be transmitted to the eastern provinces where they are mostly consumed, implying more demand for copper.
Warburton believes rising equity and real estate prices are an inferred policy objective of the government. There is enormous embarrassment over the financial sector bailouts and capital injections and a desire to offload these responsibilities at the earliest opportunity. If the financial markets recover sufficiently in the months ahead, the government may have an opportunity to sell their holdings back to the private sector.
Warburton concludes as follows: “The re-leveraging of the core of the U.S. financial system has been facilitated by the reduction in the capital haircuts on the Treasury repo. Haircuts have been embraced as a new policy control variable by the Fed, as indicated by the work of Tobias Adrian and Hyun Song Shin, recently published by the New York Fed. The Fed’s objective is to anchor the 10-year Treasury bond yield by guaranteeing that auctions are well-subscribed by recipients of the Fed’s lenient funding. The problem is that commercial banks, investment banks, broker-dealers etc. are warehousing massive amounts of U.S. Treasuries without a ready demand from end-customers such as foreigners or U.S. long-term savings institutions. The central theme in all of this is Moral Hazard on a colossal scale. The authorities have become fearful for what would happen if they withdrew their support, even marginally. Those who point out tirelessly how awful is the real economy are contributing to this fear and prolonging the reign of Moral Hazard.”
All this plus an improvement in the economy will prove a major shock to market participants. The personal savings rate might well head down next year as consumers conclude the financial crisis is over. The increase in the U.S.
unemployment rate is more likely attributable to the unemployed claiming benefits, rather than a worsening of the labor market. (It can be argued that extending unemployment benefits actually creates perverse incentives to remain unemployed.) In any event, the trend in monthly non-farm payroll losses has been shrinking, from -700,000 or so earlier this year to -190,000 in October. Indeed, non-farm payrolls, Warburton believes, could deliver positive surprises over the next few months.
Ned Davis Research recently noted that “inflation worries have put upward pressure on the long-end, causing the yield curve to steepen.” The 30-year to 2-year, and the 10-year to 2-year, spreads have moved up to their highest points since 2003. “Implied inflation breakouts could put the Fed in a difficult spot of having to battle high unemployment and rising inflation expectations.”
* * *
Garet Garrett (see related reports) is probably the best financial writer of the 1920s and 1930s. The passages below from A Time Is Born need no explanation and answer the question at the top of this section with great historical insight.
When the First World War started it was the solemn opinion of finance that it would end within six months because it could not be financed beyond that limit. There was nowhere a war chest that could stand it.
That opinion was sound enough provided the laws of solvency were going to hold. But they were not going to hold. The war went for four years and then did not stop for want of money. Governments had learned a new thing. They had learned that in war the very first step is to suspend the laws of solvency; when you have done that you can print money to pass from hand to hand, and that can go on for a long time. If it breaks down, you have only to wipe the slate and begin all over.
After the war, international finance was powerless to prevent the colossal mark swindle, Germany printing and selling all over the earth billions of paper marks that were going to be repudiated. What made it possible was that nobody could believe that a great nation would in a deliberate and calculated manner sell out the honor of its signature on a piece of engraved paper. Who would ever trade again with a nation that did that, or take its word for anything? Well, Germany did it. What was more, it paid her very handsomely to do it. Worse still, finance was unable to visit the slightest penalty upon the authors of this financial enormity; on the contrary, international finance was
obliged afterward, for political reasons, to float a gold loan for Germany and restore her to solvency and credit. In Germany itself, finance was unable to prevent the industrial dynasts from appropriating to themselves all the middle class wealth that was invested in bonds, mortgages, annuities and savings banks.
Thus ended in the world the moral authority and prestige of international finance.
After the First World War the horizon was dark with a confusion of strange omens; and although some of them were dim and shapeless, at least ten were distinct, and the ten were these:
The advance of government everywhere toward control of the economic life; The identification of industry with political power;
An excess of industrial equipment already present in the world;
The continued and competitive increase of that equipment nevertheless for national and political reasons;
The rise of trade barriers, every nation fearing the effects upon its own industry of receiving cheap goods from another;
Unemployment as a chronic social evil in the richer industrial countries, and yet in the world at large people still running from the soil to tend more machines;
The amazing growth of urban tissue in the economic body;
Inflation and debasement of money on grounds of national policy in order both to force exports and diminish imports, everyone wanting to sell more and buy less;
The total collapse of debtor and creditor relations, and,
A moral debacle that made nations callous and cynical toward repudiation, which became competitive and was carried to a point at which only one great nation could say it had not dishonored the signature on its bond—and that one, alas! held out only until its honor began to hurt, whereupon repudiation became universal in the world. |
