Gravity and the Dollar
Strike Up the Band
How Far Down Is Down?
The Scary Fact of Who Owns America
We're in Deep Kimchee, Kemo-Sabe
Interest Rates, the Yield Curve and the Next Recession
By John Mauldin
As I predicted several months ago, the dollar is beginning to show
signs of real weakness against the euro and a host of other
currencies. It has the potential to happen even faster than the
gradual process I originally thought it would. But what does it mean
for you and your investments? Today, we are going to look at some of
the implications of a weaker dollar, whether or not it means
inflation or, even worse, stagflation is in our future and what the
implications of a weaker dollar will mean for the Muddle Through
Economy. As promised last week, we will take a pass at what all
this means for interest rates, as well, so we have lots to think
about.
Gravity and the Dollar
As mentioned above, a few months ago I suggested the current account
deficit will take the dollar down later this year. But it seems to
be happening a little faster. What gives?
Currency moves are always part perception and part gravity. By that
I mean, currency traders are subject to what they perceive the
various governments of the world will do to protect their
currencies. If you are trading at 20 to 1 leverage, you do not want
to be on the wrong side of a currency intervention by a major
government. It can ruin your day.
There are dozens of other factors currency traders focus on, and
their perception of these facts makes for one of the most dynamic
and fluid of world markets. Perception can result in some violent
short-term movement in currency values. Perception can be like an
Olympic pole vaulter. It can be quick up and downs. Or it can be
like an airplane, and stay up for quite a while, straight and level.
But eventually gravity wins and pulls the jumper and the plane back
to earth. A government cannot artificially prop up a currency
forever beyond the long-term demand for a countries products and
services. Eventually the gravity of the marketplace will force a
currency to its correct level.
It used to be that central banks were given at least a modicum of
respect about their ability to control their currency. That changed
in 1991-92 as one currency after another came under the attack of
the world currency markets. The classic line attributed to George
Soros, who had made a large bet against the British pound, when
asked to comment upon the Bank of England preparing to spend 30
billion pounds to protect the value of the pound was, "What are they
going to do in the next 30 minutes?"
What he meant was that the Bank of England's 30 billion would last
about 30 minutes. The world currency markets are now larger than
central banks. The central banks can punish currency traders in the
short run, and that threat is taken seriously. But in the long run,
over-valued currencies will drop like a plane out of gas.
The classic acknowledgement of this was in 1992 when Walter Wriston
wrote an Op-Ed piece for the Wall Street Journal (which was
essentially a puff-piece for his book, "Twilight of Sovereignty.")
Wriston was perhaps the last major force as a banker of the last
century. He was head of Citibank, the Council on foreign Relations,
etc. When you were looking for insiders, you always found him at the
center. You couldn't get any more inside than Wriston.
That editorial made as much of an impression on me as any one piece
I can remember. Basically, this insider waved the white flag and
said to his cohorts, "Gentlemen, we can no longer control the flow
of the world's currencies. We are now at the not so gentle mercies
of the markets." The implications were that countries would have to
actually subject their sovereignty to the opinions of the world
markets.
This was a blow to the ego of your average demi-god central banker,
but a big step in the cause of freedom. Next time you see a currency
trader, remember that he is just as much, and maybe more, a freedom
fighter as any armed partisan. Maybe he thinks he is fighting for a
few dollars at the end of the day, but the result is that
governments no longer can manipulate currency values beyond
reasonable levels.
So, back at the ranch, why is the dollar dropping earlier than I
thought it would?
First, my prediction was based upon gravity. The current account
deficit will pull the dollar down, and the Day of True Reckoning is
approaching later this year. I should point out that I am not the
only one who can see the obvious. You can bet every major currency
trading house can read the hand-writing on the wall as well.
So, if you can see it coming, why not get in front of the parade?
Because we have seen this parade coming for several years. Up until
this year, I ignored it, as foreign appetite for the dollar has been
more than enough to keep the dollar strong. Gravity was tilted in
the dollar's favor. But late last year, and early this year, you
could see those dollar flows slow down. That was when I wrote my
warning.
But I also assumed that the US would maintain a strong dollar
policy. By doing so, that would imply a slow and orderly retreat.
The euro goes to 95 by the end of the year, the yen to continue down
as the Japanese central bank seemed hades-bent upon destroying their
currency and nothing happens quickly.
Strike Up the Band
But now we have already seen the euro at 92 and the yen is rising,
not dropping. What gives?
The strong dollar policy is what gives. I believe the markets now
perceive the US will not intervene to protect the dollar. Here's
why.
"When asked a year ago about the end of the strong dollar policy,
U.S. Treasury Secretary Paul O'Neill was quoted as saying that he
would hire a band and march through Yankee Stadium if he was ever to
announce the end of the policy. Well, on May 1, Treasury Secretary
O'Neill paid a visit to Capitol Hill to speak on trade and
competitiveness.
"Everyone expected Secretary O'Neill to get up and say front and
center that he supported the strong dollar policy, and that it
remained in the best interests of the United States to maintain such
a policy. But then something amazing happened…he didn't mention the
strong dollar policy at all! He made two statements that led
currency traders to believe the strong dollar policy was being
phased out. First, he said that he didn't believe in intervention of
any kind….The one that really got the blood boiling was this little
ditty: "I am interested in doing whatever I can to help exports."
(Chuck Butler, Review and Focus)
When Treasury Secretary O'Neill talks about a strong dollar policy,
that is tantamount to intervention. The mere thought that the US
would enter the currency markets in a major way has to put the fear
of God into traders.
He may not rent a band and go to Yankee stadium, but currency
traders heard 76 trombones at that Senate hearing. When he says I
want to help exports and I am against intervention, it was like
turning on the blue light at K-Mart. Traders could see where gravity
would be taking the dollar, and if the US was not going to spoil the
parade, it was time to begin to move to the front. Shoppers began to
get in line, and the dollar has been dropping ever since.
How Far Down Is Down?
Let's put some perspective on this. I must have read 15 studies on
the dollar in the past few weeks. Many of them use words like
precipitous, dramatic, staggering, calamitous and explosive when
they talk about the drop of the dollar. But I can't find anyone who
uses an honest to Pete number with anything close to analysis I can
get my hands on. It mostly amounts to guesswork.
Are we talking 10%? 20%? 50%? And against what? And over what time
period?
When the euro was introduced two years ago, it came out at $1.13, if
memory serves correct. It dropped to $.81 and change, bounced,
dropped and is now back up to $.91. I think parity - that is one to
one - is in the cards.
If it does, that is almost a 25% increase in the euro from the
bottom, but it would still be 10% below its price of two years ago.
That is hardly staggering or even dramatic.
The yen is a few points off its low, but still much lower than a
year ago. The Japanese government is actually intervening to keep
the yen low. It will be interesting to see if this succeeds.
Remember, I said that a government cannot prop up a currency
indefinitely. Eventually they run out of reserves.
But the Bank of Japan can print as many yen as it wants. There is no
limit to the ability of a government to destroy its own currency.
They have clearly stated they want the yen to go lower so their
products will be cheaper in the US. If you can't trust a central
bank to keep its word when they say they want to destroy their
currency, then who can you trust?
The Scary Fact of Who Owns America
My friends at Apogee Research (www.apogeeresearch.com) put out a
very useful publication, especially for stock traders. You might
want to check it out. This week, they included a research piece
from Bridgewater Associates. They spelled out in detail how much of
American assets are owned by foreigners. I must admit some of the
numbers shocked me. The implications are huge, and not pretty for
the stock market.
Let me list a few of the more interesting items. Foreigners own 40%
of the US treasury market, and when you back out the Fed holdings,
they own 48% of the of the liquid treasury market.
I knew the above number. This is the one that shocked me:
foreigners own over $8.2 trillion of US assets, while we own only
$5.6 trillion of assets in the rest of the world. For whatever naive
reason, I always assumed that we owned more of their stuff than they
did of ours. To put it in perspective, that $2.6 trillion difference
is 26% of GDP.
Foreigners hold 24% of corporate bonds, 13% of the equity market and
22% of US corporations. Foreign ownership has risen from 33% of US
GDP in 1990 to 78% today.
Their conclusion, which seems reasonable to me, is that a decline in
foreign demand would hit all US markets, not just the dollar.
Bridgewater concludes:
"The willingness of foreigners to fork over hundreds of billions of
dollars to the US fed the massive spending spree and, to some
degree, investing spree that US households and corporations embarked
on over the last eight years. Now foreigners hold a high percentage
of all US assets, and these assets are beginning to under perform.
If foreign selling of US assets sours as we expect, a vicious cycle
of foreign selling of US assets would likely ensue. These holdings
are so big, and so much larger than US assets abroad, that they are
a long-term risk to the financial markets."
We're in Deep Kimchee, Kemo-Sabe
Let's take the view of an investor in Europe. He now sees his US
investment losing value against the currency he ultimately needs. He
also sees the US stock markets either flat or down. But he looks
around, and things are not all that great at home. Today's Bloomberg
headlines tell me that the French economy grew a whole 0.4% last
quarter and the UK economy is "stagnant." Germany faces a massive
budget shortfall, has slow growth and a real unemployment problem.
If you are in Asia, your government is telling you they want to keep
their currency competitive with the yen. That is code for keeping
their currencies low against the dollar. However, your stock markets
are beginning to take off. Are these latest moves for real?
What do you do? Where do you put your money?
(The hottest hedge funds of late are those in the emerging (third
world) markets and especially Russia. Of course, they were dogs
before that. But as Dad said, every dog has its day.)
Much has been written in the past few years about how the US has
become an empire, much in the sense of Rome or Britain. Benign, to
be sure, but Pax Americana has certainly been a major influence in
the flow of dollars to the US as a haven of security in an insecure
world.
But as foreigners look at Enron, one accounting scandal after
another, admitted wrong-doings at major investment banks, and a
seeming inability of the stock market to take off, how long are they
going to be patient? How much can you trust the American markets?
Will they start to take their money home?
If they are like most investors, not until they begin to feel some
real pain. Inertia, the tendency you have to not do anything until
the horse has left the barn, is a strong human trait. It is also
universal. People wait until the last minute to run for the exits,
hoping something will save them.
Especially when they don't know what to do. There just doesn't seem
to be a lot of good options, especially in the traditional markets,
no matter which way you look.
This re-enforces, to me, the validity of the latest rise in gold. My
view of gold is that it is just another currency. I don't hold a
romantic view of the barbarous relic. But I do think its value as a
currency is real.
When gold rises against every currency, something is up. I think
gold is telling us that all of the paper currency in the world is
suspect. That is the real message here. Paper assets, especially
those backed by a central bank, are increasingly being seen as,
well, paper. The huge flow of money into alternative assets like
hedge funds and other assets not correlated with the markets, which
is currently underway, is a sign that wealthy investors are nervous.
Do I think the dollar will drop 50% against the euro? I can see no
logical reason to think so, although anything can happen. If you
have been to Europe lately, things are NOT cheap on the continent. A
50% drop in the dollar would make America such a bargain that even
the best Wal-Mart sale would pale in comparison.
But a 50% drop in the value of the dollar against the yellow
currency is not out of the question. Not next week, of course, and I
don't even think next year, but until the current account deficit is
brought into balance, the bull market in gold is probably for real.
Interest Rates, the Yield Curve and the Next Recession
I have recently begun to wonder what will signal the next recession.
Historically, it has been a negative yield curve. That means short- term rates on US T-Bills are higher than long term rates on US
bonds. I cited a Fed study in August of 2000 showing a precise
correlation between yield curves and recessions, and that is why I
predicted a recession to begin in the third quarter or so of 2001. I
was right, or rather I should say, the Fed study was right. I just
bought the logic at the time.
A corollary to that concept is that there has not been a recession
without a negative yield curve preceding it by about one year since
WW 2. (I have seen no studies prior to that time.)
Will we have another recession? Of course, we have been having them
since the Medes were trading with the Persians. It is a fact of
life, like winter follows summer.
The question I am now wrestling with is: "What will make the yield
curve go negative the next time? Will it be rising short-term rates,
a drop in long-term rates or a combination?"
If we were to dip back into recession later this year, the classic
answer would be that this was a double dip-recession and therefore
should be seen as a single recession with a bounce in the middle,
which is actually the norm for recessions.
But the longer we go into a recovery, even a Muddle Through
recovery, the weaker that argument gets. At some point, you would
expect that the recovery, however weak, is in place and that before
another recession we will see a negative yield curve.
What could make that happen in the future (a few years out)?
Deflation is one answer. Deflation would bring down long rates, and
a cash crunch caused by foreigners pulling cash out of the US could
boost short rates for a short time, thus a negative yield curve. Or
maybe the economy heats up too much, and the Fed pushes short-term
rates up over long-term rates. Then again, inflation produced some
negative yield curves in the 70's and early 80's.
Or there is one other possibility. What would a massive flight from
the dollar and US government debt do to the bond markets? What would
a flight from the US equity markets do to the ability of companies
to raise money in the capital markets?
Already many large companies are having problems getting access to
commercial paper markets. The spreads on the yields on corporate
paper are quite wide for a recovery to be in progress.
I can think of several scenarios which would drive long term rates
down and short term rates up. A flight to long-term quality while
short-term money leaves our borders is one. How likely? Don't ask
me. We are getting ready to enter into economic territory that is
unfamiliar terrain to all but a few mystics.
"History doesn't repeat. It rhymes," said Mark Twain. I am not so
sure this will be true in the decade before us. I think it is more
likely to be found mumbling and stammering, and in a foreign
language at that. Trying to understand what history is telling us in
order to predict the future will require linguistic skills of
interpretation that only a few possess.
We will know who these talented souls are only in retrospect. My
suggestion is to make your prediction now. You have as much of a
random chance as being right as anyone else, and a much better
chance than an economist, who will almost certainly be wrong. Those
who are right will get book contracts. Those who are not can become
college professors.
It seems highly probable that the dollar will lose value against the
euro, although I rather doubt it will be something I, at least,
would call calamitous. It seems likely that some of the money from
foreign sources will leave the US, and that will put pressure on the
US equity markets. Will that push up short term interest rates?
Maybe, but not as much as you might think, at least not in the near
term.
The upshot to this is that there will be a demand for alternative
investments in the future. Investors will want to put their money in
investments which are not correlated with the stock and bond
markets. I will start posting random chapters of my next book,
Absolute Returns, on the web next month as I finish them. I hope to
finish by fall. The book will cover hedge funds and other
alternative investments. I will let you know as chapters are posted.
While my publisher will make me take them off at least 60 days prior
to publication, it gives me a chance to get some good feedback, and
give you an advance peak.
If you want to put some of your money into foreign currencies, you
can call the trading desk at Everbank. They will open you a US bank
account that is denominated in euros or many other currencies, and
that even pays interest in those currencies. They can send you
reports to help you sort out what might be right for you. The number
is 800-926-4922. Please note that I am NOT suggesting you put a
large portion of your assets in euros. But a small portion might
give you a nice pop over the next year without risking too much.
A National Treasure
Peggy Noonan is one of the most talented, perceptive and gifted
writers I know. She should be declared a national treasure. I have
this secret dream of having dinner with her and some small portion
of her eloquence rubs off, simply from being in her presence. Her
latest comments on the recent Bush speech in Europe were very
thought-provoking. I suggest you read them if you get the time. You
can read them at
opinionjournal.com
I will be in New York June 2-5, and will be available to meet with
clients and prospective clients. Contact the office at 800-829-7273.
This weekend is one which should cause us to remember those who have
died so we might live in freedom, even if we spend too much time
worrying about the small things. So, this weekend, spend some extra
time with family and friends. I will go with my bride to Scarborough
Faire, a local medieval theme park, and think about a time long
past, and enjoying the fantasy.
Your quite positive Life is Good analyst,
John Mauldin
John@2000wave.com
Copyright 2002 John Mauldin. All Rights Reserved
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