DECEMBER 15, 2003 ERIC SPROTT 416·943·6420; SASHA SOLUNAC 416·943·6448
SPROTT ASSET MANAGEMENT INC. 1
Dollar Smackdown!
The US dollar is down for the count. Once the shining star of the currency world, the dollar has taken such a beating that it is becoming increasingly unlikely that it will be
able to avoid the three-count. In spite of the successes of the economy and the equity markets this year, the dollar has been the weak link in this tag team – so much so, that it is threatening to put the whole financial system on the ropes. The only question that
remains is: when is this precarious financial system, especially the bond market, going to break? As bullish as the financial markets have been for the most part this year, they may be in for a body slam if the dollar keeps plummeting.
For although record levels of monetary and fiscal stimuli have done wonders for pulling the economy and the stock market out of the doldrums, it has come at a substantial cost.
With budget and current account deficits running at an annual rate exceeding $1 trillion combined (with no respite in sight), the dollar has become the big loser in this equation.
So far this year the dollar index is down 13% (27% from it’s high in 2001). But the fall has been especially precipitous in the past three months, plummeting 10% in a short period of time. But this may be just the beginning.
Woe to the bond investor who bought US treasuries at their peak earlier this year, especially foreigners who have not only lost on price but also on currency. Four years of
yield have disintegrated into thin air. The worst part for a bond investor is that the dollar will only deteriorate even further from here in our opinion, perhaps even at a quickening rate. Savvy investors with stalwart reputations such as Buffett, Templeton, and Soros (among others) have never been more negative on the dollar and are avoiding US dollardenominated investments like the plague. Foreign investors should be even more worried.
If the dollar keeps falling, and yields rise in tandem, then foreign holders of US bonds are in for quite a trouncing. To the extent that they bail out in anticipation will only lead to a vicious circle of further bond and dollar weakness.
Even Pimco, the world’s largest bond fund manager, is calling for an immediate 30-40% further decline in the dollar. In a recent article titled “Red Alert: The Current Account Deficit and Corporate Bond Spreads”, Pimco alludes to “the potential for a state ofcomplete chaos in the bond market”. For a bond fund manager to be so alarmist is
courageous indeed; after all, their livelihood depends on the performance of the bondmarkets. There aren’t many equity fund managers out there raising the alarm on equity
valuations, for obvious reasons. But the motives of Pimco are clear. It is precisely because they realize that the value of their bond holdings will get clobbered if things keep going the way they’re going that they are banging the warning bells. They want to change
the policies of the government and the Fed before their bond portfolios get demolished.
Given all the negative publicity, and the fact that bona fide investors for the most part don’t want to touch the stuff, it is surprising that the bond market has been able to hang in there at all. Although down from their lofty levels of mid-year, treasuries have behaved well throughout this bout of dollar weakness, with the 10-year being down only 4% since the beginning of September while the dollar has fallen 10%. Not a bad performance at all
considering that there are seemingly few willful buyers. By all rights, yields should be exploding… but they are not. So what’s going on?
One of the keys lies with the Fed. If you believe the statistics, the economy is booming –
to the tune of 8.2% annualized in the third quarter. Impressive indeed. Yet the Fed is behaving like we’re still in a recession. Not only are they keeping rates at 45-year lows when precedent dictates that rates should be increased in a booming economy. But more importantly, they also decided to keep their “considerable period” shtick alive and well in their most recent statement last week. Highly unusual, but these are not normal times we live in. The bond market hangs on a tether with every Fed statement.
As it turns out, the buyers of treasuries are t “investors” at all; rather, they are predominantly speculators and foreign central banks. Without either of these two forces, it is our view that the bond market would be in serious trouble already. Fully cognizant of
this, the Fed realized long ago that without the “considerable period” promise in their
policy statements, speculators who play the Fed-insured spread between treasuries and Tbills (by going long at the long end of the yield curve and short at the Fed-managed short end) would recognize that their win-win bet is no longer on, and would thereby be dumpers of treasuries. From the first time Greenspan uttered his reckless promise, the Fed has dug itself into a hole from which it will be difficult to extricate itself without
clobbering the bond market in the process. Furthermore, this policy shows that the Fed doesn’t give two cents about the dollar (pardon the pun). But if a Central Bank doesn’t care about its currency, who in the world should?
The other major buyers of treasuries these days are foreign central banks, especially China and Japan. China has a huge trade surplus with the US and a currency that (for the time being) is pegged to the dollar. Japan, for competitive reasons, is loath to see its currency strengthen any further against the yuan (by supporting the dollar it is indirectly also supporting the yuan). This makes these two central banks buyers of dollars and
treasuries at any price, regardless of fundamentals or returns. If either of these two megabuyers
were to change their policy, US treasury yields would soar. Such is the situation that has arisen as a result of the dearth of fundamental buyers. Greenspan’s recent
remarks that China should loosen its peg is further evidence that the Fed doesn’t care what happens to the dollar. Once again, who should?
It is for these reasons that the dollar is losing its lustre as the currency of choice. OPEC recently decided to effectively abandon its target range for the dollar price of oil. Instead, they will concentrate on targeting production levels only. One of the reasons they site is
the diminishing purchasing power of the dollar in international markets. It’s become difficult to aim at a moving target. Not just oil, but energy prices in general have been on the rise.
In other fallout of dollar weakness, many South African gold and platinum mining companies are cutting production because the rand has strengthened so much versus the
dollar that it has become difficult for them to make a buck (or even a rand for that matter). Commodities worldwide are appreciating substantially… in dollar terms. The CRB commodities index is up 44% in the past two years. The price of platinum is near an all-time high. And they say there is no inflation? Inflationary pressures to date have been substantial regardless of what the stats and the Fed are saying. The more the dollar weakens, the greater these pressures become. At one point or other they will start to appear in consumer prices in the US. When that happens, bond yields will doubtless soar
from their current low levels.
The whole thing is reminiscent of 1987, which is why we find the following chart foreboding.
Back in 1986-87, the dollar was on a downward trajectory after coming off highs similar to what they were at its recent peak in 2001. Bond yields for the most part were tame until they finally started to crack under the pressure of the falling dollar in March of
1987. The yields spiked 150 basis points within two months, then checked back. This is ominously similar to what yields did in June of this year, when they spiked 150 beeps off their low within two months, and then checked back. Throughout most of 1987 the stock market was rallying – again, very similar to this year. Then in late August of 1987 yields broke through their interim peak, the dollar continued its tumble, and within a month the
stock market was toast. Right now, yields are on the verge of breaking through their trendline, which is currently at 5.2% for 30-year treasuries (see chart below). Are we set
up for a repeat? History shows that falling currencies usually bring ill tidings for financial markets.
Another thing that will ultimately put pressure on bond yields, and financial markets in general, is the lack of savings in the US. A dearth of savings when combined with a glut of debt issuance (thanks to trade and budget deficits) means that dollar-denominated
assets must be increasingly supported by the savings of foreigners. Savings is good for financial markets, as it creates demand and keeps markets up. The Department of
Commerce recently revised the US savings rate statistics for the past 13 years, in each and every case downward. In the second quarter the savings rate was revised down to
2.3% from the original 3.2%. In the first quarter it was revised down to 1.9% from 3.5%.
As well as continuing the prevailing theme of downward revisions after the fact, these statistics should be worrisome to the markets.
The dollar is in flux and the situation is precarious. With a budget deficit that just keeps getting bigger, a trade and current account deficit that refuses to turn in spite of a weakening dollar, and a financial behemoth that has been built up over the years with debt issuances and derivatives on top of derivatives, no reversal of the dollar trend is imminent. Ultimately the fate of the financial markets is inextricably linked to the fate of
the dollar. This is especially true when foreigners are holding an increasing share of US dollar-denominated assets. Unfortunately, there is no clean and easy solution to the dollar’s woes. All roads lead to pain. |
