Being that I enjoy a good debate, I was recently posting on another blog. When I posted that the current liquidity cycle was coming to an end along with a few dollar notations another poster chimed in and said he was going to give me an economic tutorial. His tutorial was, “When capital is fleeing uncertainty as in Asia, a declining dollar makes U.S. markets look like a safe haven”. He must have done some Googling because he came back a few hours later and recanted. His new post was “I didn’t mean it made the declining dollar appear as a safe haven. What I meant was a declining dollar makes U.S. assets look like a safe haven.”
I guess my question is, “What is the dollar?” Uh, it’s a U.S. asset. So, is the U.S. dollar excluded from that comment of U.S. assets? I’d like to sell you a few rubles before the Russian currency crisis if you think a declining currency either represents a safe haven or that assets in a declining currency represent a safe haven. Maybe if that currency theoretically went to zero as an extreme statement of decline, you’d really enjoy holding assets denominated in said currency. You could always sell those assets and exchange them for another currency. Let’s see. Theoretically, how many units of a currency valued at zero do you need to buy a currency not at zero? (Hint: You don’t need to Albert Einstein to get the right answer.)
My point is that there is a lot of misunderstanding out there about the dollar. And a lot of misunderstanding about the forex markets and what drives them. Given many have declared an end to the dollar and, by inference, all things U.S., I thought now would be a good time to talk a little bit about a very complex topic. It’s quite convenient that the wrong way crowd over at The Economist has the incredible shrinking dollar on their cover. Their dollars calls are the poster child for idiocy. They are always wrong!
This post includes remarks on Fed policy as I said I would post a few weeks ago. One cannot have a currency discussion without central bank policy. If you are going to read this, it’s going to take you a few minutes because it’s a long post. If you are interested in economics, the dollar or the Federal Reserve, I'd hope you will take the time to read on. The objective of this post is not necessarily to answer all of the questions concerning the dollar. I don't know the answers. But, it should dispel quite a few myths and hopefully be somewhat educational.
First off as I've stated, I'm expecting a repricing of risk in most asset classes. That does not mean I am not long term bullish on the U.S., Europe or Japan. Developing markets? Well, that depends. I'm certainly not bullish on developing economies without painful political and economic reforms they've had decades and/or centuries to undertake but haven't. Some modicum of reform has been achieved but nothing compared to what needs to happen for most. Without reform, their domestic investments and consumption will suffer at the first whiff of a serious economic slow down. That might have been the impetus for the Thai Baht fiasco. We’ll soon see if their economy was softening with their rising currency. I'm actually more inclined to be bullish on Japan than any other large Asian economy because Prime Minister Abe is very reform minded unlike politicians in Korea and China. In addition, much of the heavy lifting has already been accomplished in Japan decades ago. That said, Japan is disproportionately reliant on a very muscular export engine. Historically domestic consumption has not been able to offset that export engine when America experiences a significant slow down.
I surely don't profess to know what all of the ramifications are of a global slow down but that's why my definition of long term investing is-until my models say step aside, hedge, become defensive or whatever. If that's a year, then that's my definition of long term. If it's ten years, then that's my definition of long term. I do know my money will remain in dollar denominated assets. I'm most comfortable with this statement because it is the safest place in an unsafe world. If I were British or Japanese or German or French, I'd feel quite confident with my investments being in Pounds, Yen or Euros as well.
Remember, recessions or worse are part of capitalism. Recessions have always been here and they are not going away with current policy, economic tools or methods of thinking. Nor are they exclusive to the U.S. There is no economic certainty, but should we cheat this cycle and not experience a recession, it would be a first in modern times (post 1925) given the circumstances. In other words, with me the question is more a matter of “if” not “when” we will experience a repricing of risk and a recession of some sorts. If we do cheat the business cycle, there will be no one happier than me. I don't particularly enjoy bad news or loss. What does economic weakness mean for company profits? Well, if they drop a comparable percentage as took place in 2001's very minor recession (Remember, the 2000-2003 sell off had little to do with an extremely mild recession. It was all about repricing asset risk.), we will see the S&P with valuations similar to the most extended indices in 1929. The Russell 2000 PE could end up in the stratosphere comparable to the Nasdaq in 2000. How many times can I say this market is not cheap? Obviously one more time as witnessed by my incessant rantings. I won't belabor the point but the bubble we are experiencing is far more disconcerting than the narrowly focused bubble in 2000. This one is global and includes commodities, commodity laden stock exchanges, the broader small caps in the U.S., global real estate, private equity, debt and credit as potential asset classes. Now the markets are chugging along without a concern today but given the risk and historical precedence, I'm not ready to jump on the bull bandwagon. Especially given some of the data points in my recent postings. Currently the markets are consuming massive amounts of risk and the rewards are not commensurate from what I am measuring.
There are many journalists, media and bloggers telling us the Fed is pumping money into the system, that the U.S. is going to have a dollar crisis, a credit crisis, a debt crisis and even cede economic leadership to China. The reality? Most of these people don't know a whole helluva lot more than the neighborhood bartender. (Maybe that's being too harsh on bartenders.) Yet, what is ironic is that many are paid quite handsomely to know what they are talking about. If they are supposed to be paid for not knowing, they are performing quite well. Let's break some of these fallacies down.
First, let's take a look at debt. Debt by itself is hard to quantify. There will be a day when the cumulative debt in the U.S is over one quadrillion dollars or whatever we are using as currency. What does that mean? Well, that depends. As long as my assets grow faster than my liabilities or as long as I can service that debt, am I to panic? No. In fact, the public debt of many nations, including Japan and Europe, is greater in percentage terms (burden) than the U.S. But, there is some concern because the U.S. economy is not as vibrant as it appears. Even the Fed has recently stated that underemployment is a problem. In other words, the labor participation rate is down significantly post 2000. I recently read on statistic from a very reliable money manager which had the labor participation rate of American men under the age of forty something to be around 83%. A little different than the unemployment numbers of 5%. If there is ever to be a concern, it is likely at a stage when the consumer is due a recession from a cyclical perspective, labor participation rates are down and wages are generally stagnant. I could cite a concern with debt every single year and many have for forty years. Is America richer than it was in 2000? Of course it is in nearly every measure. Does it have more debt? Yes in nearly every measure. Are we living in a Utopian society? Not hardly. Maybe we'll see much of the wealth created since 2000 disappear. Not just in the U.S. but everywhere. I've pointed out in prior posts that the finance industry is almost surely peaking and we are going to have a bout of wealth destruction. Ultimately assets, people and investment will be reallocated to productive use in comparison to an overabundance of all three pushing around money. That means a re-industrialization and reallocation to growth industries such as biotechnology, capital equipment, general technology, alternative energy research, etc. We’ve seen this act before and we’ll see it again.
So, what does history tell us about times of massive debt? Democratic societies realize
problems reach a level of concern and remedial consensus is reached. Or put another way, quit driving through the rear view mirror. Trends never last forever. If debt is peaking on a percentage basis and America
once again becomes a nation of savers, who will suffer disproportionately? The rest of the world. Specifically economies closely aligned with the American consumer. Who is most reliant on the American consumer? China
. Who is the least reliant? Europe
What have I said repeatedly?
The only place I would personally invest my money today is European or U.S.
Additionally, I'm not a big fan of personal savings rates measurements. It's an incomplete method of calculating wealth. Are Americans spending too much? Likely. Is it going to last forever? Of course not. Will there be pain associated with that change? Possibly. Is any western economy much different? Well, since I see the British and Australian press talking about their negative savings rates and cracking jokes about their healthy spending practices, it's likely the same most everywhere in the western world. That is to be expected after experiencing tremendous wealth expansion over the last three decades. People forget about rainy days when it is generally sunny for decades. The method of calculating savings rates is less than adequate for today's society. It does not capture a huge bulk of savings by Americans. Yet, the same calculation might capture the bulk of savings in China
. Why? Because people in China
don't trust anything other than cash so they disproportionately bury their investments in their mattresses rather than invest in new business, financial instruments, investment, etc. There was a time when Americans felt the same way. Ever see someone who lived through the Great Depression who wasn't a saver? My grandparents wouldn't invest in anything other than CDs. They didn't even have a checking account until they were over seventy. So, what will it take to make western societies save again? Likely some type of serious economic or financial shock that reinforces the fact that good times never last forever. When will that happen? Maybe soon or maybe not so soon.
Some of that answer may depend on how accurate the data is.
We all know there are lies, damn lies and statistics.
Now, what about foreign ownership of American debt or American assets? I even hear many of the people I respect worried about this. This is such a non issue for me. First off, if the foreign world wants to buy our national debt, let them.
Fiat currency depreciation over time means that we can borrow today and pay foreign investors their investment back with a depreciated asset.
In other words, tis better to have foreign capital financing our debt than my money.
The long term real returns for them will likely be negative.
Good for the U.S.
and good for me. On the broader topic, is America
not a melting pot for all nations and peoples? So, why is investing in U.S.
assets any different than buying triple A rated bonds in GE?
Do we complain about foreign investors owning GE debt?
Seriously. Who cares? The peoples, nations and companies of the world want safety and they want to invest where they are most assured of getting it.
Or maybe they just want to recycle dollars from the current account deficit.
Whatever the answer is, today safety and the best returns are achieved by investing in the U.S.
(Risk adjusted returns.)
Americans should wish for foreign investment. Just not at the expense of hollowing out national industry. In other words, I don't want to live in a society like China
where foreign investment comprises most of the exports. Should companies decide to move assets out of China
, what national industries are going to pick up the slack? More importantly, how does China
convince labor arbitraging exporters not to pick up shop and move elsewhere when it is economically beneficial? By depressing wages?
By some other unattractive method?
I'm leading up to the dollar with all of this. The dollar is everybody's whipping boy. I see these ridiculous articles such as the one in Der Spiegel
and there's almost an air of exuberance that Goliath is ready for a fall. Even if it is a generally benevolent Goliath.
Der Speigel’s article is an embarrassment.
Very short on facts and very long on emotion. Or, as we used to say in Texas
, "Big hat, no cattle". Every statement made in the article could be applied to the dollar over the last forty years. It is also an argument which I could apply to nearly every country's currency. Simply take out the U.S.
and put in your country of choice with one difference: the dollar is the world's reserve currency. A little bit of schadenfreude in nearly every dollar bear's representation of the dollar.
So, now everyone has become a forex expert. I know enough to know those squawking about the dollar generally don't have any idea as to what the variables are moving the dollar. Look, being the world's reserve currency is a tough job with alot of demands not placed on other currencies. If the world was denominated in Yuan, we'd likely see gold at $3,000 an ounce and oil at $250 a barrel because of China
's monetary policy. Some may argue that is because China
has effectively outsourced monetary policy to the U.S.
I say that's a little bit of bunk as well. As for the Euro, I remember when people laughed at the Euro because it immediately plummeted when introduced. Now it is up over 50% against the dollar. Yet, the money supply growth in the Euro region is just as high as it is in the U.S.
So, actually, I could argue their central bankers have an inferior policy to that of the U.S.
Why? 55% of global trade is in dollars.
All commodities are priced in dollars.
Oil is traded in dollars.
With commodity prices being significantly higher than they were six years ago, it takes 6x as many dollars to buy the same amount of oil today than it did less than a decade ago. Ditto for other dollar denominated commodities.
What are all of the commodity producing nations doing with all of the dollars they are collecting due to higher prices? Couple that with a dozen countries that use the dollar as their currency. Then we've got global central bankers buying and selling dollars in the currency markets.
Some on a massive scale to affect their currencies.
We've got normal credit creation and economic growth in the U.S. on top of that.
Then we have instantaneous movement of capital around the global financial markets.
Then we have complex financial leveraging and derivatives.
Then we have excess cash sitting in short term instruments because people and companies are not investing. So, we have alot of dollars floating out there for reasons other than central banking policy and alot of stresses on the dollar not experienced by the Euro or any other nonreserve currency. I could type a book the size of War And Peace on all of the dynamics regarding the value of the dollar.
But first I’d have to know them all. The dollar isn't necessarily going to weaken because of Fed policy. Nor is it necessarily going to weaken because of fiscal policy. Nor is it necessarily going to weaken because the American economy is slowing down. Nor is it necessarily even going to weaken period.
It's all very complicated and anyone who quotes M3 as proof the Fed is in some sinister plot to secretly pump money into the economy and ultimately destroy the U.S.
is simply showing their lack of sophistication on the topic. (I'm being really generous with that statement.) What they are effectively saying is the Fed is pumping money into the system so that people and companies will turn around and park it in short term cash accounts. Because that’s what is happening. If I know that, I can assure you the Fed knows that. As I've said in prior posts, there is a lack of demand for capital. That is why mergers are off the charts. Why private equity is able to do deals that make no sense. That is why corporate cash is at astronomical levels. That is why stock buy backs are off the charts.
That is partly why commodities exploded in price. That is why emerging markets are booming with American and European investment.
That lack of demand is adding to money supply growth as an overabundance of dollars is parked in cash and cash equivalents. That contributes to dollar weakness. That is why I've stated those expecting a ramp up in massive capex spending are going to be trapped in the likes of IBM
, Microsoft, Oracle, GE and others major capital equipment players. If companies aren't spending now, is throwing more money at them two hundred basis points lower going to convince them to spend?
We are experiencing a liquidity trap, dollar glut, savings glut or whatever you want to call it.
It’s all part of the same dynamic and all caused by the same systemic problem: lack of demand for capital.
It was reported a few weeks ago the head E.U. central banker intimated there might be something lacking with a policy that does not take into account money supply.
This was after Bernanke said half of all dollars in circulation aren't even in the U.S.
, therefore he doesn't monitor money supply growth that closely. Well, how might Trichet handle all of the complex issues of the dollar? Oh, I forgot. He doesn't have to worry about most of them because the Euro is not the world’s reserve currency. The U.S.
effectively restricts money supply growth through the same method the E.U. uses. In the end, the E.U. hasn't done any better job managing their money supply with a lot less complicated situation than Bernanke has.
The point I’m making is any concern about the dollar is driven more because of the concept of reserve currency issues and economic malaise and not because the U.S.
central bankers are inept. The concept that the world's central bankers, sans the U.S.
, are somehow running a much more sound policy is maddeningly ridiculous. Anyone attempting to say the Fed has a death wish for the U.S.
or is attempting to destroy the U.S.
with massive debasing of the most important U.S.
asset, the dollar, is attempting to bamboozle you on a topic they know little about.
Don’t be fooled by fools. Or as Benjamin Franklin said, "Of learned fools, I have seen ten times ten.".
The reality is currencies are an extremely complex topic. Especially when it comes to being the reserve currency. It's easy to work out the obvious issues in your head-Fed cuts rates and the dollar drops because there is more dollars available. Simple supply and demand. But, that is applicable to any currency. So, will the dollar drop comparatively against another currency if central bankers on both sides are cutting rates? And what about the other ten thousand variables?
How do they affect that statement?
Do you have a supercomputer, a slew of economists, a few dozen mathematicians, a thousand programmers and a billion dollars? I’ll give you a higher probability of what the dollar is going to do.
Most currency traders don't understand the issues.
That isn’t so surprising.
If you work for the Bank of Korea, all you know is buy dollars to weaken your currency.
You don’t care about any of the other dynamics affecting the dollar, the other fifty currencies trading against the dollar, the American economy, global derivatives or what China
It’s too complicated for a salesman so nary a person on Wall Street knows what they are talking about. At least the ones trotted out for public consumption. Most dollar prognosticators are linear thinkers trying to solve a nonlinear problem. The issues are very esoteric and the inter workings are hugely complex. Thinking about the dollar is like playing chess. If you want to know what the dollar is going to do next, I'd search out Garry Kasparov and have him punch it into that massive nonlinear machine in his head.
Let's say the global economies slow very significantly. Commodities will likely take a serious hit. Emerging markets will take a hit. Asian economies will ltake a hit. Government traders across many exchange markets will try to keep the dollar within certain price bands. That means enormous dollar buying by foreign central bankers.
Emerging market risk will multiply. Rapid wealth creation and monetary growth in emerging markets will likely mean situations
may develop that they have no experience handling.
Therefore, their currencies could weaken significantly.
Less dollars will be required to buy commodities and less commodities will be in demand.
Central bankers everywhere will modify their policies.
What if the carry trade is broken?
If complex methods of borrowing yen or other currencies and buying dollar denominated bonds is broken, what will happen?
Will interest rates rise in the U.S.
as leveraged demand for Treasuries is unwound?
That could cause a spike upward in the value of the dollar. And on and on and on. All of those issues affect the dollar supply & demand characteristics. How will the dollar react? Maybe it will rise as a safe haven comparatively. Why would I want to own Argentinean denominated assets? Korean? Indian? Assets denominated in those currencies would have a much higher risk profile than dollar denominated assets including gold. Will there be a rush for dollars? Will central bankers turn there dollars in for gold?
Why would they do that when such an act would strengthen their currencies and kill exports?
Does anyone really know what will happen or why? I’m going on the record and stating that the easily discernable variables do not point to a dollar collapse.
In addition, I surely wouldn't want to be short the dollar right now with it being on the cover of The Economist and written about as being nearly worthless by the New York Times.
Now, I have waffled back and forth on the dollar a few times. Mostly on whether the Fed should devalue the dollar as they did in the 1980s. Something that may actually be in the works today for all I know. There is something wrong with how international trade has developed. It hasn't always been that trade was based on floating rate exchanges. Nor has the dollar always been the world's preferred currency of trade. We've seen change in trade mechanics and currencies
which last a handful of decades then something happens or something is changed. We are on our third or so iteration in the last eighty years. There is something intuitively wrong with the current implementation of currency exchange rates, trade and the imbalances it is creating. In the future, trade may not be conducted the same way it is today.
That wouldn’t be such a surprise as change has happened before. Maybe we have one currency. Maybe we have a partial gold standard of nine or ten cents on the dollar and similar backing by other currencies to help mitigate imbalances. My point is exchange rate rejiggering is not going to fix the imbalances we now see.
Hank Paulson and Ben Bernanke can make all of the visits to China
Floating rates will not solve the China
dilemma both the U.S.
and E.U are dealing with.
It is likely going to require a different solution at some point. What will instigate change? Maybe it's war. Maybe it's a dollar crisis. Maybe it's trade sanctions. Maybe it's something else.
But, I can assure you, it will change at some point be it violently or otherwise.
Be it expected or unexpected. Be it tomorrow or ten years from now.
I like to use this simple story told time and again with the “America
is going to hell in a hand basket” crowd--Two men find themselves in an exotic locale and hear the roaring of a lion. Whereupon one of them starts to do warm-up exercises. "Have you gone mad?" says the other. "You think you can run faster than a lion?". "I don't have to run faster than the lion," says the first man, "I just have to run faster than you."
So, as ugly as it seems, the U.S.
style of government, capital markets and economics don't need to be perfect. God knows they aren't. They simply need to be better than most anything else. As long as the world doesn't go to into deep depression, the U.S.
economy will remain the most resilient in the world.
’s wealth will continue on an upward trend for a long time.
Frankly, most of the world's politics and economic policies are a mess at best. That is why thinking in absolutes or refusing to take all data into account produces nothing more than GIGO queuing theory. Garbage In--->Garbage Out.
Let's end it here. Most bloggers, journalists and media have a very strong opinion on most topics. Present company included. That doesn't make any of them right. Present company excluded. :) The insanity focused on the demise of everything U.S.
is deafening. Those people are clueless. Maybe if they whine long enough, they'll get a few things right. Recession? Yes. Worse? Maybe. Comparative destruction of the U.S.
In closing, I can share two facts with you. First, dollar volatility is at a half a decade low so there may be a significant move at some point in the next year or so. Second, every trader this side of Jupiter is crowded into the Euro/dollar trade as a dollar bear and that tells me that just as The Economist magazine puts "dirty dollar" on it's cover, the dollar will likely strengthen, at least for now.
Free your mind and question everything. Always seek the truth. As it pertains to the dollar, regardless of what happens, it likely has little to do with Federal Reserve policy or what is being written in the press and more to do with the massive globalization stresses placed on a fiat reserve currency regardless of whether that would be a dollar, a euro, a yen, a yuan, a loonie or a baht.