TFTF

Gravity and the Dollar

May 24, 2002

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 (click here) 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 here.

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

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