US dollar as a reserve currency
John Hussman clarifies that the European bailout last week was a loan,
not a printing effort. It will be sterilized. This could have direct implications for the
global stock market, as it may continue to head lower. Stay tuned this week,
as technically a follow through to the downside is crucial for the bear case.
We could also be at risk of yet another “flash crash” due to the lack of liquidity
in the global financial system.
John P. Hussman, Ph.D.
Last week, the European Central Bank pledged to spend as much as 750 billion euros (about a trillion US dollars) in an attempt
to discourage market concerns about European debt, particularly that of Greece, Portugal and Spain. The intended message
was to show the markets – particularly bond market “vigilantes” speculating against European debt – that the ECB has deep
enough pockets to thwart the mounting pressure on European debt and the euro itself.
ECB President Jean-Claude Trichet has been quick to deny concerns that the move by the ECB will be inflationary, emphasizing
that the intervention will be “sterilized” in order to prevent a major increase in the amount of euros outstanding. This is “totally
different,” he argued last week, from the massive increase in monetary base that has occurred as the U.S. Federal Reserve has
bought up over $1.25 trillion in debt obligations of Fannie Mae and Freddie Mac. A “sterilized intervention” is one where the
euros created through the purchase of distressed Euro-area debt will also be absorbed by selling other assets from the ECB’s
balance sheet, in order to take those euros back in.
In order to evaluate the arguments being made, it’s helpful to understand the balance sheet of a typical central bank. Whether
in the U.S., Europe, or elsewhere, the basic structure is the same. On the asset side, the central bank has government debt
that it has purchased over time. A small proportion of total assets might be held in “hard” assets such as gold, but primarily,
the assets of each central bank has traditionally represented government debt – mostly of its own nation (or in the case of the
ECB, euro-area governments). As a central bank purchases these securities, it creates an equal amount of liabilities, in the
form of “monetary base” (currency and bank reserves).
Notice, for example, that the pieces of paper in your wallet have the words “Federal Reserve Note” inscribed at the top.
Currency is a liability of the Federal Reserve, against which it has traditionally held assets such as Treasury securities, and prior
to 1971, at least fractional backing in gold.
In this context, consider the ECB’s proposed 750 billion euro line of defense. Essentially the ECB is saying “We stand ready to
buy as much as 750 billion euros of distressed Euro-area debt in order to defend the euro.” Simultaneously, despite the fact
that Euro area countries are running large fiscal deficits, the worst being in Greece, Portugal and Spain, the ECB is saying
“However, we intend to sterilize this intervention, which will ultimately require that we sell Euro-area debt into the market in
order to absorb the euros we create.” The only way that both statements can be true is for the ECB to admit “Therefore, we
are fundamentally promising to debase the quality of our balance sheet, by exchanging higher quality Euro-area debt with
lower-quality debt of countries that are ultimately likely to default.”
Far from being “totally different” from what the U.S. Federal Reserve has done, the ECB is essentially promising exactly the
same thing – to corrupt its balance sheet and debase its currency in order to protect the worst stewards of capital from the
consequences of bad lending and poor investment.
This picture is worth 1000 words. While Sovereign issues in Europe have become
an immediate concern for the global markets, the big offenders are the G7 countries!
The UK, Japan, and the US are at the top of the list.
If the total debt load becomes a concern for the markets, I would expect very
difficult financial conditions.
Are funding problems in US housing bubble States such as California, Florida or
Nevada that much different from the problems in Southern Europe? Not
really. However, Sovereign bond ratings are assigned by US credit rating agencies,
which will be reluctant to downgrade US. The crash of the Euro due to PIIGS (Portugal,
Italy, Ireland, Greece, and Spain) blowing up appears to be overdone. Time for
a reversal soon?
Here is the EURUSD COT position
Curtis Hesler, Professional Timing Service, 04.06.10, 07:10 PM EDT
Last December I headlined my monthly newsletter “How To Play The Dollar Rally.” The short version is that the same technical indicators that were bullish at the end of last year are beginning to transmit bearish omens. There is likely a bit more on the upside for the dollar before it turns, but this final phase of the rally will press precious metals and crude back. It will provide us with a final buying opportunity before the next leg in the commodity bull unfolds.
Here is what is developing. First is sentiment. Everyone on The Street was bearish and was selling the dollar at its late 2009 lows, but there is nothing like a good rally to bring out the bulls. I guess folks just like to buy high and sell low.
There are, of course, those dyed-in-the-wool dollar bears who refuse to recognize the cyclical aspects of the markets. Nevertheless, I am currently seeing more articles espousing a dollar recovery than talk about a return to new lows.
A good number of the dollar bulls are basing their stand on the weakness in the euro. There is some truth to this argument. The euro has been pushed from over 1.50 in early December to about 1.32 lately, and there should be good support at 1.25-1.30.
If you look at the Moving Average Convergence/Divergence (MACD) and Relative Strength Index (RSI) patterns on a chart of the CurrencyShares Euro Trust ( FXE – news – people ) you’ll note that neither the MACD nor the RSI are making new lows with the FXE. MACD is about to produce a second buy signal replete with positive divergence. The positive divergence in the RSI since it bottomed out in February is also telling us to start looking for the end of this decline in the euro.
The euro is setting up for at least a short-term trading rally. I believe fundamentals will support this. Germany is going to orchestrate assistance for Greece without getting personally committed. The Germans will use the crisis to augment their position of power in Europe — something they have not had for many years. Things will appear better in “euroland” soon, and that will give the euro support. As it finds support, dollar traders will begin selling.
The technical omens are present in the dollar also. It is not surprising that the MACD and RSI patterns that we see in the U.S. Dollar Index are the mirror image of those in the FXE chart. Beyond that, the Commodity Channel Index on the weekly dollar is hovering at +100.00, and a break below that will produce a major sell signal. Bottom line, the dollar rally looks like it has a little more life left in it, but not much. It may even venture toward 83.50, but my indicators are telling us to be ready to use a last ditch dollar bounce to our advantage.
The best way to play the next turn in the dollar is to use the last phase of the dollar rally to build positions in precious metals. You need to do this now before the dollar’s top is in. We have a little time, but not much. I expect that the dollar will find its final rally high by the end of this month.
As the precious metals markets pull back in response to a stronger dollar, we will see some magnificent buying opportunities in individual mining shares. I have reviewed the downside buy prices; and by and large, they are where they should be.
See more recommendations and the full article here.
This video from inflation.us explains the problems US is currently facing. Is this
the beginning of US currency crisis or hyperinflation? The video is rather long,
but it is a must watch.
Sovereign defaults present serious risk for the stock market. Overall, stocks in
affected countries decline considerably, and the desease infects the rest of the
Globe. Here is a recent example, the currency crash in Iceland. While US is
much bigger, the problems in the US, the UK, and Southern Europe are all similar.
2008 proved that TBTF (too big to fail) do fail!
Be careful and prepared
Over the past year since March 2009, the Federal Reserve not so quietly
engaged in a major printing effort (of 1.75 Trillion dollars), while
concealing the fact that this monetization was required to keep
US economy afloat.
They use the term of “quantitative easing” to mask the truth for the general
public. Quantitative easing is printing money out of thin air. They also
directed the printing presses toward bailing out very sick US mortgage
market (mostly MBS), although there was also explicit monetization of
Explicit monetization of US treasuries by the Fed is almost equivalent to
default. However, US credit rating agencies continue to rate US sovereign
debt as AAA (surprise!)
It appears China, the largest holder of US sovereign debt, is finally
starting to “get it”. If China is serious about De-pegging from US
dollar, as pressured by US authorities, then we may see US
dollar plunge. For now Chinese currency is pegged to US dollar,
thus, Chinese buying is determined by the peg. Read more in this article in FT.
By Gerard Lyons
Published: April 27 2010 15:50 | Last updated: April 27 2010 15:50
There is a ticking time bomb under the dollar. When it explodes depends not just on the US economy
but also on policy actions in Beijing and Washington. Over the last year the Chinese have undermined
the dollar by the back-door, questioning it as a store of value and medium-of-exchange.
Although the Chinese are not advocating the renminbi as the alternative to the dollar this may be only
a matter of time. One needs to focus on what the Chinese do, as well as listen to what they say. A key
development is China’s encouragement of international use of the renminbi, although they prefer to call it invoicing.
This may be from a low starting point but one Chinese saying may be worth bearing in mind: “A march
of 10,000 miles begins with one small step”. Early signs are promising.
China is encouraging exporters to invoice in the renminbi and is setting up systems to allow trade
payments in renminbi. This make sense. China’s trade is soaring. New trade corridors may soon
require new means of payment. When the Chinese and Brazilian Presidents met last
year they agreed to use their own currencies to settle more of their bilateral trade, rather than
invoicing in dollars. Although viewed as symbolic, it is a sign of things to come.
This picture is from the Chicago tribune
US national debt is a disaster in the making. Currently the demand for treasuries
is being artificially propped by US credit rating agencies that downgrade European
countries but keep their mouth shut about the fiscal position of the United States and
the States in the United States, such as California, which are much worse off than
Greece (in the EU).
Essentially, the two choices for the Fed are not pretty –
hyperinflate or face a devastating deflationary collapse due
to mega-Ponzi derivative fiasco. The Fed chose hyperinflation.
“Any serious attempt to withdraw the stimulus at
this point will trigger a deflationary depression and
a continuation of the current policies will put us
firmly on the road to hyperinflation”
Here’s what the Deutsche team, led by Jim Reid, say:
Although we’re positive in the near-term, looking at the world today it’s clear that the current macro environment will be
difficult to sustain. The markets will need evidence in 2010 that there is an observable path back to fiscal discipline for those
countries that have been most aggressive in responding to the fall-out from this crisis. If not we continue to run the risk of
Sovereign land mines disturbing the benign corporate landscape.
Indeed if 2010 is a difficult year it’s highly unlikely that the catalyst comes from within the equity or corporate credit markets.
This means the macro environment will decide 2010, and in reality investors in Sovereign debt around the world will probably
decide the fate of risk assets. In late 08/09 the authorities had little to lose in aggressively attempting to stave off a
Depressionary cycle. So far they deserve extremely high marks. However 2010 could be a transitional year between heavy
intervention and the paying of the bills. A return to positive global growth should help but we would expect more volatility in
2010 than in H2 2009.
Back to Sovereign risk, history is littered with examples of inflation, devaluations and Sovereign defaults after financial crisis.
One might wonder why this time should be any different. Sustainability is the key word. As soon as markets doubt the
sustainability of a country’s deficit then we have a problem. This is why it’s important that in 2010 the authorities provide a
credible path for future fiscal discipline, even this path involves many years of adjustments. One of the largest challenges will
be funding the still large global government issuance in a world with less QE. QE limited the discussion on the impact of
crowding out in 2009. Will we be as fortunate in 2010?
Deutsche Bank has the following scenarios:
Scenario 1 — This scenario is the most optimistic and is one where the authorities have as good a year as they did in 2009.
They likely keep stimulus extremely high in the system without there being any noticeable consequences of their actions (e.g.
rates at the short and long-end stay low). Under this scenario we would expect equities to be significantly higher, credit
spreads be much tighter but with bond yields only edging slightly higher as the authorities are seen to have firm control of
inflation expectations and may even be continuing to buy bonds.
Scenario 2 – This scenario is the most likely and suggests that we start to see gradual easing off the gas from the authorities
but only as it’s proved that there is some momentum in the underlying economy. Under this scenario risk assets have a good
year but returns are checked to some degree by rising bond yields and less stimulus being injected into markets. A satisfactory
year for risk, especially equities, but a mildly negative one for fixed income. Credit investors will likely have to rely on spreads
(and higher beta credit) to get positive total returns.
Scenario 3 – This is the second most likely scenario overall in 2010 but one that potentially becomes more likely as the year
progresses. Here we are likely to see sharply higher bond yields start to disrupt the positive momentum in markets. These
higher yields could be either due to Government supply starting to overwhelm demand (especially as the impact of QE, and
similar schemes, wane), or because of inflation fears. It seems unlikely that actual inflation will be a concern in 2010 but it’s
quite possible for expectations to become unanchored. We would also have to include the potential for a Sovereign crisis
somewhere in the Developed world within this scenario. We would note that the higher yields in this scenario are not based on
positive growth momentum but by inflation/Sovereign risk. Such a scenario is incorporated in Scenario 2.
Scenario 4 — This is the nightmare scenario of Deflation or in less extreme terms perhaps a double-dip. Given that much of the
world is currently still in negative YoY inflation territory it is difficult to completely rule out even if we do live in a fiat currency
system and even if inflation is expected to return to positive territory in early 2010. For deflation to be sustained we would
probably need an exogenous event to hamper the authorities ability to continue to successfully fight this credit crisis. Such
events could be a fresh banking crisis arising, a political backlash encouraging immediate increases in 2 December 2009 Macro
Credit and Equity Page 4 Deutsche Bank AG/London economic regulation or withdrawal of stimulus, or possibly a Government
bond/currency sell-off that forces the authorities to aggressively reign in stimulus for fear of a sovereign crisis. A Sovereign
crisis outside the Developed world could also encourage this scenario as there would be a flight to quality into Developed
market bond market in spite of the fact that these markets have their own large fiscal issues. Bond yields would eventually rally
strongly but risk assets would experience a very poor year. As time progresses this scenario becomes less likely as the system
gradually repairs itself and the authorities are allowed more time to inflate the global economy. As we discuss in scenario 3, the
more likely risk scenario is inflation, especially as time progresses.
We have tried to simplify and narrow down the scenarios as much as possible to allow for easy explanation but the reality is
that there are many other permutations for the year ahead. For example and as discussed above, within the worst case
scenario we would have to include a slightly less severe outcome where growth fails to show any momentum after the stimulus
starts to fade (a double dip perhaps?). If the authorities are unwilling or unable to stimulate further then we could have a weak
economy even if we don’t see outright deflation. This would likely be negative for equities/credit but the outcome would be
unlikely to be as negative as the -30% outcome.
The other big problem in differentiating between the two negative scenarios is with regards to Sovereign risk. If we have
Sovereign risk within the EM complex (e.g. Dubai) then Western bond yields could rally strongly on a flight to quality basis. So
an element of this risk is priced into Scenario 4. However we are in a fairly unusual point in history where there is also an
increasing risk of a Sovereign crisis occurring in the Developed world at some point. The fiscal deficits arising from this crisis
have to be addressed at some point. If the market eventually sees no credible medium-term way of certain Western countries
balancing their budgets and repaying their debts then we may see a large rise in Government yields. This in itself could be
enough to raise funding costs to levels that encourage a vicious circle.
Figure 1 and Figure 2 help us understand why we are entering into unknown territory in terms of Developed market debt. These
charts simply show the Debt to GDP ratio of the US and the UK. The Government part of the deficit is starting to rise sharply in
both regions and although it looks within the range of historic observations we have to remember that Governments have
implicitly and explicitly backed the debt of other parts of the economy. This makes Government liabilities potentially much
larger. The hope is that growth rebounds strongly enough for the Debt/GDP ratio to fall naturally over time. Such a scenario
would also require yields to stay low to facilitate such an adjustment. All we can say is that there are risks that the deficits of
such indebted countries at some point appear unsustainable to the market. This is when far more difficult decisions than those
made in 2009 would have to be made.
Investors should favor government bonds in countries with strong fiscal positions, such as Germany, this year, and prepare for a
tougher year in the U.S. and the U.K. in particular, where interest rates will rise as governments and central banks start to
withdraw their huge stimulus efforts, according to Bill Gross, co-chief investment officer at bond fund giant Pimco.
Bill Gross, January 2010 Pimco investment outlook.
Distressed as I am about the state of American democracy, a rational money manager cannot afford to get mad or “just get even” when it comes to investing clients’ money. Still, like pilots politely advertise at the end of most flights, “We know you have a choice of airlines and we thank you for flying ‘United’.” Global investment managers likewise have a choice of sovereign credits and risk assets where stable inflation and fiscal conservatism are available. If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector. If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.