A fistful of dollars, a bundle of contradictions

A fistful of dollars, a bundle of contradictions

Where there’s risk, there’s opportunity.
The dollar’s depressed level may itself hold the key to its eventual recovery.

The dollar slide seems never-ending. The forex market is in the grip of two intolerable contradictions, and unless a resolution emerges — a new way of thinking about things — the prudent bet is on continuation of the slide.

Contradiction No. 1
Aside from one good year in 2005, the euro has been cleaning the dollar’s clock since bottoming in 2001 just under 84 cents (Figure 1). The price of crude oil is shown on the same chart to highlight the degree of correlation that has developed between these markets in the past five years.

At a late-November OPEC meeting in Saudi Arabia, Iran and Venezuela pushed for moving away from pricing oil in dollars. Iranian President Mahmoud Ahmadinejad said the falling dollar means oil producers are, in effect, subsidizing the U.S.

“They get our oil and give us a worthless piece of paper,” he said. “We all know that the U.S. dollar has no economic value.”

Iran already prices oil in euros but has to accept the world oil price is first set in dollars, so it’s an empty change. For his part, Venezuelan President Hugo Chavez called for a “revolutionary OPEC” that embodies a socialistic/ populist political stance.

These two leaders — OPEC’s own little lunatic fringe — are not among the world’s most respected, but the uncomfortable fact remains the dollar is, to a fairly large extent, a hostage to the price of oil. Other countries are equally dependent on imported oil, though, and while Europe may be getting a break because of the Euro’s strength, it’s not a get-outof- jail-free card. Since the end of 2005, the price of oil has risen 56 percent in dollar terms ($61 to $95) while the euro has gained only 24 percent (1.1844 to 1.4631).

The price of oil is not a single cause of inflation in any economy — most economists still think an increase in money supply is necessary to feed inflation — but it is a worrisome contributing factor. But because of the credit crunch, which has many more months to run, the bond market thinks the probability of a Fed rate cut at the Dec. 11 Federal Open Market Committee (FOMC) meeting is 90 percent. This means, unless the yield curve steepens substantially, the market is pricing in a humdinger of a recession, probably in the form of stagflation — drastically slower growth (such as 1 percent vs. the natural rate of 3.5 percent in the U.S.) accompanied by dramatically higher infla-tion (such as 5 percent compared to the Fed’s desired 2 percent or under). In a normal scenario, a recession would reduce activity and thus the demand for oil. And
since the world is not really decoupled from the U.S., demand should fall elsewhere, too.

The market is in the grip of an intolerable inconsistency. It sees inflation rising — a lot — hence the near-doubling of the 2-year/10- year yield spread to 0.825 percent since Sept. 17 (before the Fed started cutting rates). The yield on the 10-year T-note just before Thanksgiving was 4.15 percent, well under the Fed funds rate of 4.5 percent. It’s never a good thing when the 10-year is yielding less than the overnight rate; it means the market is certain recession is coming. Therefore, the Fed should cut rates to boost growth.

At the same time, however, the market finds the Fed’s embrace of the core Personal Consumption Expenditures (PCE) price index unacceptable because everyone is pretty sure consumer behavior is predicated on disposable income, which is affected by the headline.Consumer Price Index (CPI), including oil and food.

At last count, the headline CPI is up 3.5 percent, but in practice consumers know it’s up a lot more for some items, such as heating oil. But the bond market believes the Fed will cut rates again at its Dec. 11 meeting. How can the Fed cut rates if inflation is rising? Doesn’t this value growth more than inflation?

Another rate cut means the Fed is honestly afraid of recession. It’s what Mr. Greenspan would do. But this is the Bernanke Fed. Does he have the salt to stand pat, as suggested in the last Fed statement (“the risks are roughly balanced”)? A Fed rate cut in December would be a big blow to Mr. Bernanke’s inflation-fighting credentials.

We can’t have it both ways — denying the existence of rising inflation and pretending rate cuts will not boost it further. A rate cut removes whatever remaining yield advantage the dollar has over the euro — the yield spread between the U.S. 10-year note and the German Bund (the equivalent 10-year German treasury note) has already been pared to a mere 10 basis points from more than 200 basis points only two years ago. The loss of yield advantage is severely dollar-negative and, if the euro-dollar-oil connection is valid, it implies even higher oil prices, which in turn feeds inflation (or the perception of impending inflation), and so on. It becomes a vicious circle, which is why periods of stagflation need an external shock to be broken.

These shocks can take the form of a war, a tax cut, government pump-priming, or something from left field we can’t imagine yet — like a meltdown in an emerging market stock market that sends funds fleeing to the safe-haven dollar. Figure 2 shows the Shanghai Composite Stock Index, which has increased roughly six fold, from 1,000 to 6,000.
This brings us to the second contradiction

Contradiction No. 2.
“Investments” such as metals and emerging-market equities remain more attractive than dollar-denominated securities, and it will take a crash of titanic proportions to redirect money back to developed markets in general and the U.S. in particular.

Consider that the return on U.S. equity investment from 1989 to today is 10 percent, while it’s 12 percent in emerging markets — and in some cases, such as China, a gain of nearly 600 percent. Japan has been the major loser in all this, going from a 40-percent share of global market cap in 1989 to 13 percent in 1997 and 9 percent today. Emerging markets had one percent of global market share in 1989, seven percent in 1997, and 11 percent today.

From 1989 to the present, the return on Japanese equities has been -2 percent. But where the outgoing investment flow from Japan used to head directly to the U.S. or Western Europe, today it is increasingly going to emerging markets, especially China.

The market is in the grip of another unbearable contradiction. It wants to flee the dollar — for euros, for Chinese stocks, for speculative positions in metals and oil — but it has to keep returning to the dollar every time a scary piece of news comes out. After every incident, however, the dollar is a little lower than it was before, getting no lasting support from hot-money inflows.

If you have been trading forex since August, you know the drill: Some bad news emerges about credit markets, oil inches another notch toward $100, or the stock market wobbles, and risk aversion gets a grip on panicky traders. They dump high-risk securities and high-risk trades, which in the forex market means carry trades such as Australian dollar/ yen, British pound/yen, and euro/yen.

as investors flee to safe-haven U.S. government paper. But this is a fleeting thing — as investors buy U.S. government bills and notes, they drive the yield down (hence the aforementioned tightening of the bond-Bund yield spread).

Then things calm down for a day or two and risk appetite, which until recently was called “greed,” pokes its head out again. Carry trades are re-established, the yen falls against everything, and traders are free to bash the dollar. On several occasions, sentiment flip-flopped in a single day, or every two or three days. Trading has been horrible for more than three months now. Sometimes it seems as if the only way to make a buck is by sheer luck — by guessing, for example, that the price of oil would take a breather short of $100. The seeming correlation among equity indices, oil, or gold and currencies is confusing and can be explained only by the unifying factor of risk aversion.

The question on everyone’s mind is whether the summer credit crisis was the tipping point that shifted securities markets into another gear. The answer is likely yes. The new gear is higher and it’s moving money around faster. Who would have imagined that carry trades would be put on and taken off in a few days, let alone hours? Carry traders used to be far more staid and cautious; you could calculate breakevens over the course of months. Now our heads are spinning from daily and weekly reversals in currencies such as the Canadian dollar and Australian dollar, whose fates are now divorced from central bank management and economic performance.

The threat to the U.S. dollar takes two forms — reserve diversification and hot-money flows. Reserve diversification has been around for a while, although it was a little unsettling for the Gulf Cooperation Council, which includes Saudi Arabia, the United Arab Emirates, and Qatar, to announce it will study the dollar and consider advising a change to their currencies’ fixed rates against the dollar. A summit will take place in Doha, Qatar Dec. 3 and 4.

Let’s assume various countries continue to embrace diversification away from the dollar. This is certainly what the market is expecting and it’s even beginning to be taken in stride. It’s a core assumption now, not a shock. The chief consequence is to make the U.S. current account deficit appear harder to fund. But long-term portfolio inflows don’t fund trade; bank and supplier credits fund trade. The shocking long-term capital outflow in August, which was a function of managers liquidating to get their hands on cash at the height of the credit crunch, was only partly reversed in September.

The most recent Treasury International Capital System (TICS) report was only a little positive. The net long-term portfolio inflow rebounded in September to $26.4 billion from an outflow of $70.6 billion (revised) in August. However, the “Total TICS” number, which includes bank deposits and short-term paper, was negative: -$14.7 billion from - $150.7 billion (revised) in August when it is usually a big inflow, as it was in July ($83.5 billion). Foreigners bought $26.3 billion in U.S. Treasury bonds, $11.5 billion in U.S. agency bonds, $15.1 billion in corporate bonds, and a feeble $2.5 billion in U.S. equities. This is better than the giant sale of $40.7 billion in U.S. equities in August. (Meanwhile, U.S. investors bought $9.2 billion in foreign equities and $19.7 billion in foreign fixed income.)

We can rationalize this was an ongoing need for liquidity and doesn’t necessarily reflect a loss of confidence in the U.S. economy. It must be acknowledged, however, that flows into and out of U.S. paper (even plain, old checking accounts) can be red-hot in today’s electronic world.

Hot money is dangerous. We saw what it did in Thailand and other emerging markets in the 1997-98 crisis. The only real antidote to hot money flows is: 1) restored confidence based on hard evidence and 2) capital controls.

It’s difficult to see where hard evidence of structural integrity and excellence is going to come from when the U.S. trade deficit is more than 5 percent of GDP and U.S. debt is an unknown number (there are so many conflicting reports). Nobel Laureate Joseph Stiglitz, author of Making Globalization Work, recently estimated the Iraq war alone has cost about $2 trillion so far (in an economy of $13 trillion). Stiglitz also says from an economic perspective, Bush is the worst president since Herbert Hoover, which is not unrelated to the pickle the country is now in.

Here’s the contradiction: The U.S. has the world’s biggest economy, the most liquid and transparent financial markets, and is the world’s sole military superpower, but to fund its operations it depends utterly on foreigners to buy its private and public debt while at the same time it acquiesces in the devaluation of the currency. As have all of Mr. Bush’s treasury secretaries, current secretary Henry Paulson continues to repeat “let the market decide.”

To be fair, the government can’t meddle in the Fed’s decision-making, and it would discover outright intervention distasteful and contrary to free market principles (as well as making the U.S. look desperate, which generally only makes things worse). But as with inflation and interest rates, you can’t have it both ways. Something’s got to give. You can’t be the world leader and continue running twin deficits that depend on the kindness of strangers — while offering those strangers less of a return than they can get elsewhere.

This is why tension is so high, markets are so choppy, and the dollar is melting like the polar ice caps — a little faster all the time and in a self-perpetuating way. Although we may yet get a sizeable correction that turns the euro away from 1.50 for a while, forecasts of 1.6500 and 1.75 no longer seem off-the-wall.

At some point, the dollar will become so cheap that direct investments — factories, shopping centers,and real estate of all descriptions (foreigners are already flooding New York City and housing prices there are rising, not falling) — will become deliciously desirable.

Direct investment saved the dollar in the late 1990s, and it can do it again. But the allure of the U.S. has been eclipsed by the glamour of Shanghai and Mumbai. It’s just a place to park some capital safely until the next new thing comes along. This is a very bad spot for the U.S.

The solution? Incentives for foreigners to make direct investments. After the U.S. repulsed Dubai Ports and a Chinese attempt to purchase a U.S. oil company, it’s not going to be easy to write a convincing invitation. But from a policy perspective, it’s the only dollar rescue plan imaginable today.


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