The Case For and Against the Dollar
We have been cautioning for some time that volatility in the currency markets may increase further, even from the elevated levels of the past year. Nonetheless, violent market action is nerve rattling, even to seasoned investors. An uptick in volatility tends to be associated with an unwinding of leveraged positions. This is also the case this time, but the types of trades being unwound look very different from those just a few months ago when the "carry trade" was the talk of the day. To shed some light on recent activity, we will focus on some key forces we believe act on the dollar and the currency markets.
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Ultimately, the U.S. dollar's value is determined by supply and demand. And just as with anything else that can be traded, the traders of the moment determine the price. Many may opt to trade on short notice, but typically most holders of the dollar or any security do not trade on a daily basis. In our view, in making medium to long-term term forecasts, it helps to look at possible cash flows scenarios to gauge who may be buying and who may be selling in the future.
To be less abstract, referencing the U.S. budget deficit in discussing risks to the U.S. dollar is appropriate, but there is little correlation to short- or medium term currency moves. The budget deficit is a balance sheet item; of greater relevance to short-term currency moves would be the trade deficit or its broader measure, the current account deficit: foreigners must buy over US$ 2 billion in U.S. dollar denominated assets every single day to finance excess domestic spending and a lack of exports to compensate for imports. Even so, as the U.S. economy slows down, the trade deficit may narrow because of a drop in domestic economic activity; if that's the case, it may not be a good omen for future investments in the U.S. by foreigners.
The concept of differentiating between balance sheet and cash flow items sounds simple enough, but even experienced policy makers seem to get overwhelmed with the rapid succession of bad news coming out of the financial markets. In early July, solvency concerns of Fannie and Freddie, the government sponsored mortgage entities (GSEs), made it to the headlines after our senior economic advisor and former St. Louis Federal Bank president William Poole stated what was publicly known. The public discussion then focused on a government bailout; unfortunately, a phasing out of the GSEs has not been center of the discussion. One concern was whether guaranteeing the debt of the GSEs would increase the U.S. government's debt by over $5 trillion and, as a result, cause a meltdown in the U.S. dollar. Without a doubt, such an escalation of government debt overnight would be more than a balance sheet event. However, this argument wrongly assumes that the debt of the GSEs was not government guaranteed beforehand. While there was no explicit guarantee, the public had always assumed these entities were too big to fail and would be bailed out. If one assumes that there was a 95% probability that the government would guarantee the debt, then making the guarantee explicit would "only" add 5% US$ 5 trillion to the public debt or about $250 billion. On the scheme of about $10 trillion in government debt, an increase by $250 billion is not a positive, but unlikely to cause a meltdown. We do not suggest that the giant debt loads of the GSEs are desirable, but we believe the market is smart enough to realize that this debt did not come out of nowhere in recent months.
Accounting schemes, be they by the government or private institutions, are unlikely to be hidden from the markets forever. Conversely, when mortgage insurer MBIA recently announced it would reduce the value of its own debt because the market trades it at a discount, such a smokescreen is unlikely to convince investors that MBIA is suddenly healthier. MBIA then trumped its arrogance by not taking any further reserves, again telling the markets more about its own desperation than its financial strength.
The far healthier approach would be to phase out the GSEs. Fannie Mae is a relic from the Great Depression, a socialist Ponzi scheme that makes housing not more affordable, but more expensive to potential new home buyers. If private enterprise were allowed to take their place, the mortgages would truly be in private hands and not on the government's balance sheet; indeed, a few years ago, there was a period when Fannie and Freddie had a very low market share of new mortgage acquisitions as a result of limitations imposed by Congress at the urging of the Federal Reserve. Such a transition cannot happen overnight without disruptions, but, in our assessment, are urgently necessary for the long-term health of the U.S. dollar. The problems we have with Fannie and Freddie now are because of inaction of Congress for too long to clip their wings.
Given a sharp drop in euro holdings in the U.S. Treasury's Exchange Stabilization Fund, it seems that the U.S. Treasury may have intervened in the currency markets, possibly out of fear that a more significant run on the dollar could have resulted while Congress was pondering about its GSE bailout. While taking out insurance against such a scenario may be understandable, we would argue that the recent surge in volatility may well be the side effect of such intervention. Without having proof, we would not be surprised if other countries, notably Asian governments, also interfered in the markets, although with very different motivations.
Asian countries have been suffering from a slowdown in the U.S. However, because of surging commodity prices and inflation, they have been reluctant to keep their currencies weak to spur exports. With commodity prices off from their highs, Asian governments may be blinded into thinking that inflation is less of a problem; that would allow them to weaken their currencies yet again. Taking advantage of historically low trading volume during August seems to be a tempting opportunity.
The positive of the surge in volatility is that it teaches hedge funds a lesson - too many of them pile into the same trades. In recent months, we believe these funds may have shorted financials to buy commodities and sell the dollar. The global deleveraging must continue; for that to happen, hedge funds must have their access to credit be tightened as well. We hear that brokers close out positions of speculators if margin calls are not met promptly; such a development causes more severe pain in the short-term, but may be necessary.
In the meantime, a lot of technical damage has been done to precious metals prices and hard currencies versus the U.S. dollar. Just as everyone was piling into the same trade, now it seems the speculators all either wanted to exit or received margin calls and had to exit their trades. Pundits were eager to call a major shift in the market, declare the end of inflation, the rebirth of goldilocks.
It is on this perceived drop in inflationary pressures that has contributed to the dollar's recent rally. As European growth may be coming to a halt under a strong euro and high commodity prices, the idea is that the European central bank will focus more on growth, thus possibly lowering rates; that the Fed may be able to raise rates; and that Asia may be able to keep their currencies weak. Indeed, these are good arguments for a dollar rally.
We are concerned that pundits and policymakers alike may be pining their arguments more on hope than reality. The potential for interest rate hikes in the U.S. with drops in Europe may be the most compelling one to support the dollar, but will it happen anytime soon? In Europe, we expect the European Central Bank to take their time before they are convinced that the commodity boom is indeed over. The reason to be skeptical is that, of all things, the Fed may see falling commodity prices as a warning sign of a downward spiral in economic activity. Given the large number of homeowners that owe more on their homes than they are worth, the Federal Reserve may actually want inflation: a recent survey shows that one third of those who bought a home in the past five years now owe more on their home than it is worth. The Fed would never say it wants inflation, but what is needed is a relative adjustment of the cost of home ownership versus other goods and services. This can happen through a decrease in the value of homes - something most undesirable due to the negative implications on consumer spending -, or through an increase in the cost of other goods and services relative to housing. It's the latter that the Fed may be banking on. In our assessment, the Federal Reserve will try to push growth until inflation can no longer be ignored. For the Fed, this threshold is likely to be the TIPS spread over Treasuries; that's the premium paid for inflation-protected securities (TIPS) over bonds. Note that these TIPS reflect core inflation as measured by the government.
By then, real wages may not have picked up and if the Fed indeed decides to tighten monetary policy then to try to bring inflation under control, it may cause a rather severe recession. To wait until inflation is apparent even in the TIPS market may be waiting for too long as it may be extremely painful to get inflation back under control. However, the Fed may think it does not have another choice as the consumer and financial sectors are too fragile to tighten monetary policy.
Will inflation bring the dollar lower? It is possible that we will enter an inflationary growth period, but that may not be enough to cause a sustainable rally. In our assessment, the risk of a lower dollar is alive and well. We don't have a crystal ball, either, but investors agreeing that this risk is real may want to consider diversifying to take that risk into account.
We manage the Merk Hard and Asian Currency Funds, mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. We manage these funds because we believe the forces weighing on the dollar reflect long-term issues. We do not typically engage in tactical trading or hedging in these funds; as a result, when there is a bounce in the dollar, investors in the funds may lose value; conversely, we do not have the cost of hedging if the dollar were to decline. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.