The Euro - Are There Any Hard Currencies Left?
With gold reaching $1,000 an ounce and posting new highs versus all currencies, are there any hard currencies left? Over the past 100 years, we have moved further and further away from the gold standard. We see no indication for that trend to reverse; if anything, it may accelerate. As a result, we have cautioned long before this credit crisis erupted that there is no such thing as a safe asset anymore; investors may want to take a diversified approach to something as mundane as cash. This lack of confidence in cash goes beyond "cash equivalents" such as money market funds, commercial paper, auction rate securities, to currencies themselves. We all rely on cash for liquidity, but are concerned about purchasing power. While we are told that equities outperform in the long run, the deflationary forces in the equity markets, and the threat of a depression, has many looking for ways to avoid systemic risk affecting equity markets. While there are deflationary forces, there is also the threat of inflation because of the governments' efforts to restart the economy; as a result, investors do not want interest and credit risk, either. Is physical gold the only answer? Possibly, but even the staunchest gold bugs rarely ever invest all their net worth in gold, if for no other reason than it is impractical. The principal motivation to invest in other currencies is to diversify based on concerns that the U.S. dollar's purchasing power may not hold up and that - on a relative basis - it may hold up better in other currencies. We have long promoted baskets of currencies to mitigate the risks associated with the policies of any one country's monetary policies. This analysis is intended as an overview of where we believe currencies stand.
This analysis is one in a series; today, we focus on the U.S. dollar and the euro. To be informed as we discuss other currencies, subscribe to our newsletter at www.merkfund.com/newsletter.
The U.S. dollar
We are rather concerned about the U.S. dollar. Because it has been in the interest of other countries to have a strong dollar to export to U.S. consumers, the U.S. has gotten away with policies that - in our assessment - would have been detrimental had the U.S. not enjoyed its safe haven status. But the status as a reserve currency has to be earned on an ongoing basis - at some point, the abuse may come back to haunt the U.S.; some say that they will take action only if and when the dollar falls sharply. We would like to remind everyone that gold has quadrupled from a low of $250 to now around $1000. Further, the dollar nearly halved between October 2000 and the spring of 2007 versus the euro; it has since rebounded a bit, but make no mistake about it: the U.S. dollar has been in a long-term downward trend.
In making investment decisions, we take into account risk based scenarios. We do not know whether policy makers will come to their senses or whether they will continue to pursue policies to the potential detriment of the U.S. dollar. But if investors believe that there is a risk that policy makers will continue to make bad decisions, then investors may want to take that into account in their portfolio allocation.
Don't miss an Insight:
Sign up for our Newsletter
Read past Merk Insights
A key concern we have is that inflation may become embedded long-term into the U.S. dollar. For now long-term inflation expectations influence the way the Federal Reserve (Fed) monitors them - the spread between 10-year inflation protected securities (TIPS) and 10-year government bonds - are low. In our humble opinion, that's not good enough. Specifically, look ahead at the exit-strategy for the current monetary and fiscal stimuli. Fed Chairman Bernanke, in a speech on February 18, 2009, tried to persuade the public that the Fed can mop up all the liquidity fairly easily: the Fed would simply let many short-term programs expire. That may well be the case with short-term funding facilities. But that is not the case, for example, with the $500 billion program to buy mortgage-backed securities (MBS) before the middle of the year, a program that may be expanded. In our view, it will simply be impossible to sell these securities back to the market. The Fed's balance sheet before the credit crisis hovered around $800 billion. Adding $500 billion permanently is inflationary unless the Fed somehow "sterilizes" it; quite possibly, the Fed's recent interest to issue its own debt may serve this purpose (the Fed would be competing with the Treasury if it were to issue its own debt). More importantly, however, the policies we have seen encourage maintaining high levels of consumer debt. Unless we have a surge in real wages, consumers will remain extremely fragile even as the economy shows signs of improving. While we believe that both fiscal and monetary stimuli are rather ineffective, at some point, some of the money will stick. The Fed says it knows how to fight inflation. We don't believe so: in our view, there is no way that policy makers will be willing to raise interest rates like Volcker did in the early 80's to weed out inflation - it would cause a collapse of economic activity, if not a revolution. At "best", the Fed will start to tighten when inflation starts to show in the statistics they follow, but may have to revert course right away as economic activity falters as a result.
In the same speech, Bernanke also said that the Fed's activities do not add to the budget deficit. That's why Congress loves the Fed - the Fed can print money that is off balance sheet. However, as the Fed veers closer into fiscal policy by providing not just money to the banking system as a whole, but to specific industries and companies, the love affair with Congress may end. We believe the Fed underestimates the political fallout that will result from all the policies pursued; ultimately, the credibility and with it the effectiveness of the Fed may suffer. This credibility is not bolstered by Bernanke's comment that Congress will benefit from the Fed's activities as the Fed starts to pay taxable interest on deposits held by banks with the Fed. This sort of comment shows the audacity of the Fed - John Law could not have made a better sales pitch as the interest the Fed is referring to is printed by the Fed at will. The "benefit" to Congress will be dubious at best.
The Fed has been actively engaged in the purchase of agency securities, those of Fannie and Freddie. In doing so, many have praised how the cost of mortgages has come down. However, the flip side is what has us concerned: in buying agency securities, the Fed drives up their prices (lowers the yields). What rational market participant would want to buy securities that are intentionally overpriced? This is relevant to the dollar as foreigners, in particular the Chinese, are the traditional buyers of these securities. As these securities are now labeled "overpriced", we fear that foreign buyers may abstain. Last summer the Treasury had to provide an explicit government guarantee to Fannie and Freddie as foreign buying of these securities vanished. Zooming in on China: the Chinese may now be discouraged from buying U.S. agency securities; they may need to deploy their reserves at home for their domestic stimulus package; on top of that, they get insulted by the new administration. It seems like a real possibility to us that at least on the margin, the Chinese may buy less U.S. debt, just as the need to raise money for the U.S. government explodes. We don't need foreigners to sell the dollar for the dollar to be under pressure: because of the current account deficit, foreigners need to buy over $2 billion dollars every single day, just to keep the dollar from falling. By the way, contrast that with the comments by Wen Jiabao, the Chinese premier, who says he wants to use his country's reserves to buy U.S. and European technology while downplaying efforts to convert some of their reserves to U.S. dollars. The Chinese have no interest in a plunging dollar and work hard to be constructive in the public policy debate; as we elaborate more below, the Chinese may be the most prudent in the world right now - that in itself should give everyone pause to think.
Should protectionist sentiment flare up further, countries with current account deficits are most vulnerable. Trade barriers punish those who have adjusted to the world we live in. In recent years, when trade barriers have been discussed, the dollar has generally suffered; that's because we are dependent on foreigners buying U.S. dollar. If there is less trade, there are fewer dollars to be reinvested in the U.S.
So far, the types of protectionist activities we have seen are unconventional, let's call them "stealth protectionism", and have actually favored the dollar. Specifically, the expanded guarantees on bank deposits have drawn money away from weaker countries, specifically from Eastern Europe and some Latin American and Asian countries, to the U.S. and the eurozone. Separately, the enormous amount of debt the U.S. government needs to raise this year is a form of protectionism: as over $2 trillion is likely to be raised, this is money not available to the corporate sector or weaker sovereign countries. At home, even if there were a magic wand to cure the ills of the banking system, the clients of financial institutions - corporations and sovereign countries - will continue to pay a high price to access the credit markets; in this environment, economic growth is likely to continue to lag behind expectations. Internationally, however, weaker countries will see the pain in their reduced ability to raise money; we see this already in the downgrades of sovereign debt of Spain and Greece; we see it in Eastern Europe; it is also possible to see both higher borrowing costs and a weaker currency as foreign appetite to provide funding is lackluster - one need to look no further than the U.K. In this environment, protectionist measures will be called upon to counter the stealth-protectionism pursued.
The potentially most serious threat to the dollar: the Fed. In our view, the Fed wants to have a substantially weaker dollar. Bernanke has repeatedly praised Roosevelt for devaluing the dollar during the Great Depression by taking the U.S. off the gold standard. Bernanke argues that the countries that came off the gold standard had more rapid growth recovery. Bernanke is right, naturally so: when your savings lose their purchasing power, you have a greater incentive to work. There are those, however, that don't love work so much that they would be willing to give up a good portion of their purchasing power for the incentive to work harder. A Fed that doesn't like home prices to fall because of the fallout of having too many homeowners "upside down" in their mortgages, prefers to have the overall price level rise so that the relative prices of homes aren't as overvalued anymore. In our view, the Fed wants to have inflation. The purchase of agency securities and the potential increase in purchases of Treasury Bonds speaks for itself. We are concerned that the Fed may be getting more than it is bargaining for, especially since we believe the exit strategy for this risqué approach is doubtful.
The rally in the dollar we saw in the second half of 2008 was reflected in a surge of buying interest in U.S. Treasury Bills. Typically when a currency rises, inflows from abroad are deployed throughout the economy, not just short-term Treasury securities. As the panic abates, we fear that some of this money will flow out of the country again, putting renewed downward pressure on the dollar.
Everyone loves to hate the euro these days. We are not as negative about the euro, mostly because the European Central Bank (ECB) for years has shown more restraint. As a result, the bulk of European consumers are in far better shape than their American counterparts. When European consumers were told there would not be money for their retirement, they stopped spending earlier this decade; in contrast, American consumers racked up their credit cards.
Conventional wisdom says one needs growth to have a flourishing currency. True, growth helps, but it is countries with significant current account deficits that require growth to sustain their currencies. The eurozone has a rather small current account deficit - the area's "worst" deficit of 2008 was still smaller than a single month's deficit in the U.S. Think about what Bernanke says about countries that went off the gold standard during the Great Depression and devalued their currencies: those who did not devalue recovered more slowly, but had stronger currencies. Indeed, we believe the eurozone is likely to have a rather painful recession; if the U.S. and Asia manage to reflate the world economy, the eurozone may experience a bout of stagflation. However, we believe the euro will be surprisingly strong in this context.
There are both fiscal and monetary reasons why we like the euro more than others. At the peak of the financial crisis in the fall of 2007, Europe (first the UK, then the eurozone) was faster than the U.S. in guaranteeing the banking system. In the meantime, the world has shown that a disorderly collapse of the financial system will be avoided at just about any cost. The next phase should be to allow an orderly adjustment to weed out the excesses of the boom. However, most policy makers around the world are not willing to let the markets adjust; instead, there is a drive to re-inflate the system. In our view, the U.S. will be far more "efficient" at this process than the eurozone. In 2009, the debt to GDP ratio may go as high as 18 percent in the U.S. In contrast, the eurozone growth and stability pact requires that this ratio not exceed 3 percent of GDP. Granted, that pact has more holes than Swiss cheese and member states may deviate from this goal for just about any "emergency" as long as they pledge to revert to the 3 percent ceiling in reasonable time; however, we believe the bureaucratic structures of Europe will prevent the eurozone from being as forceful with its stimulus as the U.S. As a result, growth may lag in the eurozone, but the currency may be stronger as fewer long-term inflationary seeds are planted.
On the monetary side, we also see far more restraint. Trichet, the head of the ECB, has repeatedly expressed his dislike for a zero percent interest rate policy. He seems more concerned about the downside risks of such a policy than its advantages. Instead, the ECB has opted to provide almost unlimited liquidity to financial institutions. Eventually, this may allow zombie (technically insolvent) banks to survive, but it will avoid the inflationary or even hyperinflationary risks that the U.S. approach may be risking.
The ECB has for years been reluctant to join the U.S. and Asian growth frenzy; one can of course argue that this hasn't helped the eurozone much as they now also suffer in the downturn. However, the ECB policies make European consumers in particular more shock resistant; there will be suffering, but that is nothing new to European consumers. Retail stores in Germany, for example, had an extremely tough couple of years before the credit bubble burst. Even Wal-Mart withdrew from Germany as margins were too thin to compete with domestic discounters.
ECB president Trichet is the only central banker governing a major currency we are aware of that believes money supply plays a role - all other central bankers have joined the academic bandwagon that money supply is irrelevant as long as "inflation expectations are firmly anchored".
All the prudence at the ECB hasn't stopped European financial institutions from leveraging up their balance sheets with toxic assets. The motto in Europe has been to copy any idea Goldman Sachs has, but being late to the party, they engaged in greater leverage when pursuing them. A lack of understanding of the instruments purchased was, and in some cases still is, prevailing at many institutions. Whereas in the U.S., money to support the banks can simply be printed, the structure in the eurozone requires that member states - or in some cases regional governments - must finance any bailouts. As a result, the fear that some institutions may be "too big to bail" has spread. Rather than injecting capital, European governments have favored to a "ring fence" approach where the debt of institutions is guaranteed, thereby avoiding the deployment of cash until it is called upon.
While European financial institutions loved all that are now considered toxic securities, they have been suspicious of the U.S. dollar for some time. As a result, many institutions hedged their dollar exposure. Ironically as the value of the toxic securities plunged, the hedging position was still based on the full value of the securities. That meant that those institutions had to buy dollars in 2008 to bring the value of their hedging positions in line with the value of the securities. A good portion of the dollar rally in 2008 may have been attributed to this alignment.
There have been calls to create European bonds, i.e. bonds issued by the European Union rather than member states to address this issue. Currently, when we, or anyone, buy European sovereign debt, one buys, say, German or French government bonds. If the euro were really to break up, one would still be left with the bonds issued by the respective governments and they would revert to, for example, Deutsche mark or French franc bonds. However, the current proposals provide for bonds guaranteed by the member states. Unfortunately that seems too much like a structured product to help the weaker member states Greece and Spain; we don't think there is a market for such a product at this stage. If one wants to pursue this route, a true European bond issued by an EU Treasury with independent taxing authority would be needed; then, if a member state were to break away or default, the debt would truly be EU debt and not shaken by turmoil in any one country. Having said that, adding another layer of taxation in Europe is the last most want to see. While the idea may work on paper, it may easily create another runaway bureaucracy in the long run. Europeans are also deeply suspicious of whether providing such power could lead to excessive spending.
We don't think the euro is at the risk of a breakup because a breakup would be far too expensive for all involved; the pain of staying together is the lesser evil. This doesn't mean that a member state couldn't break out of the eurozone in a bad case scenario, but the euro itself, in our view, is here to stay. In our view, widening risk spreads in different eurozone countries should be embraced, not fought. Member states with fiscally sustainable policies should be rewarded by the markets through lower interest rates; those who promise too much to their pensioners or make too many concessions to unions should pay the price through a higher cost of financing. In the U.S., different states also have varying costs of financing, something to be embraced rather than shunned.
Earlier, we mentioned the stealth protectionism the U.S. and Europe has engaged in by guaranteeing their banking systems. These guarantees have now come back to haunt those institutions that have heavily invested in Eastern Europe. Austrian banks in particular, but also banks in other European states, have bought many Eastern European banks or extended loans to Eastern Europe. The trouble is that Eastern European homeowners and many businesses have been lured by low interest rates available in Europe, particularly Switzerland, taking out loans denominated in Swiss francs or euro. The banking guarantees provided in the eurozone exacerbated a flight of money from Eastern Europe to the eurozone, thereby placing downward pressure on Eastern European currencies. That is a major problem for those who borrowed heavily in euro or Swiss franc as the value of the collateral in local currency has diminished.
In our view, European governments will ultimately provide support to their financial institutions exposed to Eastern Europe. Moreover, after the typical grudging discussions taking place in Europe, support may likely also be provided to Eastern Europe itself. Much of the industry in the European Union has focused on building the infrastructure in Eastern Europe. It may be cheaper for the European Union to subsidize its customer, Eastern Europe, than to allow market forces to cause massive failures. This is not a judgment of whether this is desirable or not from a free market perspective, but our assessment of how the politics will play out.
Note that while it may be cheaper for the European Union to bail out Eastern Europe, the same cannot be said for China; for China, it will be cheaper to stimulate its domestic economy than to prop up U.S. consumer spending through cheap exports. More on China in an upcoming analysis.
To be informed as we discuss other currencies, from the Swiss franc to the yen to the Australian dollar, subscribe to our newsletter at www.merkfund.com/newsletter. We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.