Son of "A Day Late and A Dollar Short"
Contrarian Roundtable authors George and Sol revisit their "dollar short squeeze" theory.
In the spring of 2004 we published "A Day Late and A Dollar Short" an analysis outlining the risks of what we called a "dollar short squeeze" scenario where we envisioned a rapid but short-lived deflation caused primarily by the effects of excessive dollar-denominated debt. The article caused quite a stir and inspired many analysts to respond, both positively and negatively. We thank all of the authors who took the time to reflect on our thoughts and respond to them. Our goal was to spark a dialog about a subject that was completely ignored by the mainstream press and that goal was achieved. The "dollar short" theory has since been endorsed by Richard Russell, Bob Hoye, Rick Ackerman and others. Many other writers have taken a strongly critical view of the theory and we respect their opinions.
Many months later, the dialog continues but we have noticed that our original thesis is now being misrepresented as a "deflationist" theory and one that is primarily concerned with the forex (foreign exchange) value of the US dollar. Reviewing our own work, we can understand how misunderstandings could be gleaned from such a long and complex article. In retrospect, we now see how we could have presented the subject more clearly. Discussions of currency value are difficult and prone to misunderstanding because of the dual role of a currency as both an asset and benchmark of value. We take this opportunity to restate and amplify our views with respect to the current situation.
Our original thesis contained the following points:
- Cash in the form of US dollars is a fundamentally weak asset class.
- This weakness is well known to almost all market participants due to the long-standing trends of US indebtedness, current account deficits, weakening manufacturing sector, and chronic inflation.
- The vast majority of investors and consumers have taken on large amounts of debt to capitalize on the belief that inflation will continue uninterrupted into the far future.
- This massive debt load is similar to, but not identical to a "synthetic short" position on the dollar.
- A debtor is similar to a short seller but one who is short cash rather than another asset. A debtor can be ruined if the cash value of collateral falls below the amount owed just as a short seller can be ruined if cash margin falls below net asset value.
- Massive short positions have consequences in markets, often creating the conditions that cause weak assets to rise quickly in value in a situation called a "short squeeze". These short squeezes are common in all markets that allow short selling.
- Short squeezes are rapid but short-lived events that can cause investors with bearish short positions to be wiped out due to a sudden rise in the asset value as other short sellers make panic and buy back their short sales. This can happen even if their fundamental bearish opinion of the asset is correct. Short squeezes are counter-trend events.
- A cash short squeeze in the US dollar would be functionally equivalent to a rapid but short-lived deflation where general prices fall in response to a sudden collapse in demand as cash and/or credit becomes temporarily scarce.
- Official responses to a sudden deflation by rapidly increasing money supply would take time to implement due to administrative delay, political infighting, and the slow speed of diffusion of new money into the economy. Ultimately, reflationary policies from the central bank and other authorities would gain traction and again create the desired inflation but only after much damage has been done.
In our original analysis we only briefly touched the topic of foreign exchange and how the dollar would fare in relation to other currencies. The article was already long and honestly we did not fully analyze how such a scenario would unfold in the forex markets.
In no way did we imply that a short squeeze deflation would be permanent. Our original article stated "In the aftermath of such an event, it is quite likely that the dollar would resume its decline due to the continued deterioration of the fundamentals of the US economy. Remember, a short squeeze does not indicate any change in the fundamentals of any asset or security. In fact, it is a confirmation of its weakness. The irony of the situation is that those who are convinced that the dollar is slowly dying are probably right but their collective action makes their investment positions untenable." In the long run, we assume that inflation will continue and may even accelerate. Our point is that inflation is not necessarily a straight line to oblivion but can take a complex course, even reversing at times.
Although we feel that the actual event itself would be short-lived, damage from even a short bout of hard deflation could be deep and long-lasting considering the huge overhang of debt in the US. Highly leveraged investors could find themselves wiped out even if their securities quickly recovered. Consumers who fall behind on debt payments may find themselves unable to catch up or may find they owe more than their collateral is worth. Marginal businesses may fail if demand and/or pricing temporarily collapse. Faith in mainstay investments and assets would be broken.
In the time since our original essay was published, there have been no indications of dollar short squeeze phenomena. However, there have been a number of developments that can be interpreted as precursors to such an event:
- The US Dollar appears to have put in an intermediate-term bottom on forex trading
- Many commodity sectors have fallen substantially including some metals, agricultural, and other soft goods.
- Long-term US interest rates have fallen.
- Many measures of inflation have fallen.
- Most stock indices have fallen.
- Money supply growth has stalled.
- Increasing inventory in national real estate is indicting topping action in home prices.
- The US consumer is showing signs of fatigue as indicated by sluggish retail sales figures.
Forex Implications of a Dollar Short Squeeze
If prices temporarily fell within the US, how would the dollar fare in foreign exchange markets (forex)?
Everything in the world has a trend and it's well known that nothing will simply trend in one direction forever. So even though the dollar is technically shot to pieces and fundamentally rotten, it will have a strong counter trend rally at some point. When the dollar begins to rise these signs will start to manifest themselves.
1) Goods will start to drop in price. This has already started to take place and will keep accelerating for a while. Electronic goods, now even many agricultural products are dropping in price and what is even more interesting is that gas prices are no longer rising even though oil keeps setting new highs almost on a daily basis.
2) The currencies that rallied while the dollar plunged will be in the process of topping or putting in their final highs.
3) Consumers will start to cut down on their spending; the latest consumer spending figures seem to indicate that the consumer is slowly tightening his or her belt.
The Feds won't sit still. They believe that the US cannot have deflation take over under any circumstance, so they will start running the printing press at full speed. In fact we believe the recent rate hikes were implemented to confirm the illusion that the economy is improving and that most likely next year the Fed might have to reverse some of the rate hikes implemented this year. If the Feds lower rates, then investors won't really want to hold dollars because most of them are not speculators. Only speculators will then be willing to play the rise in the dollar. The Feds will most likely succeed in triggering of inflation and putting an end to these initial deflationary forces. This could actually back fire and bring on hyperinflation.
We need to stop here for a while and explain something else. Currently we have both deflationary and inflationary forces co existing in almost perfect harmony. We have extreme inflation in the energy sector and extreme deflation in the manufacturing sector. Another thing to remember is that deflation and inflation are nothing but cycles. In other words they are nothing but trends, and when the trend breaks in one it will trigger an up trend in the other. Example the Feds could actually trigger hyperinflation as a result of their fear of deflation by running the printing presses into the ground. This will force everyone to try and cut down his or her debts as soon as possible. In this case, a bout of hyperinflation could bring about a cash short squeeze because prices are rising faster than consumers can absorb.
Well, the theory is that you usually don't pay your debts when one is in inflationary times, because the future value of your dollar keeps declining. There is one little problem, what if you have no future dollars coming in or what if you future dollars are not coming in as fast as inflation is rising. In other words what if your income is not increasing enough to pay rising bills? What if your income is declining? We are already witnessing that in the health sector right now. A big article was published on Yahoo stating that insurance rates are rising at three times the levels of individual's salaries. This is equivalent to a reduction in salary because health insurance premiums are deducted directly from paychecks. In such a situation one would either look for ways to cut down one's debt or at the very least try to spend less. Eventually such spending cuts will trigger deflation as out of necessity business and individuals seek to cut their discretionary spending.
John Tyler (www.trader007.com) recently had the following to say as far as the dollar goes:
The G7 have been meeting recently but have been keeping it very quiet. "I suspect they are trying to create the impression of a falling dollar so traders will be caught out". Bush, Blair and Howard are all getting together, they are all facing a rather tight race and they want low oil prices so they will team up to pump the dollar. It fits the BIS objective for stability; which is political first and foremost so that they can continue to operate, a Darwinian survival imperative.
How would a rising dollar affect other currencies?
In a way this question is really rather idiotic. We don't have a constant to measure any currency anymore so everything is just arbitrary now. However if we look at a 10-year time period, we see that several currencies increased in value while several decreased in value. So when the dollar rises, some currencies will pull back while others might actually rise with it. What everyone is missing is that not one central bank will allow its currency to simply keep appreciating. This is because if one currency should be allowed to get too strong, that nation will be priced out of the export markets. Since we are a global economy and interdependent on trade with each other, a very strong currency is something no nation wants at this point. So we will actually enter the stage of competitive currency devaluations, where nations will start to devaluate their currencies just to be able to stay competitive. This virtually assures us that the Dollar will not be allowed to rise up in value indefinitely. In some way these moves are being engineered as the current value of the Euro is hurting the entire Euro zone and benefiting Asia and the USA tremendously. It makes our products more competitive.
So the real question is what will happen once we enter this aggressive stage of competitive currency devaluations? Gold will finally start to shine as it will enter the true bull market stage and rally in every currency. Currently Gold's price is based on what the dollar is doing, but there will come a day when Gold will rally in the face of a so-called rising dollar. I think those that waste too much time in analyzing the rise of the dollar in terms of the forex value are missing the big picture; that being the slow but sure competitive currency devaluations that are currently taking place. China has decided to take part in this by pegging the Yuan to the dollar, other Asian countries are doing this by selling their currencies and buying dollars and the list goes on. We have not entered the fiercely competitive stage, where the theme will be devalue or die. Once we get into that stage, the only thing worth looking at will be Gold. Yes eventually they will come out with a currency scheme that will be partially backed by Gold, a point in time, which will represent the peak of the gold bull market.
Noted Austrian-school economist Marc Faber expresses a similar view to ours:
"I should also like to mention that if this scenario of a weak economy does come into play, the dollar could surprise on the upside simultaneously with the bond market. Why? Because weakness in U.S. consumption will lead to an improvement of the U.S. current account deficit as imports falter. I should like to emphasize that this view of dollar and bond market strength isn't a long-term call, but intermediate in nature, based on the prevailing negative consensus about bonds and the U.S. dollar and my expectation that the economy might suddenly fall off a cliff."
In short, we believe that the US dollar would probably rise in forex markets during a short squeeze event, but the rise would be temporary and have limited upside.
By George J. Paulos
Both Sol and I acknowledge the possibility of a period of hyperinflation, but a whiff of hyperinflation could actually be the trigger for a cash short squeeze by diverting precious income from discretionary consumption to non-discretionary consumption and debt service. In fact, I believe that we have already experienced that whiff of hyperinflation and the damage has already been done to consumers who have increased their non-discretionary debt-service expenses while incomes have remained stagnant. As a result, consumers are increasing their debt loads even further to maintain lifestyles. This is not sustainable. The debt service burden will soon reach a tipping point.
The official response to these problems is always additional monetary expansion. The end game of unlimited monetary expansion is eventual currency collapse. Monetary expansion and currency debasement are not just a US phenomenon. All central banks are playing this game. This is why currency collapse will probably include all of the major national currencies due to their unstable fiat nature and their need to maintain relative parity. If all major currencies collapse together, then their relative value may not change dramatically but buying power would be severely reduced as inflation becomes globalized. The world will be forced into a new global currency valuation model as a result. Such a new model may be gold-based, but could also be a novel system based on a basket of commodities. I believe that the best way to play the currency debasement game is via gold and silver.
Global currency collapse is not currently an imminent threat, however collapse of other asset classes may be. This is where the danger lies in the cash short squeeze scenario. A rush out of some large asset class could create a shortage of ready cash to settle transactions, causing massive declines in those assets and resulting in deep recession. Cash is like any other asset class: "You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run."
"... the least desirable asset today is cash. Therefore, a contrarian investor should consider holding above average cash positions." - Marc Faber, Sept. 2004
By Sol Palha
So to summarize, the dollar short will result in deflationary forces taking the lead for a while. Currently they are both co existing pretty much in harmony. The Feds will come out with an aggressive attack which could lead to hyperinflation; this could in turn lead to consumers cutting back on their expenditures simply because their salaries are not keeping up with inflation and its going to take more of the same old dollars to buy the basics that they need to survive. This in turn will trigger deflation in full force as we have mass bankruptcies across the board. The rise of the dollar will trigger a drop in the value of some of the now stronger currencies, however no nation will allow it currency to get too strong. So we will enter the competitive currency devaluation phase where one either devalues or dies. In the end the death of the dollar will actually bring about the end of fiat and possibly the implementation of some Gold standard.