Currency Rhetoric

By: Ed Bugos | Tue, Dec 3, 2002
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Truth is a delicate lining, not easily seen except in certain light - Ed Bugos

Dollar bulls beat up on the Yen Monday, pushing it back down to October's low after a recent spate of dollar weakness saw it rise back up to September's levels.

Not surprisingly, this happened as CRB futures broke out of their three month consolidation to tap the high made in 2000, intraday, but closed one point above their best 2000 close for their best close in five years.

I'm not surprised at the coincidence because the selling was seen to be coming from offshore (or U.S.) hedge funds, as opposed to some sort of homegrown panic; and it came on the heels of rhetoric first by Japan's Finance Minister Masajuro Shiokawa who allegedly said that the appropriate level for Dollar/Yen is 150-160 (recent range has been 120-125). Then Dr. Yen weighed in with a warning that Japan's deflation was a risk that's spreading through the global economy.

He must mean like in Argentina, Russia, Turkey, Brazil, Mexico, South Africa, Australia, Canada, and like in the US of course, since the PPI and CPI no longer are affected by what's actually going on in the commodity markets (are Sakakibara and Soros working off a debit at Citigroup or something... they sound awful similar in their nonsensical themes these days, though its none of my business!).

Of course Shiokawa is a dollar bull too; he works for the government in Japan, and the dollar is their reserve currency just the same. In what has been typical of many Japanese policy statements, Shiokawa later said his comments were misinterpreted. I don't know, maybe, maybe not, but maybe you can make sense of it:

Shiokawa was quoted in a Japanese newspaper as saying during a speech in the northern city of Sendai at the weekend that the yen was excessively strong and should be around 150-160 to the dollar. "What I said in Sendai is that the Japanese economy is not weak at all," Shiokawa said. "If you take purchasing power, for example, it shows that the economy is strong." His comments confused the foreign exchange market - Reuters, Dec 3, 2002

Confusion, rhetoric, it all has the same effect, and it tends to be loudest around trouble spots in the dollar's technicals. Thankfully, Morgan Stanley has some sensible comments to say on the subject:

Analysts said Shiokawa's range was based on the consumer price index (CPI), but they said the dollar/yen rate has rarely been near CPI-based PPP (purchasing power parity). Part of the reason is that CPI includes non-traded goods. PPP is a way to compare living costs between nations by looking at prices of similar items. The gauge to calculate it can be anything from a hamburger to the CPI. Analysts said using Japanese and U.S. September CPI data, the PPP is now around 165 yen. That means what a consumer can buy for $1 in the United States would cost 165 yen in Japan. But using the wholesale price index (WPI) of final goods for the month, the PPP is around 103 yen to the dollar. And if PPP is based on the most competitive export products and services, what a dollar buys in the U.S. would cost only around 70 yen in Japan - Reuters, Dec 3, 2002

That's more like it.

There are all sorts of fears about Japan's banks in the backdrop, but apparently there is no fear about US banks, and the distance they may yet have to fall from grace.

I can't figure out the (yen) bear's claim. On the one hand, the bears say that a banking crisis is causing yen weakness and will continue to, but on the other hand, they say that Japan's banking crisis coincided with an uptrend in the yen, and is the source of Japan's so-called deflation. It's almost as if they'll pick either argument as long as it feels bearish for the yen that day.

Let me make it clear that we're not bullish on Japan. We're bearish on the Dollar, and in particular versus the Yen because Japan has accumulated the most dollar reserves, and because it has exported the most savings, proportionately. My view is that the dollar is overvalued, period, but that the yen has been a highly strategic pillar of dollar policy through the late nineties, and continues to be such to the extent the yen carry-trade still exists.

The growing plausibility of inflation targeting in monetary policy circles (despite limited evidence of deflation risk since 1933 and the discrediting of Peel's Act even before the Reichesbank folded) has given rise to increasing pressures within the Japanese community favoring yen devaluation as a policy tool employed to achieve a better pricing environment.

What Most Investors Don't Know About Dollar/Yen
Of the past seventeen years, the yen spent ten of them rising against the greenback, and since 1985 when Dollar/Yen traded between 200 to 250, it has generally been in an uptrend (see chart below). After failing to turn the (primary trend of the) yen down in 1998, the primary bull market argument is being tested again (it would be more correct to classify the primary sequence in dollar/yen as neutral, with a bearish bias developing over the past two years, but that would omit the fact that the prior bull market support has yet to be taken out at the 143 dollar/yen rate).

The long term rise in the yen against the dollar is easy to understand if you accept that the higher rates of dollar inflation relative to yen inflation over the period has anything to do with their valuation. Of course, it's actually more complicated because these inflation (indicated by money supply growth rates) differentials don't always explain the short term moves in currency relationships. And when one considers the claim that Japan has been a strong source of foreign capital for the US economy, the difficulty in understanding the yen's long term uptrend grows.

To understand it means to review the past. We'll try and make it painless.

The yen's biggest gains came during 1985 through 1988, and 1990 through 1995. Both periods are marked by dollar weakness, but in the former period during the eighties, Japan's inflation rates surpassed US inflation rates and gains in the Nikkei overshadowed gains on Wall Street. After the yen peaked in 1995, the opposite occurred. US inflation rates surpassed Japan's and their stock markets outperformed everyone's save the most speculative developing markets. Those gains added to the dollar's value, ephemerally I suspect, which was further helped by widening interest rate differentials between dollar and yen assets. When this happens, a currency sees a rising liquidity premium, or as I call it, an investment premium. It may look and feel like deflation, but you can bet it isn't by looking at what's happening to equity valuations simultaneously.

The significance of the yen-carry trade is that it came to dominate the dollar/yen relationship in the late nineties (the peak for the yen against the dollar occurred in 1995 - since then it has fallen into a neutral primary sequence, and has spent more time falling than rising).

The trade is the result of a widening interest rate differential in the US' favor, particularly at the short end, as the Bank of Japan tried to support its ailing banking industry through the nineties, in the aftermath of prior eighties excesses.

It became increasingly profitable to borrow yen and invest in dollars after 1995. This was the basis of the yen-carry trade.

After 1998, as interest rates in the US were lowered to shore up the failures of at least one large US hedge fund and perhaps some banks, the dollar started to fall against the yen again (actually it began earlier... as the US stock markets peaked in July). By 2000, the dollar had bottomed, and has again been rising relative to the yen until this year at any rate.

There is lots of confusion in this market today (technicals too). We'll try and simplify our point.

Managing Liquidity Premium To Stabilize FX Rates
Some traders reckon the rise in the yen since 1985 is a consequence of Japan's banking contraction, and proof of the deflation they keep talking about, as if currencies only went up due to deflation. They reason that as the US goes in the same direction - monetary bust - they'll have similar deflationary symptoms to contend with from the value of the dollar as it rises when the mighty US banks call in their overseas loans.

They omit a few facts. There is a strong theoretical and factual correlation between the value of a currency and the value of the bank shares doing business in that currency, or more accurately, between the value of the currency and the real rate of return potential in financial assets denominated in that currency. This, loosely, is how we define the currency's liquidity premium after all.

Moreover, it's laughable to think that America's trading partners have nothing to say about the value of the dollar they help support. US trading partners have probably acquired more dollar credits than entered into dollar liabilities, which is indicated by the fact that the US investment income account fell into the red over the past few years.

The rise in the value of the yen in the eighties wasn't tied to deflation. It was the consequence of a rising liquidity (investment) premium for the yen, which was reflected by the richer relative equity values in Japan at the time.

The rise in the value of the yen from 1990 to 1995, however, is still seen to be the result of deflation by most currency players; 1990 after all was the peak in Japan's bank index.

But something else occurred in 1990.

In the eighties, as we mentioned, Japanese inflation rates soared, and the difference over US inflation rates increasingly widened so that Japan saw it eventually manifest in an incredible real estate and stock boom. But after 1990, US inflation rates began to outpace the Japanese inflation rate, and continue to until this day.

If you compare the two periods, before and post 1990, you'll notice that in the first half of the eighties, the yen sagged and in the second half, as the inflation caught on to financial assets, the yen soared, peaking only one year ahead of the Nikkei.

The US dollar followed the same path in the nineties. It sagged in the first half of the nineties, but US inflation rates accelerated with a sharp increase in equity values after 1995, which resulted in a soaring dollar, peaking one year after the peak in US stock markets (this is the Paul Krugman quantitative easing model at work btw).

The result was a 10-year bull market in the yen (1985-1995): the first half due to a rising investment premium, the second due to a sagging greenback. Now, US policy makers would like to see a 10 year bull market in the greenback. The first five years is behind them and it was marked by a rising liquidity premium for the dollar as was the case for the yen in the first half of its 10 year bull market. The hope of dollar bulls today is effectively that policymakers will guide a weak yen policy similar to what was said to be a weak US dollar policy from 1990-1995 in its day, with the aim of sterilizing their relative inflation policies and coordinating a global investment boom in perpetuity. In other words, its Japan's turn to bite the bullet so to speak.

Naturally, we might expect this coordination of monetary policy to continue indefinitely, with the US dollar only half way through its bull market (that started in 1995), and the next five-year period dominated by yen weakness as Japanese inflation rates are expected to begin outstripping US inflation rates as they did in the early eighties, in a bid to ignite a new asset boom in Japan (down the road) and save the global economy from deflation! no less.

There are big differences between now and then, however, in the context of this seesawing of monetary policy in order to stabilize long-term foreign exchange relationships, and sustain a global monetary boom indefinitely:

Today, the ability to devalue the yen rests with increasing the relative inflation rates in Japan (we're not talking about the CPI by the way) and a repatriation bid from Japanese assets to US assets. But while the Japanese may have had a surplus of dollar investments in the early nineties, to buoy the yen, there is no such surplus of Japanese investments by US interests today. There's just the ability to short them, and to carry on the yen-carry trade for as long as it will stretch.

Moreover, to legitimize the yen-carry trade, the dollar needs either a bull market in US shares or bonds, such that it's profitable to borrow in yen and play in dollars.

There is no other currency in the world dependent on an inflow of foreign savings to supplement investment policy to the extent that the dollar is today. There are many in the same boat, but not as large.

Dr. Yen Has It Backwards, the Dollar Is the Reserve Currency
On the other hand, there is hardly a currency in the world less dependent on foreign savings than the Japanese yen. This doesn't mean the Japanese economy is better, only that this is the way it is.

Of those countries, whose currency values are dependent on the uninterrupted inflow of foreign savings, many have seen their currencies devastated, as in Asia during 1997, or Russia in 1998, or the Latin American currencies over the past year. But these are the smaller replicas of the US monetary system.

Make no mistake, they are replicas. The US dollar is not invincible, and there is no sign of deflation. In fact the dollar is so wobbly, the Fed sent out their new guy (Bernanke) to deliver a speech claiming dollar devaluation as their idea, just in case the free market tears into it on its own accord in the near future.

The dollar is an international reserve currency, the yen isn't. Consequently, deflation and inflation don't spread from Japan, they spread from the United States, and what is happening is that dollar devaluation is going to cause deflationary symptoms every where else in the world including Japan. But it won't really be deflation.

Profligate US inflation policies tend to put pressure on trading partners to pursue the same policies or suffer a deflationary wrath, and sooner or later, if they don't keep up with US inflation rates, and similar policies, "relative" deflation is what they'll feel (feel is different than what is) as their currencies rise in value. Weaker currencies and monetary unions bust sooner if their inflation rates run too high, so they don't experience the deflation until later, when the value of the dollar falls.

Sooner or later, inflation is precisely what makes a currency weak. The schemes that have been put in place to support the dollar as an international reserve currency have been all but compromised by years of profligate money and credit inflation, and today, there are increasingly fewer candidates willing to make themselves the sacrificial lamb of US dollar policy. Japan's economy may indeed be in trouble, but so is the dollar, and dollar devaluation is about to throw the world economy into what will appear to be deflation, in as much as those foreign currencies rise in value, but what will actually be increasingly inflationary since the dollar is also everyone's reserve currency (i.e. the one most banks have most of their assets invested in). Such is prognosis of the Fed's inflation trap.

Will They Confiscate Your Gold This Time Around?
One of the questions investors often ask me is what are the chances that the Fed, or government, would nationalize the country's gold mines if they felt they had to - which means, to shift control over the means of production to the government in a vain attempt to guarantee the State a source of gold supply to sustain the value of the overvalued dollar.

I'm bullish on gold prices, obviously. In my view they could go to $2000 in the context of a primary bull market. Bull markets in gold can be quick, or they can be gradual, though even if they're gradual, they tend to occur over a shorter time frame than the typical bull market in paper assets we get in between periods of dollar devaluation. In my own market experience, bull and bear swings tend to over shoot more often than not. I know many of you would say the same. By the time gold prices would get anywhere near $2000 per ounce, we may be looking for an $8000 price, or maybe we'll be selling. Anyone that thinks they'll be selling before the rest of us is likely to sell way too early, while anyone not thinking about selling at some point is likely to be someone else's food.

It may be true that a bull market of that magnitude would reflect a global economic crisis. People don't like to be bullish on gold because they think they're being pessimistic on their economy. This could be corrected simply by emphasizing the truth that it isn't an economic crisis at all. It's a monetary crisis.

During such a crisis, the markets are trying to heal the economy, whose structure has been dislocated through the intervention of excessive inflation of money and credit in the prior years leading up to the crisis. These monetary cycles have nothing to do with capitalism, but some people would love to believe they do, since money after all is the basis of any free exchange of goods (which is what capitalism comes down to) and they are politicians employed in the manner of interfering with the free flow of capital and free exchange of goods with the aim of transferring wealth from hard working folk to lazy pompous bureaucrats who think they know everyone else's worth.

It's this system that breaks down when we have monetary busts. It's a political crisis, but it becomes an economic crisis to the extent most people have become vested in their corrupt leaders' ideas.

Here's the worst part. If the reaction to such a turn of events is to confiscate private property (in this case gold and gold production), it would bring further punishment to the economy, and by virtue, most people.

It would be like the kind of plundering of ancient civilizations' gold that the world's most inflation prone economies have historically resorted to. It would be imperialism at its height. It would be George Lucas' Star Wars coming to life.

In every instance, gold has got a bad wrap because it has been the lust of mankind's worst travesties throughout history, and so, there are those who believe it is itself the root of all evil, so to speak. Some people believe money is too, as if, without money, the people doing evil deeds wouldn't.

The truth of the matter is that the typical monetary bust drives gold demand, not some voodoo magic spell when it glitters. The inelasticity of supply is what makes gold prices so volatile, as the academics like to say. How would government control over the means of production alleviate that problem? I mean, it could in the short run, but in the long run gold supplies would have to be quickly exhausted.

Please Tax Us Some More
After all, it's the inflation policies that are well known tools of wealth transfer and hidden taxation, and which drive gold demand in the long run (i.e. when they fall apart, often unpredictably). This is the tax.

Every 17 or 20 years, whatever has been the case, we are taxed by the consequences of prior inflation policies, which is that we can't afford anything because the currency debases. This happens when they can no longer "control" the inflation. Then, when our kingdom needs to acquire more gold to sustain this ongoing looting of the people that work hard for their wealth, we send out an Inquisition to find the Incas guilty of not believing in our religion, so that we can confiscate their gold! It's not rocket science, just economics.

Can you see my point? So now when we see events unfolding that suggest we're experiencing one of these typical monetary busts, the idea that nationalizing the gold mines could be a remedy has surfaced. Politicians are seen to have little trouble persuading people that this is where FDR went wrong, that he should have not just outlawed gold ownership, but also that he should have outlawed private control over the means of gold production.

Gold is still the bad guy. We can continue plundering each other so long as we have a scapegoat, is that it?

Look, if one accepts that the great nineties bull market was at all a bubble then they must also acknowledge it wasn't real by definition, to one extent or another. If it wasn't real, it was the result of inflation, or too much money (currency and credit), as it always is.

Now, if that were the case, duh, how would the abolition of gold ownership and/or the private control over the means of production solve that problem, or prevent it from reoccurring? If not gold, who or what could discipline reckless monetary policies? Larry Kudlow?

No way. You see, gold isn't the problem. Neither is money. The problem is too much (easy) money. It's impossible and calculating to isolate the aftermath of such policies from their prior contribution to the crisis at hand. But this is what is effectively done when remedying the crisis by alleviating the symptoms, as if there wasn't already a cure.

To Be, Or Not To Be, That's The Fed's Question
Granted, the cure is hard to swallow. It would taste worse than the oldest and warmest cod liver oil you could imagine. The cure is to abolish central banking and embrace private property. They can't coexist, which is why the answer to the question at hand today is going to come down to a choice between abolishing the Fed and abolishing gold ownership/production.

Those fearing an assault on gold ownership fear that presented with the choice, people will opt for a scapegoat and take the path of least resistance, a reasonable expectation in light of events.

Other people, such as Mises, like(d) to believe there is nothing the government could do to win in the end. He believed in the power of the market not only over the other economic alternatives, but also over the ignorance and corruption of a society bred under generations of inflationist doctrine. Of course, he also didn't mean that government couldn't grow; just that there was no end that could justify it, and that every attempt by the government to overcome market discipline must inevitably fail.

Personally, I'm mixed.

Today, It Would Be A Buy Signal
However, I do believe "the crisis" (bust) has a ways to unfold, yet, before this choice is brought to bear, and that investors will stand to make much more money between now and then by investing in gold and gold shares rather than betting on the house. I believe that before this choice is seriously considered, dollar devaluation will have at least been tried if we're wrong about the market dictating it. I think gold prices will be much higher than they are today, so the risk to our gold positions today stemming from the nationalization of gold production in the future I believe is minimal, particularly relative to the alternative investment classes.

In fact, even the prospect of serious consideration to such a scheme by any important government body today would be a bull market signal like you wouldn't believe.

For, the one thing holding back a gold bull market today is the question of whether gold is really money. If the Fed or Treasury were to bring up the prospect of nationalization today, when they're still trying to keep the strong dollar, and while the bullion banks are still short, they would be shooting themselves in the foot. It would be an admission that gold is money, which is the one thing they've worked very hard to keep from people for decades.

Even Roosevelt's administration realized that they had to devalue the dollar first to make their plan of restricting gold ownership work.

There is no way that such a plan is bearish for gold at current prices.

The ability to expand credit and money without resulting in an instant proportionate devaluation of the currency rests 100% to the credit of US dollar policy, and the ignorance of economic participants, to the extent they aren't able to differentiate real economic activity from nominal economic activity at any rate.

So to ask, "Why couldn't they just print all the money they needed to buy the gold producers outright," is to not realize that they don't print money. They print (create) currency and credit, and fool us into thinking its money. The moment that the nationalization of the nation's gold mines became a serious consideration, therefore, the jig would be up, we would know the dollar wasn't money. The market would first have to adjust to the new perception, and they could print all the currency they wanted, but still couldn't afford to buy the gold production because gold prices and gold stocks would rise incredibly fast.

Of course, the government could come out and tell gold producers they have no choice but to sell out at a fixed price (below the real market). But your guess is as good as mine is in determining what value gold would have to rise to in order for such a plan to become politically feasible in what is still the most free market nation in the world. In other words, the mere threat of gold's ascent isn't likely to initiate the scheme.

Thus, I consider the question of gold ownership restrictions and the nationalization of gold mines moot at current gold prices.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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