October 27th, 2008
I think it´s safe to say that most market commentators have been thoroughly suprised at the fact that the dollar has gained heavily against most currencies, aside from the Yen. In retrospect, it somewhat makes since, especially when you look at an instance like Iceland. With the EU, the diversity that the currency gave you during the good times made it much more favorable than the dollar. However, with the bad times, the exposure you have to all the different European Union countries makes it more problematic than anything. Because of T-Bills and the U.S.´s ability to act autonomosly, quickly, and with relatively little needed consent compared to the European Central Bank (ECB), I can understand why people would rather be exposed to dollars at this point than anything else. The only question is, will the trend last?
Massive Printing and Lending: Will They Be Able to Mop Up the Liquidity in Time?
With all the bailouts, incentive spending and direct investments, theoretically the government only has three ways to create this money: raise taxes, print more money or borrow. The first one is garbage: after Herbert Hoover made that mistake in the Great Depression, no one would even dream of trying to boost taxes. Because of this, we´re left with two options. Printing money obviously leads to inflation, because now there´s more money supply, hence the relative value of each dollar goes down. With borrowing, the value of the dollar is theoretically preserved, however the chance of the U.S. defaulting goes up, thus lessening the demand for dollars and dollar investments.
Either way, it would seem to point towards much higher than 3% inflation. Unless of course, there was someway to mop up all the liquidity. The Fed could do this by raising the Fed Funds target rate, and thus reduce the money supply. However, the question is whether they´d be quick enough on this. Also, there´s the question of what happens if America´s lenders throw up their hands and say ¨no más¨. Theoretically, they all have a vested interest in propping up the dollar, because so many of their investments are in dollar denominated debt. Hell, Japan survives economically by maintaining a favorable exchange rate with the U.S. and exporting to us. But what happens when a few of the countries say ¨well, we´ll just reduce our supply of lending a little bit¨, or ¨we´ll just sell a little bit¨. If one nation does it, that´s probably ok, but if one starts, others will follow to try and get ahead of the tidal wave.
This is a pretty apocalyptic scenario, but it´s the downside risk, of course, especially when you consider how much debt we have as a nation. Looking at the U.S. debt clock and dividing that amount by GDP, U.S. debt represents about 70% of annual GDP. Theoretically, you can go much, much higher and still be ok, but the problem is the U.S. has neither trading nor fiscal surplus´, meaning that the debt would be expected to increase. You extend that situation out on a long enough timeline and it´s not a good sign.
So Which Way Do You Call It?
The problem right now is that either way you go, whether going long dollars or short dollars, you´re risking a whole lot. My short dollar bet would be something like gold, silver or commodities, which have been absolutely punished as the dollar has gone up in value. Thus, if this trend continues, we might see gold pushed to the $600, potentially even $500 region.
That being said, if the dollar starts falling, my prediction is that gold is going to go up pretty substantially as people start taking their gains in dollars and making the move over to gold. Thus, you have this sort of guillotine effect: if you´re right, you´re really right, but if you´re wrong, you´re really wrong.
Because of this, I think that a policy of holding on to cash and seeing where the currency trade goes is a good bet. I think in the short term, the dollar is likely going to rise, although I see this path getting steaper and steaper as the dollar approaches 1 to 1 with the Euro, and people start questioning whether there are fundamentals to support this exchange. Especially after the commodities bubble this summer, when shorting the dollar and going long oil seemed like a slam dunk, I think you´re going to have a harder and harder time convincing people that there´s rationale at this level. I´d say that under $600, you should definitely be picking up gold, although under $700 would be a good point if fundamentals aren´t changing. At that point, upside starts looking in your favor, since I think a serious dollar selling rush could easily push gold over $1,000 an ounce.
That being said, right now we´re in no mans land, so I think you really have to sit on the sidelines and watch, lest you fall prey to the market guillotine.
Disclosure: the author of this article is long GLD, DGP, SLV, SIL, FCX and trying to build a position in EDD
Questions? Comments? E-mail me at thesaneinvestor@yahoo.com
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© 2008 Andrew Jarmon
With news yesterday from Reuters after market close that the treasury department would invest “$5 billion in equity in auto and mortgage finance company GMAC” and increase “a loan to General Motors by $1 billion” using money from the $700 billion bailout fund, the plot thickens for Detroit’s finest as the battle for the American car company bumbles along. The equity investment, one of ”senior preferred equity with an 8 percent dividend”, certainly doesn’t leave much to be desired in terms of returns, presuming the company does not declare bankruptcy. Although the investment seems like a drop in the bucket after the whirlwind of other rescue packages and the $50 billion in loans that the Big 3 were requesting, the precedent that it creates may be anything but. (more…)
