Premise #3: A Falling Dollar
In March of 2002, I wrote an e-letter entitled "King Dollar and the Guillotine," which as the title suggests was a quite negative view of the future prospects for the dollar. Two weeks earlier, I had written a bullish letter on gold, having been bearish (really more agnostic) on gold for years. Since that time, we have seen gold and the euro rise over 50% from the cycle bottoms in dollar terms. Other currencies have not risen against the dollar at all. The Chinese Renminbi is exactly where it was and has been for many years. Almost three years later, we will review the future prospects for the dollar in this week's letter.
This is the third in a series of letters in which I review my major investment themes. The first two were on secular bear markets and the Muddle Through Economy. You can find them at the archives at www.2000wave.com.
But before we get into such weighty matters, I have had more than a few readers ask me to comment on the upcoming election. Of course, most of them know I am a Texas Republican and have a pretty good idea who I will vote for next Tuesday. They just want me to say something good about Bush or bad about Kerry. I am not above a little partisan politics, having served on the Executive Committee of the Texas Republican Party when President Bush was governor. But I am going to leave that partisan debate to other more skillful writers. The beat we cover here is money.
What I AM going to do next week (assuming we know who won) is focus on what the next four years will be like in terms of the economic and political climate and what will be the effect (or lack thereof) on the markets. In terms of the economy, whoever wins has a daunting challenge with remarkably few tools to bring to bear upon the major problems. Fortunately, we as investors do not have to sit back and do nothing. We do have the tools. It should make for an interesting letter. But back to the dollar.
The trade weighted dollar fell from around 110 when I wrote in 2002 to 85 early this year and has gone sideways since then. Even with the rather significant drop in the last few weeks, we are only roughly back to where we were in January against the major currencies. One final note, the trade weighted dollar is back to where it was in late 1996 and even 1991.
The Federal Reserve defines the trade weighted dollar as "a weighted average of the foreign exchange value of the U.S. dollar measured against a subset of the broad index currencies that circulate widely outside the country of issue." What that means is they look at the countries with which we trade and create an index based upon the average of their currencies. The more we trade with a specific currency, the more "weight" it has in the index. That is why the euro can rise 50% and the dollar only fall some 25%. The currencies of Japan, Mexico and Canada are in the index, as well as that of China. The dollar has risen recently against the peso, is flat with China and has not moved all that much in terms of many of our Asian partners. The euro has taken the brunt of the declining dollar.
I am still bearish on the dollar and will list the reasons in a few paragraphs. But before we start, let's take a deep breath. The dollar falling is not the end of western civilization. It is not some calamitous event which will shake the US to its core. It will have consequences, of course, but far less import than the problems a secular bear market will have upon our portfolios. It is, however, a trading opportunity.
I invite you at some point to go to http://research.stlouisfed.org/fred2/series/TWEXMMTH/95/Max. This is the St. Louis Federal Reserve's web site with hundreds of tables listing every sort of economic data that you can imagine. The link is to the long-term history (since the early 70's) of the dollar. The index began in 1973, and we can see several major moves. The dollar went sideways to slightly down for eight years from 1973. The real rise began from the high 90's in 1981 to 140 in 1985. It then dropped to around 80 by 1995 before rising back to 110 in 2002.
The point is that a drop of over 40% was not noticed by most of America in the late 80's and 90's. Unless you were traveling overseas, you did not see much difference. The economy grew fairly well throughout the period. Inflation continued to fall. There were some great trading opportunities and many commodity traders made their reputations and fortunes in that period. In fact, the recent drop of the dollar has not had that much of an affect upon the average American (again, unless you travel). Some industries are helped and some are hurt, but most of us just plow on ahead.
But it was certainly not a disaster. The valuation of the dollar is a symptom, not the problem.
Secondly, we should take note that currencies are the one market in the world where profit is not the end game. In stocks, bonds, commodities, real estate and anything else that moves, the object is to make a profit.
Currencies are a manipulated market. They are manipulated by central banks of sovereign nations who make decisions about what the level their own currency should be for the own economic and political purposes. That makes them volatile and very difficult to predict in the short term. In the long term, the markets work. But it can be much longer than most people think. Now, with those caveats let's proceed. I am going to work very hard to condense my thoughts, because you could make a book out of this topic. Indeed, Richard Duncan did an excellent book called The Dollar Crisis. My own book has several chapters on the dollar.
It's All About the Trade Deficit
There are many reasons to be concerned about the dollar, but the number one reason is the trade deficit. It is now at $600 billion and rising. I readily acknowledge there are those who say deficits do not matter. In the short term, you can make case for such an argument. But over the long term, I am at a loss to see how you can make such an argument.
Yes, $600 billion is a fraction, and a very small one at that, of the annual international currency market, which trades $1.2 trillion every day. I understand that the US is a very desirable country to live in and in which to invest and do business. I understand that $600 billion is less than1% of our total national assets. I understand that our intellectual capital is a huge selling point. As many have pointed out, the dollar is holding its own this last year.
Most of the above were true a few years ago, and the dollar still dropped since 2002. While the above reasons may make dollar bulls feel better, it seems to me like they are whistling past the graveyard. They really do not have much to do with currency valuations.
I have often quoted from a Fed study which shows that any time a country gets to a 5% trade deficit, there follows a sharp correction (usually 20-30% or more) in the value of its currency. We have been there for some time, and are going higher. The rising price of oil almost guarantees the deficit will rise.
Why have we not seen such a correction? As noted above, currencies are manipulated by governments for their own benefit. There are governments who believe it is in their best interest, at least for now, to keep the dollar propped up. (See more below.)
The Fed Will Not Protect the Dollar
As Bill Gross of Pimco noted this week, the Fed is between a rock and a hard place. (www.pimco.com)
"Despite candidates' insistence that this is the most important election of our lifetime, I suspect that the ones in 1980 and 2000 were more important, and the latter was decided by 500 votes in Florida or the U.S. Supreme Court depending on your political persuasion. Four years later and much deeper in debt, there's little either candidate can do to stop the near inevitable hegemonic (not hedonic!) decay. It's really quite simple you know. Asia has hollowed out our manufacturing base and is now making inroads into services. Job growth is and will continue to be hard to come by. To compensate we temporarily turned ourselves into a finance-based economy, dependent on paper profits and capital gains that in turn were driven by the march to historically low interest rates. That journey ended sometime over the last year or so - some marking their hegemonic calendar at June 13, 2003, the 3.13% low of the 10-year Treasury, others signaling the beginning of the end on June 29, 2004, the point of the Fed's first cyclical hike in short-term rates. Whatever, whenever. If the driver of profits and job growth is the price of money as opposed to domestic investment, it should come as no surprise that when the price goes up, the good times fade away. Either Bush or Kerry - Hillary as well - will have to contend with this near inevitability....
"My/our most certain idea, as expressed in previous Outlooks, is that real interest rates in the United States will have to be kept low, that the old Taylor rule is out. Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing; it leads to asset bubbles, potential inflation, and a declining currency over time."
If the Fed raises rates too far, too fast it will slow the economy and bring on a recession. If it keeps rates low, it risks inflation and a falling dollar. As I have written on several occasions, members of the Fed have let it be known that a little inflation buffer is not a bad thing if it is the price of protecting us from deflation during a future recession.
Inflation, however, is not good for a currency, as Gross and practically everyone else has noted. But the Fed does not care about the dollar. They will not willingly watch the economy wilt in an effort to protect the dollar. The only central banks interested in protecting the dollar are across the Pacific Ocean.
How High Can the Euro Rise?
The euro was launched January 1, 1999 at 1.21 to the dollar. It "promptly" (over a few years) fell to a low of $0.82. Today it is at $1.27 and change. The British pound and the Swiss franc have traded roughly in concert with the euro. I have been in London, Paris and Geneva this past year. I am amazed at the prices of ordinary items in terms of dollars. I wonder how people can afford to live. $25 to take a family of four to McDonalds? $2 cokes in the stores and $6 cokes in the hotels in Geneva?
Yet, the "locals" don't think much about it. In terms of their currencies, there has been little inflation. Things roughly cost the same as they did a few years ago. While we have seen gold go on a tear in dollar terms, there is no bull market in gold in Europe.
Our trade deficit is far higher than it was almost three years ago when the euro started to rise. Can the euro rise another 50%? I seriously doubt it. Such an imbalance in the world would reap a harvest of trouble.
It could rise another 20% to above $1.50. While a long way from $0.82, in one sense, this would not be far from the value of $1.21 that the European Central Bank originally placed on the euro.
In the last three years, the euro has done the heavy lifting of dollar devaluation. China has helped not a whit. Japan has protected the yen, aggressively buying dollars. The rest of Asia has followed suit, making sure their products would not be at a disadvantage to the American consumer. It is called competitive devaluation and has been the dominant theme in the currency markets for many years.
The Chinese Lynchpin
How long can the dollar go sideways or avoid another significant drop? As long as China, Japan and the rest of Asia continue to want their currencies in rough balance with each other. And that might be a long time.
I still believe the lynchpin is China. When they decide to allow the Renminbi to float, then other Asian countries will follow. It will not be smooth, as one can make a case that Chinese citizens will actually want to move some of their money abroad and will buy other currencies. But over time, the dollar will head south and balance against the Chinese currency.
The longer the current competitive devaluation scenario continues, the greater the problems for Europe and countries which hold to a sound monetary practice. Not only do they see their American competitors get a currency advantage, they lose "share" to Asia as well.
Supposedly, the Chinese are set to float their currency in 2007 due to a World Trade Organization treaty. In global terms, that is almost tomorrow. The prediction is that they allow the currency to float in "bands," controlling the movement and hopefully keeping it from becoming too volatile.
(I say supposedly, because I do not think the Chinese will do anything they feel is not in their best interest.)
Things may be changing. The Korean Won has risen 6% this year, the second best currency against the dollar in the world. Canada is #1, barely nosing out Korea.
And another interesting sign that has not been picked up on in the western press, but I think is quite significant. Everyone knows that China raised its interest rates this week, as part of an effort to slow the economy and bring it to a soft landing rather than waiting for the usual boom-bust cycle. Oil fell quickly, as oil traders believe this means less demand from China. That will not be the case, but that's a story for another letter.
But the Chinese also made a significant change in their lending rules. This interesting note from GaveKal Research in Hong Kong:
"On Wednesday, the Goldman Sachs commodity index dropped -3.7% (the biggest fall in over a year). This fall followed sharp reversals in a number of metal prices last week (since their Oct 11th highs, copper is down -14% , nickel is down -20%... ) and coincided with overall weakness on most China related equity plays (H-shares have fallen -5% over the past three weeks). Initially, we felt that this brutal turn-around in China-related plays did not jive with the bullish news coming out of China. But following yesterday's interest rate increase by the People's Bank of China (PBoC), the above weaknesses make a lot of sense (needless to say, we would never suggest that Chinese officials in the know front-ran yesterday's move).
"The market's reaction to the Chinese interest rate increase is, we believe, quite interesting. Judging from the market opens here in Asia, the perception is that the decision by the PBoC to raise interest rates by 27bps to 5.58% (for one-year lending) and 2.25% for deposits is a bearish development. But we disagree.
"For a start, given China's growth rate of over +9% and inflation of +5.2%, interest rates had to increase. With yesterday's increase, real interest rates are finally out of negative territory.
"For seconds, the important element in the PBoC's move is not the marginal increase in interest rates, but the elimination of caps on RMB lending rates. Previously, since Chinese banks were restricted to charge customers no more than 1.7 times the official lending rate, only the most connected of borrowers had access to capital. This restriction made it practically impossible to lend to new small businesses and consumers; and consequently sparked a wide-spread black market of predatory loan sharks lending. Yesterday, China was a country with a low cost of capital, and a low of availability of capital for anyone who was not connected. After the PBoC move, China is a country with a higher cost of capital for big politically connected companies, and a lower cost of capital (and wider availability) for everyone else. This is to be welcomed.
"As we see it, yesterday's move to abolish the credit restrictions is good news and implies that China is taking another step towards bringing its banking system closer to international standards. We always like a deregulation and we believe any potential sell-off on this rate hike should be viewed as a buying opportunity."
This is another necessary step for China to make in order to be able to float its currency without undue disruptions in their own economy and also develop a market based banking system and economy. It indicates that they know where they need to go and are making progress, albeit at their own pace.
The Dollar: The Good, the Bad and the Ugly
A few weeks ago, I quoted Martin Barnes of the Bank Credit Analyst about his views on the dollar and the Fed. It was a great analysis and bears repeating, and so I will.
If we do not see 4% inflation and 4-5% short term rates between now and the next recession, which I do not think will happen, the Fed will be forced to use what Ben Bernanke calls "Unconventional Weapons" to keep from having an "unwelcome drop in inflation" otherwise known as deflation or Japanese disease. As I noted in a recent letter, he suggests moving out the yield curve and possibly fixing the rate on ten year notes for a period of time at a rate which would significantly lower mortgage rates and encourage investment (or at least speculation).
Of course, this will not be good for the dollar. The normally upbeat (and always on target) Martin Barnes of Bank Credit Analyst recently released a report on the problem of a low US savings rate. Since I cannot come close to doing as good a job as he does, let's look at how he summarized the problem:
"From a medium-term perspective, the problem of low U.S. savings and a large external deficit can play out in one of three ways. Let's call these scenarios the good, the bad and the ugly.
"The Good - In this scenario, the adjustment to lower imbalances is entirely benign. Continued strong productivity gains support steady growth in real incomes, and allow profit margins to hold at a historically high level. Steady income growth allows consumers to both gradually rebuild savings and sustain spending at a decent pace. Meanwhile, the government takes action to cut the deficit in ways that do not overly restrain private sector demand. Finally, strengthening overseas demand boosts U.S. exports, and a steady but panic-free drop in the dollar helps boost U.S. competitiveness. In this near-perfect scenario, the pace of economic growth averages close to potential and inflation stays low. Equity prices grow in line with corporate earnings, and overseas investors are happy to keep buying U.S. assets. The current account deficit slowly shrinks.
"The Bad - This scenario involves more pain for the economy and markets. Consumers embark on a more determined rebuilding of savings, causing a major headwind for spending, undermining profits and leading to below trend economic growth. Weaker corporate cash flow and a rising federal deficit make it harder to rebuild national savings. The dollar suffers a much steeper decline than in the previous scenario, to the detriment of the stock market and credit spreads. A slowdown in U.S. demand growth does curb imports and, together with the much lower dollar, reduces the current account deficit. However, the world economy is adversely impacted by U.S. trends and export growth is also affected. The ultimate outcome is a U.S. recession and an equity bear market.
"The Ugly - This is where the markets riot in order to force a change in trend. A vicious plunge in the dollar triggers a crash in equity prices and risk spreads spike higher. A credit crunch takes hold as the credit markets seize up. The Fed eases aggressively, but that just feeds further dollar weakness. Central bank intervention is not able to stem the hemorrhaging of capital leaving the country. The economy grinds to a halt and a long-overdue consumer retrenchment occurs with a vengeance. With profits also imploding, employment falls sharply, encouraging further consumer cutbacks. The economy is at the edge of a deflationary precipice and policymakers are relatively powerless because there is not much fiscal or monetary ammunition to deal with the crisis. The current account improves dramatically, but the adjustment is extremely painful. The global economy is severely impacted, not only by a U.S. economic downturn, but also by the deflationary effect of a sharp appreciation in overseas currencies. This encourages protectionism and attempted competitive devaluations in the major regions, but that just makes markets even more volatile.
"Greenspan is banking on the 'Good' outcome, judging by the quote shown at the start of this article. However, the odds of this fairy-tale scenario may be no higher than 25%. The probability of the 'Ugly' scenario is also relatively low, perhaps also about 25%. That leaves a 'bad' outcome as the most likely.
"In all scenarios, the dollar is headed lower. Also, it seems that a major adjustment to the saving rate and the current account will likely occur only in the context of a recession and equity bear market. That could still be a few years away, implying that the U.S. will live with its imbalances for a while longer."
Whichever scenario, and right now I think the bad scenario is more likely, it will not result in a powerful economy. All scenarios point to a Muddle Through Era and a continued (or renewed) fall in the dollar.
So When Does All This Happen?
As I wrote three years ago, this is going to be a long process. And for that we should be grateful. The longer it takes for the world to re-balance from a US-centric world where we are the main economic consumer engine to one where consumption and growth are more evenly balanced, the better.
Look at the Fed chart I first mentioned. Notice that long-term currency moves are not one-way. They can be quite volatile. While I am still reasonably confident that the dollar drops over the next few years, there will be more years like 2004 in front of us. I would not be surprised to see the euro go back to $1.20 before it gets to $1.40. These things ebb and flow.
Speaking of ebb and flow, the dollar is not on some permanent downward path. It will find a bottom, probably ridiculously low, the trade deficit thing will get sorted out and then the dollar will start to rise. As an example, I think Europe has more long term structural problems than the US (I am speaking in terms of decades, not years) and would not be surprised to see the dollar and the euro at parity in 10-15-20 years. The more things change....
Where is the fly in my projection ointment? The one thing I worry about is that there is something "new" happening - a fundamental shift in the nature of how the world works. For instance, something on the order of an Industrial Revolution. Such a structural change is usually not apparent until after it has developed.
We don't think of trade deficits between California and Alabama, or Texas and Oklahoma. Or between Perth and Sydney or Yorkshire and Wales. Yet there must be. They are just not relevant. We are a long way from the time when the world is so globally linked that such thoughts are an anachronism. But it is happening faster than most of us imagine. What is the tipping point? Such an event will mean deep structural changes, and I believe a loss of control by central banks, which is a good thing.
Of course, my dollar scenario is good for gold and other commodities. But we will deal with that in a later letter.
Elections, Polls, Stanford and Deadlines
I have done my part. I now have five kids who will vote next Tuesday. Sadly, none are in Ohio or Florida, where they might be needed more than in Texas (or not, depending upon which horse you are backing in the race.)
As noted on the first page, I was an active part of the political process for many years (although lately not as much due to business obligations). I go to www.realclearpolitics.com nearly every day to check on the polls, to get a sense of the way the tide is drifting.
Looking at the polls clearly suggests this one is going to be close. However, I am not so sure that we can trust the polls like we used to be able to even a few years ago. More and more voters are truly independent of their phones and do not get polled. They use cell phones, block calls to their regular phones and use voice mail. They are gone, out and about, on the weekends. I know the polling pros try to factor for this, but I am not sure they have it down pat yet. Do you know anyone who has been polled?
When you look at some of the internal questions and answers in these polls, there is a discordance that makes this political observer raise his eyebrows. I hope that whoever wins next week does so with a clear majority. I would not be surprised if this will be the case. In any event, we will hopefully know next Wednesday.
I gave the wrong dates for my trip to Stanford to speak at the Accelerating Change 2004 conference. It is next weekend, Nov. 5-7. For more info, go to (www.accelerating.org).
Dr. Gary North, who writes more on so many topics than any other ten people I know, has the discipline to set writing deadlines and make them. I admire his diligence and ability. He has a great line about deadlines. He says that he is going to have the following words carved on his tombstone: "Oh Deadline, Where is Thy Sting?"
The deadline is now approaching. Not just for this letter, but for the election process. There is always a relief when deadlines are behind us. Sometimes, like this week, I get to the deadline without having enough time to go over the letter and find all those nasty little typos. You know, the ones where Microsoft Word helpfully corrects my misspelled words. Like last week, I ended up with stair rather than stare. But it is time to hit the send button, and move on to next week's problems.
Have a great week, and here's hoping we do not have to worry about hanging chads, pregnant chads and missing votes next week. If we do, someone should get hung.
Your 'hoping Karl will work his magic one more time' analyst,
Copyright ©2004 John Mauldin. All Rights Reserved.
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.