I am watching the happenings in Venezuela carefully as this might be an indication of things to come in the US. While most people naively think that “it can never happen here” I would like to warn you that every country where these things have happened uttered that exact same phrase. Whether it happens because the Federal Reserve loses control over the devaluation of the USD or because foreign debt buyers just stop buying US debt the one thing I am sure of is that it can and will happen here at some point in the future.
What I am talking about is massive devaluation of the currency which leads to inflation or, in this case, hyperinflation. I have stated that for the moment we do not have to worry about inflation, and I stand by that prediction, for now, at some point we will have to cleanse our demons and massive balance sheet. The one and only thing that is saving us right now from inflation is our pitiful employment situation, which is not getting any better I might add. Without employment there will not be wage inflation and we will continue to have subdued demand for products with the exception of food and energy.
Even though I fully believe deflation is here for the near-term, reinforced by the Fed itself, there is one caveat to my prediction, the devaluation of the USD. I have made no secret that I believe that the Fed and the current administration, along with the former administration, have had an unofficial policy of maintaining a weak dollar. The reason for the weak dollar policy is simple, it boosts GDP and earnings in a globalized world along with a host of other seemingly positive economic stimulus. However, a weak dollar is not good long-term for a country and hurts the population as dollar sensitive products become very expensive, i.e. $140 a barrel oil marks the low point of the USD in 2008, and is inflationary without the benefit of actual inflation.
Let me explain, inflation created by excess money printing usually enters the banking system and is loaned out to the population. This is called money velocity and creates too many dollars chasing too few of goods. However, without money velocity traditional inflation cannot happen, but even if the excess money printing does not enter the economy it can still devalue the currency based on the future expectation of it entering the system. This is what was happening up until the last dollar rally and I would like to point out that the last dollar rally was because, depending on who you listen to, short covering, fear about sovereign default (i.e. people were afraid of another systemic meltdown which, in turn, initiated short covering. This is the scenario I favor), or people felt the Fed was actually going to raise interest rates which is absurd, in my opinion.
The dollar devaluation that we have seen explains why oil prices are on the rise as demand simply is not there. It also explains why metals have also climbed for most of 2009 as well. What is scary about both oil and metals going up, especially in 4Q09, are the fact that these prices increased in the face of a stronger dollar which is counterintuitive. Well, it is for gold at least as oil could increase with a strong dollar if there is sufficient demand, but, frankly, there is not as much demand as the price indicates. Regardless, rising energy prices when the economy is weak, to me, is a warning sign of a problem and should forewarn you of things to come, inflation.
If we continue with our insanity that Washington and the Fed is telling us we need it is inevitable that we will end up in a situation like Venezuela where we will either willingly or unwillingly have to devalue our currency. There are pluses to devaluation as your debt, assuming a fixed interest rate, will remain static and your earnings will eventually increase allowing you to pay off your debt faster. However, the negatives outweigh the positives by a long shot as your savings are worthless. This is why we saw the people of Venezuela go out and buy everything they could because goods will be worth more than the paper money.
What is disturbing though is the fact that even though devaluation creates higher prices the Venezuelan government shutdown some stores for “price gouging” which is humorous, in a sick way. The government intentionally creates inflation to make their balance sheet look better, but because new goods will cost more stores cannot compensate by charging more for products they currently have. How in the world are these stores supposed to stay in business or id the governments point to put them out of business? The next logical question to ask is how would this type of scenario play out in the US?
While we do not really have any past history to use as a bench market I think what we see happening in Venezuela is probably a very good example. Right down to the black markets that are more than likely popping up all over the place to provide goods and services the population cannot receive from the usual sources. What I would be interested in knowing is if these black markets are using another medium of exchange, i.e. US dollars, gold, silver, Euros, whatever it might be, to pay for these goods and services. I would be inclined to believe that is what is happening, but there is simply no proof and I am willing to bet no one wants to openly talk about such things for obvious reasons.
What is usually accompanied with this type of devaluation is the government imposing its will that its citizens continue to use its currency no matter what. We saw this happen in Zimbabwe, but just like in Zimbabwe the black market switched over to an alternative payment system, gold. It is important to note that gold is being used because dollars or other currencies simply are not plentiful in the country and gold can be mined, of course gold has also been used as currency for thousands of years as well and at current prices a little bit goes a long way. Basically, forced price controls and forced use of devalued, or worthless, currencies simply do not work, that type of system never has in 4,000 years.
I am not suggesting the US or Venezuela will turn into Zimbabwe, but I am saying that we are facing certain financial Armageddon at some point in the future. All the US has managed to do is kick the can further down the road for others to manage and we are running out of road, unfortunately. We will have only a few choices in the very near future and the most obvious, because it is politically easier, is to inflate our way out of our problems. While this seems like a good idea I am thinking that the 77 million soon to be retired Baby Boomers who are about to be living on a fixed income will like this strategy. However, it is unlikely that they will like the alternative either, much higher taxes, less Social Security and steep cuts in Medicare.
We live in unique times and the one certainty we have is that there is no certainty of anything. I do not believe that there is any question of whether or not we will follow Venezuela, in my mind it is only a matter of when it will happen, not if. However, before we go down that road you will be comforted in knowing that Japan or the UK will more than likely go down that path before us as they are in worse shape than the US. Regardless, watching what happens now will give you an idea of what could happen here and is also why I am a big proponent of investing in precious metals.
So far holding gold, silver, platinum or palladium has been a very sound move on my part, but I actually hope that these investments turn out to be horrible for me because that will mean I was wrong about the future of the US monetary system. While I might be wrong what concerns me is that there are many people who are a lot smarter than I who are sounding the same alarm I am. I would also like to not be naïve enough to believe that “it could never happen here” either because I am sure there are millions of people throughout history who would tell us that you should never, ever, utter those words because no person or country is special.
Regular readers know that I am or have become a bigger proponent of income investing lately and if you don’t know what I am talking about you should be reading my material more. However, there seems to be preconceived disconnect with my philosophy and what you believe to be true about interest rates moving forward. Some people see my bullishness on bonds in the face of rising interest rates as purely insane, especially given what treasuries are doing, but I can assure you it is not.
Keep in mind I am talking about investment grade corporate bonds and high yield bonds, my favorites are ‘BB’ and ‘BBB’ rate paper in an ETF format, I do not like mutual funds because of the once a day pricing. As an aside I do like selective sovereign debt as well, but don’t go out and buy Eastern European government debt or anything, be selective as the risk return is there, but supply is going to be an issue moving forward so it will pay to be extremely selective in 2010. Anyhow, back to corporate debt and why I like it.
Treasuries are entering a bear market for the first time in my memory and I expect there to be a bear market until the next crisis hits, so for only a few months. The reason there is a bear market is simple, supply, end of story. You cannot issue an endless amount of paper and expect the market to eagerly accept it without paying more for it because people, foreign central banks in this case, know they will never fully be repaid for the US debt they buy now, it is mathematically impossible for the US to repay its debt so don’t shoot the messenger hate the calculator. Because of that mathematical probability interest rates on treasuries are going higher and, according to those wonderfully bullish, and misguided, government data figures investors are pricing in interest rate hikes which kill treasuries and other high grade corporate debt, high grade being the operative word, so remember that please.
High grade corporate debt is technically, and in my opinion, anything rated higher than ‘A’ and issues interest rates slightly above treasury yields. We are talking about your really safe corporate paper issued by IBM and similar firms. Essentially, those are a riskless investment which is why your yield is so close to treasuries and why those bonds will get crushed when/if interest rates go higher. For those who do not understand how bonds work think of bonds and interest rates like a teeter-totter with interest rates on one side and bond prices on the other side, when one goes up the other side goes down. Therefore rising interest rates are bad for bonds because new bond issues will have higher yields so your existing bond will have less appeal in the marketplace and if rates go down new issue bonds will have lower rates which means your existing bond will be more attractive because it has a higher interest rate. Make sense, good.
All of that is important because we are at zero interest, technically we are in the negative interest rate area because of quantitative easing and deflation which is bond friendly. However, this red hot economy we are in, sarcasm is my trademark, many people are expecting an interest rate hike to happen at some time this year and they are right. The Fed will raise interest rates in 2010 from 0-.25% to .25-.50%, wow. There is an outside chance that rates may go to 1% by the end of the year, but that is pure speculation right now because the economic data or ‘recovery’ is spotty at best. Even if rates go up it is relatively meaningless to lower grade corporate bonds because it does not hurt the spread as badly as it does for higher grade corporate bonds.
What I mean is newer higher grade corporate debt and treasury debt will have higher yields than current issues so existing paper will get slammed. However, existing lower quality corporate paper will do OK as we would need rates to go up substantially in order to really hurt the spread. I am not saying that there is no risk in lower quality corporate debt, defaults will be a huge issue moving forward, but I am also betting that the Fed’s liquidity programs end up not going away either. In fact, I would speculate that the Fed’s balance sheet will continue to expand over the next 12 months, perhaps double again if the FASB gets its way and the SIV’s have to be added to banks balance sheets right away, but again that is speculation right now.
If the Fed does actually raise interest rates this would be a bullish signal to the markets because it means we have real growth in the economy as well. This means lower grade paper would perform better, even if that growth is only at lower levels. However, higher interest rates will not be good for stocks, in my opinion, which is why I shifted focus to lower quality corporate bonds and to companies like Alteria. I would not expect, even if the economy is cruising, to see rates go much higher than 1-1.5% though because the Fed is stuck and it cannot move rates higher or to a meaningful level ever again. Regardless, corporate bonds of ‘BBB’ or ‘BB’ and selective ‘junk’ should do OK moving forward in the face of higher interest rates because of what I said previously. We will not see huge returns like that of 2009, but I think they will do better than stocks moving forward, plus you are first in line when the company folds, something to think about.
Why the Fed is stuck
What do I mean by that, a meaningful level? You see, the US is in a debt trap that we cannot escape from, it is simple mathematics. The Fed will not be raising rates to protect the dollar, they want a weak dollar that is for another post, they do not really care about inflation as they really want massive inflation but we cannot create it. The Fed will raise interest rates to keep politicians off of its back and that is about it, but raising rates higher than 1.5% presents problems that the US cannot handle.
Congress just had to raise the debt ceiling by a few hundred billion to fund the government for the next 6-8 weeks, unbelievable, and a more ‘permanent’ fix of raising the debt ceiling to about $14T will be coming soon.
I know this is no big deal to liberal democrats because, after all, under Bush we had to raise the debt ceiling 7 times and to them 8 or 9 wrongs make a right, but this is a major, major problem. Considering that raising the debt ceiling to $14T moves the total US debt to just about 100% of GDP marks a new low for the US and is the greatest amount of debt any country has ever attempted. What I am saying is that our current debt servicing costs with the Fed holding rates at 0% and using QE is about $500B+ a year and our average maturity of our debt is less than 10 years, again this is a first in all of the world’s history.
If the Fed moves rates up past 1.5% then that debt servicing cost will go up, dramatically, and there will be major consequences that the American people are not ready to face. Forget the debt ceiling, we will repeal that silly little rule, especially since we have to raise it almost every year anyhow. Within 7 years out debt servicing costs will begin to take its toll on the national budget squeezing out typically paid for items, like earmarks. Defense spending will have to decline immensely which is why the US remains a superpower even though we have a relatively small manned military compared to say a China, India or North Korea. The dollar will decline much further, it will anyhow as the latest rally, which I anticipated, is a head fake and was driven by Dubai, Greece, Fear, short covering and the selling will comeback harder and faster than you could ever imagine.
All of the senseless spending is coming home to roost, now. China is telling us where to stick it as there is not enough dollars to buy our debt, which is kind of funny in a sick way, and they said no to strengthening their Yuan which makes sense for them and smells of protectionism to me. When we demand a foreign country make their products more expensive in the US just so we can shrink out trade deficit thereby boosting our GDP and sell more products to them that is protectionism, straight up. I do not like to be so grime, but many of the things I foresaw and have been keeping to myself are coming out in the open. Things are not good, but hey as long as the market keeps going up, who cares right? Well, you will when it comes crashing down around you. Fixed income never looked so attractive right now.
In a surprise move by Lazard Asset Management’s “The World Trust Fund” as dumped the USD as its primary currency in favor of the Sterling. Typically these funds trade in the USD, but the fund’s board apparently felt pressure from shareholders and investors to change its primary currency from the USD to the Sterling, one can imagine it is because of the recent slide of the USD from 89 to 75 in recent months impact the real return of the fund’s performance.
In the filing the fund stated that; “In response to comments from a number of shareholders and potential investors in the Fund about the liquidity of the Fund’s shares, the Board, having consulted with the Fund’s brokers, Arbuthnot Securities, believes that having a larger number of shares in issue with a lower share price than at present and changing the currency in which the shares are traded from US dollars to Sterling, should assist in improving the marketability and liquidity of the Fund’s shares and support the attraction and retention of a diverse shareholder base.”
That is a stunning statement to read and is a possible sign of the times as the USD is under pressure from every direction and in jeopardy of losing its reserve currency status. Lazard Asset Management is a rather prestigious firm and to make such a drastic move is shocking to say the least. Will other asset managers follow suit? More than likely, but only time will tell. However, if they do this will cause unneeded selling in the USD that could cause further declines given the large holdings of international mutual funds within the US.
This is something that I am keeping a close eye on and I suggest you do the same. As I have state before, much of your real return in the markets has been phantom returns because of the decline in the dollar and the same can be said about international returns as your assets are priced in the USD. If your international assets were priced in foreign currencies you would have had substantial returns this year, i.e. Brazil’s Real appreciated 32% against the USD, so if you invested in the BOVESPA in the Real you would have had an outstanding year. Of course, if the currency went the other way the opposite would be true, but given the fiscal largesse the US is under it is unlikely the USD will have any meaningful lang-term strength, apparently Lazard feels the same way.
There is no question that the cheap dollar has had its benefits for the US in the short-term. It has propelled earnings higher for most firms who deal internationally, narrowed the trade deficit and pushed stocks higher at the expense of our buying power. It has also pushed oil and commodity prices, mainly gold and other metals higher, as well as the dollar continues to touch new 52 week lows.
There is a point where the cheap dollar begins to lose its appeal and begins to concern traders and we have to wonder if we are there yet. After we breached the 76 level on the DXY I actually expected to see a rebound in the greenback simply because it is such a crowded trade and other countries have also printed vast amounts of their currencies as well. However, this seems to not be happening and we are at the point where the 75 handle is in jeopardy of being breached.
Frankly, at this rate we are heading right to the 2008 lows of the 71-72 levels and there is not much there to stop it from going lower. All I have to say is if you thought $147 barrel oil was bad, try $200 or more a barrel. Yes, it could get that bad and food prices could go up as well, even though we technically have deflation energy prices would and could create inflation. This would be catastrophic considering we have massive wage deflation and a huge unemployment problem right now. I am inclined to believe that the treasury or the Fed would intervene if we breached those levels, but my faith is not strong and given the trading programs and deep pockets of the banks, ironically, because of the Fed it could become a crisis.
The odds are against this happening, but it does exist. If this does happen it would also not be good for stocks as there is a difference between cheap money and worthless money. It is not like I am the first to warn of such a problem, Jim Rodgers warned of this type of currency crisis in the recent past and thought it could be either the USD or the Sterling, since we both started down the same destructive paths. I will say that I believe the next 2 weeks will be critical for the greenback and everyone should keep an eye on it for an indication of its direction. A steep move in either direction would mean a selloff in equities.
The internet is riddled with rumors of the imminent collapse of the US dollar with time frames ranging from hours to months away. Now, there are legitimate concerns over the value of our currency and clearly the only thing that has buoyed its value is the entire globe has printed money on a colossal scale. However, we have certainly done more than most when it comes to printing currency with our super bailouts and mammoth stimulus projects.
The question is when will the dollar collapse? There is no real answer to this question and that is the beauty of free market capitalism. The one thing I can say is this, on the short-term I am probably more bullish than I am bearish on the US dollar simply because everyone and their grandmother is short the USD and if/when US equities head south people will run to the dollar for safety. Proof of this was last year when the markets crashed and we saw the DXY climb to the high 80’s. However, I don’t think we will see that type of rally again if we see the markets tank this time around because the fundamentals are far worse than they were last year and the dollar is far more diluted.
On a longer term basis I am very bearish on the dollar and I believe when we see the Chinese Yuan or RMB float or if we see the IMF SDR issued in greater quantities we could see the US dollar lose its reserve currency status. Those who think that this cannot happen need to learn their history as it happened to the British and many other nations in the past and the US is no different. Given our debt load and the current administration’s willingness to spend money like it’s going out of style, on top of our staggering existing liabilities, we are in serious trouble. Not only has that, but the rebalancing of central banks as of right now proved that they are not comfortable holding vast quantities of US dollars.
The question that remains is whether there will be an orderly or disorderly exit out of the dollar. This is a tough question for anyone to answer and there are a ton of variables to calculate in. For example, we have 2 wars that could escalate and possibly a third with, pick your axis of evil country, we could have another trillion dollar stimulus package, heath care reform could get passed and it could end up adding a trillion a year to the deficit, programmed trading could cause a precipitous drop in the currency and the list goes on. At this point in time I would say it is 51 to 49% in favor of a disorderly drop in the currency versus an orderly drop in the currency. Mainly because Ben thinks he can actually control the devaluation process, which no government in history has ever been able to do.
There is no doubt that this is a scary topic and that we should al be concerned about this issue on a longer term basis. Do I think we need to worry about this happening this month or year? No. However, this could happen within a 12 month period of time very easily, but again, I think it is unlikely. We know that the name of the game is supposed to be a slow devaluation of the currency, but, as I just said, no country has ever been able to actually control the devaluation process and with computerized trading this is more dangerous than ever. A few things need to happen before we see a total failure of the currency and as of right now these events are not happening.
For example, I often talk about the treasury bubble of the late 1970’s when the US suffered from inflation and dollar devaluation. There was a buying spree and a bubble in long-term treasuries and when Volker became the Fed Chairman he was charged with stomping out inflation. He did not know there was a bubble and let the market raise rates for him, which was odd, but it worked. Unfortunately, it basically almost put out of business most of the primary government bond dealers and led to credit controls. What it did was save the currency and stopped inflation cold, along with economic growth.
Many people familiar with that story seem to think we are close to that scenario today, effectively failed treasury auctions, which is not true. We have a long way to go and many more steps to go before that happens, but those steps could come fast and furious. Unlike the late 1970’s the dollar is falling a lot faster now than it did then, but the buying in the treasury market is a lot more fierce now and on the shorter end of the yield curve, unlike then when we saw it on the longer end of the curve. So, we will see what happens, but things move so fast in today’s market anything is possible and this boom bust economy cyclical period is getting shorter and much more severe. The signs are coming for a currency crisis, but not in the immediate future.
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