Fiat Currency Endgame
Four reasons explain the US Dollar's big bounce. None of them suggest permanent new strength...
SO HAVE THE FINANCIAL MARKETS already gone through their inflationary melt up phase, asks Dan Denning for The Daily Reckoning Australia.
Are they now giving way to debt deflation, in which cash is hoarded and the price of all assets (tangible and otherwise) falls?
It's true that Gold Prices tripled in the last eight years. The oil price went from a ho-hum mid-twenties to nearly $150 per barrel. And across the commodities complex, from energy to grains to base metals to precious, nearly everything went up in price.
But that was not hyperinflation. Nor was it merely a speculative bubble (something that's becoming increasingly popular to say, not least about Gold). This first up-leg in the commodity cycle represented the bottom of a 200-year trend in which tangible goods declined in real terms. Production had expanded faster than consumption thanks to industrialization). Now consumption is catching up with stagnant production, thanks to India and China.
Hyperinflation is the end-game of any fiat currency system. It results from the monetization of debts by the central bank in attempting to deal with the consequences of a credit bubble. Or, to apply it to the real world today in the form of a question:
How do you think the Federal Reserve and the Treasury Department are going to recapitalize America's financial sector? With Chinese savings? With investment-dollars from sovereign wealth funds based in the Middle East?
Answer: the Fed exchanges what remains of its stock of Treasury bonds for garbage mortgage debt. There's plenty more still sitting on and off bank balance sheets. And eventually, when the Fed's hoard of Treasury bonds runs out, it will have to buy more bonds floated by the US Treasury Dept.
And where will the money come from to buy those bonds? Where it always comes from when you have a fiat money system – out of then air!
Fiat money means never having to put a cap on your spending. But that doesn't equal an unlimited supply of real purchasing power. Backing paper promises with just more paper promises – rather than with a hard, rare, tightly limited and precious asset such as Gold – always gets found out in the end.
In any event, the bailing out of the Government Sponsored Enterprises (Fannie & Freddie) and the attempted recapitalization of the US financial system with magic money is just around the corner. It will also be where the Dollar meets its date with monetary destiny, acting out the final scenes of every fiat currency before it.
In the meantime, there's probably one other reason the Dollar is enjoying a nice rally. It's the devil the world knows. And while the Euro is the new reserve currency on the block, it has problems – notably Spain, Italy, Portugal, the over-bearing politicking from Paris and the over-blowing real estate bubble in Ireland. The Japanese Yen also has troubles all of its own. That leaves the Dollar like that loud, obnoxious friend you occasionally take out for a beer.
He's gregarious, slightly over the top, and in small doses, kind of fun to be around. Plus, you know what you're going to get from him. There's a kind of comfort with what's familiar, like an old couch with holes in it. But he can get angry sometimes, and there are a lot of casualties in this current scrap between paper money and tangible assets in the form of much lower resource stock prices.
Oil is down 23% from its high. Gold and copper are off nearly 25%. Confidence in the resource boom itself is a casualty too. What is really going on down there on the ground?
One answer: the simultaneous liquidation of three massively leveraged trades. Those three trades were (and perhaps still are) energy, commodities, and the Dollar. For the last three years, leveraged speculators – meaning mostly hedge funds – have been long energy and resources and short the US Dollar. Those trades are now being wound up. The de-leveraging of the financial markets (forced by falling asset values and tighter credit) has led to a sudden and simultaneous exit from all three trades.
The result? Traders and institutional managers have taken profits in resource and energy stocks and sold. More important, the massively popular trade of "shorting the US Dollar" seems to be over, judging by the action on the US Dollar index at least.
Combine the profit taking and the short covering and you have what looks like a resurgent Dollar and free-falling resource stocks, alongside a collapse in underlying commodity prices.
It's also possible that speculators are simply being liquidated themselves. With credit drying up, how many hedge funds will go out of business this year?
N.B: Hedge funds are being liquidated in the financial sense, not in the sense that Stalin liquidated the Kulaks. And besides, the liquidation of the Kulaks, mostly peasant farmers, led to mass starvation in the Soviet Union – not a brilliant strategy. Whereas the liquidation of leveraged speculation from the global economy, at least for this cycle, might actually be a good thing, provided no one is taken out back and shot.
It will lead to less speculation and borrowing and more saving, real investment, and real capital formation. Which would be a good thing. Right?
What's strange about the Dollar's rally, however, is that it's taking place as America's fiscal position deteriorates. How can a currency rise when its foundation continues to crumble?
Doug Noland at the Credit Bubble Bulletin for Prudent Bear reports that the US government racked up a $102.8 billion deficit in July. Deficits are nothing new for the American government, of course. But the alarming evidence is that spending is up (27% year over year) while tax receipts are down (5.8%).
To wax historical for just a moment, the US Dollar's breakout reminds us of the German offensive in the Ardennes in December of 1944. The Germans were slowly being hemmed in all over Europe. The last thing the Allies expected was an attack. Hitler ordered one though, sending Panzer divisions through the Ardennes (as he did in 1940).
It nearly worked.
The attack caught the Allies by surprise and forced the Americans to rush the 101st Airborne into the French town of Bastogne to hold out until they could be resupplied and reinforced. Hold out they did. Eventually, the German advance was repelled. But it shocked everyone in the Allied command that an opponent so clearly on the strategic ropes could come so close to reversing the momentum of events.
With the Ardennes Offensive in mind, there are at least four reasons we can think of that explain the US Dollar's resurgence. None of them suggest permanent new strength:
1. The Short-Dollar Trade is Being Covered
A lot of institutions were short the Dollar. The suddenness and swiftness and simultaneity of the short covering explains the explosiveness of the rally (and the similar carnage in commodity prices).
2. US Seen Bouncing Before Europe
There's an emerging trading thesis that as Europe and Japan post negative second-quarter growth, America's economy will bottom out before the rest of the world, making the Dollar and US stocks and bonds better investments.
This thesis is that all the world is in recession, but America is closer to exiting it. It's not our favorite explanation – as fact – of why the Dollar's bouncing so hard. But it's possible someone believes it and is trading on it.
3. Global Money Supply Growth Is Slowing – and Fast!
A stronger candidate for denting commodity prices is that official money-supply growth around the world has ceased growing as quickly. Global M2 growth is notoriously hard to compile and track. But with banks distrusting one another, the contraction in global credit is showing up in lower prices for nearly everything except shop prices. It's financial asset deflation on a global scale, in all markets and all asset classes.
4. Central Bank Intervention
Finally, there is the possibility that foreign central banks are selling their own currencies and buying US Dollars. It's a case of competitive devaluations designed to increase exports to the US and out-inflate the Fed. It also goes by the name of currency manipulation.
Are any of them true? Are all of them true? We reckon that the prospect of global recession is boosting the Dollar. Because better the devil you know. The short-covering and deleveraging by speculators is another big factor. Markets move in cycles.
But in the bigger scheme of things, we'd continue to view this Dollar rally with deep distrust. Changing attitudes currently support the Dollar. But the facts underlying the currency don't support it one bit. That to us is the best reason to sift through the rubble of the resource market for shares that will excel during the next phase of this battle royale between paper currencies and real assets.
Fiat money only ever ends one way. Unlike Gold and hard assets, it's ultimately worthless.