A Manipulated Market

"The dollar is falling! The dollar is falling! It’s the end of the world!" At least, according to the Chicken-Little’s of the financial industry…but never fear, John Mauldin is here is assure us that the valuation of the dollar is just the symptom, not the problem…

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 explain why 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 that will shake the United States to its core. It will have consequences, of course, but it is far less important than the problems a secular bear market will have upon our portfolios. It is, however, a trading opportunity.

The point is that a drop of over 40% went unnoticed 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.

Protecting the Dollar: Profit Is Not the End Game

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 the 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.

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 was 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.

Protecting the Dollar: A Rock and a Hard Place

Why have we not seen such a correction? As noted above, governments for their own benefit, manipulate currencies. There are governments who believe it is in their best interest, at least for now, to keep the dollar propped up.

As Bill Gross of Pimco noted this week, the Fed is between a rock and a hard place:

"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 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.


John Mauldin
for The Daily Reckoning
November 10, 2004

P.S. Capture the full effect of the dollar’s bear market, and get paid for your trouble! That’s how it works with Everbank’s foreign currency denominated CDs.

Today, the Fed is expected to raise interest rates again. The central bank of the United States will probably take another baby step towards normalization of its interest rates.

You will recall, dear reader, that the "Bank of Alan Greenspan" has joyfully lent money at rates well below the going rate of CPI inflation. It lost money on every transaction, but what did it care? It wasn’t Greenspan’s money and it wasn’t real money anyway. Besides, it hoped to make up the loss on volume. If it could just encourage enough people to borrow enough money, reasoned the geniuses at the Fed, the resulting boom would lift the entire world economy out of its funk.

But a real thing cannot be built from phony parts. The Fed lent phony money – money that no one ever earned or saved…it was money created "out of thin air." The phony money found its way, largely, into the mortgage market and then into consumer’s pockets – giving them a phony purchasing power. This new demand was phony too, for it was not composed of additional earnings, but of additional borrowings by people who already owed too much.

We have mentioned this many times before…and we will do so again: Borrowing is no sin…if you are borrowing real savings to build real productive capacity. Growing nations – like growing companies and growing families – often borrow money and then pay it off out of increased earnings. But when Americans borrow simply to buy more consumer items from China, there are no additional earnings to pay off the loans.

And so the phony money created a phony demand, which led to an ersatz boom.

All these transactions were calibrated in the coin of the realm, U.S. dollars. And since the financial solidity of the realm itself is open to question, so is its coin.

The dollar falls nearly every day. The newspapers have noticed. Look out below, they say. Economists practically all agree to "The dollar will continue falling", they add.

But against what? And how do you protect yourself?

All of the world’s major currencies are sinners. But compared to America’s money crimes, Europe is a two-bit pickpocket. Hauled before a judge, the euro would get a lighter sentence, we believe. Against the dollar, it should rise.

Gold, on the other hand, is a saint. The world’s oldest and wisest money has never been charged with a crime or misdemeanor – not even littering. It is the real thing; there’s nothing phony about it. What you see is what you get. And gold is what people want to get when they fear that what they’ve got already may not be worth having.

Gold hit a new high for this cycle yesterday. It is at $436. We thought it was a bargain at $300. At $436 it is no longer as great a bargain, but still a far better bet than dollars.

More news, from our friends at The Rude Awakening:


Tom Dyson, reporting from downtown Baltimore…

"It all seems to boil down to this: Everyone expects the dollar to keep falling. It’s such a cinch, we speculate, it’s unlikely to happen anytime soon. Your misplaced Baltimore-based editor thinks, with each day that passes, the dollar looks more and more like a ‘buy.’"


Bill Bonner, back in London:

*** What has happened to the naughty vicars? Generally, Britain’s newspapers can be counted on to reveal the sordid and amusing tales of men of the cloth gone bad – usually, on page 2 or 3.

But the vicars seem to have shaped up, or the reporters are letting us down.

In place of the affairs with choir mistresses is a whole new genre: Do-it-yourselfer’s who did themselves in.

Zoe Turner, 28, was strangled by her electric drill, reports today’s issue of The London Times. Somehow, the woman managed to get the cord wrapped around the drill bit and her scarf.

Yesterday, the Times reported the sad story of a man who died "after being stuck in his bedroom cupboard for a week." Ronald McClagish, 51, was apparently doing a little maintenance inside his closet when a wardrobe fell against the door, pinning the poor man inside. He then broke off a copper water pipe, apparently believing he could use it to pry the door open. But the cold water rushed in…and the man died of bronchitis, said the coroner’s report, before he was discovered.

Apparently, it is safer and probably more fun to be a naughty vicar than to try to fix something around the house.

*** Chris Mayer, reporting from Bermuda:

"When you think about some of the more reviled sectors in the market today, you may think of insurance – especially given the widening probe of Eliot Spitzer. So, this state of affairs naturally attracted us, contrarian-style value investors. So, we took off to Bermuda, home to a number of insurers. It is a sort of like a Silicon Valley for insurers.

"We’ve learned a few things. First, the Bermudans love their rum – they have it in their fish stew and they have it in their coffee. If you can imagine pouring rum in it, some Bermudan likely already has.

"Today, we met with representatives from XL Capital, one of the largest insurance companies in Bermuda and a worldwide player as well. We learned the Bermudans can be sensitive about how their country had become something of a political football in the last election. When we noted how these companies pay no income taxes, we were quickly told that there are other expenses and fees that Bermudans pay, including a 13% payroll tax and heavy import duties running around 50% for most goods and as high as 80% for a car. There are tax advantages, certainly, our gracious hosts did not deny it, but they urged us to consider the whole picture, as they believe the differences are not as great as advertised.

"Interestingly, the Bermudans have a name for those companies who are here in name only. They call them ‘brass plates.’ The insurance industry is not a ‘brass plate’ we were told, meaning they actually employed hundreds of people and maintained headquarters on the island. ‘Brass plates’ have nothing more than a brass plate on a mailbox, as we were finding out when we called a few of them. I called one company supposedly headquartered in Bermuda, where a nice lady answered the phone and told me no one from that company works here. Fascinating.

"An amusing incident: At the airport, some para-military looking officer was training a hyperactive German shepherd to sniff out drugs. The officer asked me to hold one of the bags. Having watched this dog pounce on other bags and rifle through luggage, I gingerly took the bag and dropped it near my own. In no time at all, the excitable canine charged the bag and snatched it.

"’It’s getting too easy for him,’ the officer explained to us. We were told that there were no drugs in the bag, only the scent. For what it’s worth, we think the dog is ready for duty."