Artificial High

Despite falling 25% against the euro over the past 12 months or so, the dollar is still artificially high.

By artificial, I mean the following things: first, the rest of the world, and especially Asia, is hooked on selling products to the American consumer. If prices were to rise 30%, Americans would buy less foreign products and more of their own. If Asia, for example, were to sell less to Americans, their unemployment would rise and their profits would drop.

Secondly, there are those who hold dollars because it is better than their local currency. Physical dollars are desired in many Latin American and African countries, and other parts of the developing world. The clear pattern is that the dollar is a better value than the local currencies.

Third, it should be obvious that if the dollar was not the reserve currency for the world, it would not be as high. The dollar would have less buying power. Foreigners look at that buying power and are often jealous, seeing it as part of so-called American hegemony.

Asian Currencies: Eroding Manufacturing Base

But it cuts both ways. An artificially strong dollar has meant that the American manufacturing base has slowly been eroding as more and more jobs leave the U.S. for cheaper production climates. It has created an imbalance in our trading accounts and buying patterns. There is no free lunch.

If the dollar is artificially high, is there reason to believe it can (continue to) drop? A Federal Reserve study seems to indicate there is. Fed economist Caroline Freund did a study on what happens when the trade deficit gets too big in developed countries. Here are the highlights: On average, when the trade deficit widens to over 5% of a nation’s GDP, the currency starts to drop. It typically drops 20% over three years, as the trade balance recovers.

Thus, at 6% and approaching 7% of GDP trade deficits, the U.S. is in No Man’s Land. There is real precedent for the dollar to continue to fall, if the artificial props are removed.

For the dollar to fall, however, it must have other currencies to fall against. So far, it has most notably found the euro. But what about the currencies of Asia – an area attracting more and more attention as the potential powerhouse of tomorrow?

Asian Currencies: Keeping Their Exports up

So far, Asian countries have been working hard to keep their currencies low against the dollar. Why? To keep their exports up, which is what they believe will eventually bring prosperity. Each nation feels that if their currency goes too high, it will give the other nations an advantage over them of selling products to the United States.

The Japanese, for example, have publicly argued for several years that the yen is too high, and work aggressively to lower the value of the yen even as it rises. A few Japanese leaders have publicly stated the yen should be at 160, not the 116 it is today (in mid-May). Other Japanese leaders would clearly prefer the yen to be at 130.

Now, here is the heart of the matter: if each of those Asian countries thought they could all get a stronger currency against the dollar, they would be for it in a heartbeat. It is not that they want a strong dollar, they just don’t want their currency to be stronger than the other Asian currencies. If the dollar were to show weakness against all the Asian currencies at the same time, they would not object. They would be thrilled.

The 900 pound gorilla in this process is China. The Chinese currency is pegged at a fixed rate to the dollar, so there has been no movement. Since China has a very pronounced advantage over other Asian countries in regards to labor costs, these other countries feel forced to keep their currencies low in order to compete. The Japanese have been particularly vocal in their complaints about the value of the Chinese currency.

Countries which sell to the U.S., especially Asian countries, have a choice of two potential sources of pain. They can either let their currency rise and sell less to America, or they can take dollars, which will have real downside risk.

Asian Currencies: When China Floats the Renminbi

When does the pain of taking over-valued dollars become more than the pain of selling less to the U.S.? I think it is when China allows their currency to float. Asian countries do not necessarily want an over-priced dollar; they simply want the price of their currency to be favorable in relation to their neighbors. When the Chinese allow the renminbi to rise, that will be the real end of the dollar being over-valued, as the rest of Asia will feel comfortable in letting their currencies rise as well.

There is an increasing call from many corners of the world for the Chinese to allow the renminbi to float. They have not responded to the pressure, but as do all countries, they will act when they feel it is in their own best interests. That will probably be when they think their own consumer demand is growing and solid, and thus can sustain a possible slowing of sales to the U.S.. When that will be is anyone’s guess.

China will be the surprise move which sets this set of dominoes in motion. This is one area which investors must watch closely, as it will be a surprise and will be the transition to a much lower dollar fairly quickly.


John Mauldin,
For the Daily Reckoning
May 15, 2003

P.S. Until the rest of the world and especially Asia can wean themselves from dependence upon the American consumer – [or the U.S. consumer gets tapped out] – the dollar will remain artificially high. That is not to say it will not continue its decline. It will. It is just that it will take longer than it would without the artificial factors cited above.

How will it all play out in detail? What will be the value of the dollar? How will world trade be affected? There is simply no way to know. There are too many variables to make any realistic prediction.

What we can say is that there is a high degree of likelihood that the dollar will be lower by at least 20-30% (across the board, with some currencies much higher and some much lower), that the world will find customers in addition to the U.S., and that this will cause a major shift in buying patterns within the United States.


“What morons the Japanese must be!”

We quote ourselves from nearly 4 years ago.

That was when everyone knew the Internet was making us all rich in America…and the poor Japanese couldn’t seem to figure out how to get on-line.

Now, everyone knows the way to avoid recession and deflation is to inflate the currency…and the Japanese can’t seem to find the ‘on’ button to the printing press!

As we left our story yesterday, the Japanese had had a huge stock market bubble…which put more than a few bulges into the rest of the economy, too. Ditto for the U.S..

The Japanese then had a bear market in stocks…followed by a long period of on-again, off-again economic slump. So far, America seems to be reading the same script.

Despite the best efforts of the Japanese central bank and the government, people in Japan gradually began to think that things wouldn’t get much better anytime soon, so they began to save their money, just in case. They noticed, too, that prices weren’t going up…in fact, they were going down. So, even when they felt like they might want to buy something, they were inclined to hesitate; it would only be cheaper later on.

Will that happen in the U.S. too?

No way, say investors, we have Alan Greenspan.

It cannot happen, say economists, we have Milton Friedman.

It will not happen, say our central bankers, we have a printing press.

Says Eisuke Sakakibara: “Oh yeah?”

Here at the Daily Reckoning, “who knows?” is the best we can do. But we say that with such an impertinent twinkle in our eye, we are sure it inspires confidence.

Against all odds and all apparent reason, bonds soared again yesterday. Investors bought bonds at the lowest yields since Eisenhower’s second term. Few economists could explain it. For they are counting on the Fed’s printing press to boost inflation rates in order to avoid “the Japan Scenario.” Economists said it should do so…Bernanke said it could…and foreigners have been dumping the dollar in the anticipation that it would…Ergo, bonds ought to go down, not up. Who wants to own a long bond when the currency in which it is denominated is being destroyed by the very people who are supposed to protect it?

But judging from the spread between inflation-indexed bonds and regular 10-year T-notes, bond investors don’t seem to get the message. The gap is only 1.7% – precisely the current rate of increase in the CPI. For the next 10 years, Mr. Bond Market seems to be saying, you can expect nothing more.

Only Eisuke Sakakibara seems to have any idea of what was going on. Of course bonds are going up in the U.S., he explained to the Financial Times earlier in the week; in trying to dodge the “Japan Scenario,” the Fed was doing just what Japan’s central bank did – driving down yields. Since U.S. monetary officials do the same things as their Japanese counterparts – though 10 years later – is it any wonder they get the same results?

Nothing is ever exactly the same as it was. Lower rates in the U.S. have stimulated a bubble in the bond market…and another bubble in the mortgage refinance market. Mortgage rates hit a record low of 5.27% yesterday, and the latest reports show refinancing activity up 20% from its already hyper-active levels. Home prices are still rising, reports MSNBC…and the median house in LA county has edged over $300,000.

The Chinese economy is said to be growing at a phenomenal 8.9% annual rate. This, says Sakakibara, is a major structural reason why prices are falling. China can make almost anything cheaper than the U.S., Europe or Japan. And since the Chinese peg their currency to the dollar…a falling dollar does not hurt their sales to the U.S. – and actually helps their exports to other parts of the world.

While China gets a competitive advantage from a falling dollar, America gets the disadvantage of a falling currency at a time when it desperately needs imported capital. Japan was never in such a bind. It could survive a period of moderate deflation with only moderate damage. It never had to destroy the yen, though it tried.

How this will all turn out, we don’t know. But maybe the Japanese will turn out not to be such morons after all.



Eric Fry in New York City…

– Another day, another spectacular rally…in the bond market. The 10-year Treasury note, which has rallied seven out of the past eight trading sessions, soared again yesterday, driving its yield down to 3.53% – the lowest ever seen during the 43-year life of your New York editor. Meanwhile, over in that “other” financial market, stocks, the Dow fell 31 points to 8,647 and the Nasdaq slipped 4 points to 1,534.

– Rapidly falling bond yields are stirring up a lot of chatter about deflation. Suddenly, deflation-mania has arrived on Wall Street…This hot new monetary phenomenon is the talk of the town. Just about everyone thinks we should be worried about it. After all, Chairman Greenspan says he worries about it.

– Fanning the flames of the deflation talk was the news yesterday that import prices fell 2.7% in April. While it’s true that a hefty 16.2% decline in petroleum prices may have skewed the overall number a bit, it’s also true that ALL commodities (excluding petroleum) dropped 0.9%. Most other import prices also fell or remained flat. In other words, the data looked very deflationary. Nevertheless, the New York-based team of the Daily Reckoning doubts that deflation-mania will last long. The dollar’s 20% slide against the euro over the last few months should start to show up in import prices eventually.

– Maybe it’s the water, but here in New York, a few of us can still imagine a world in which inflation seems more plausible that deflation. “What is wrong with all of us?” fellow New Yorker James Grant wondered recently in a Forbes magazine column. “Government bond yields are low the world over. In Japan they have never been lower…[Yet], in the U.S., where the Consumer Price Index is 3% higher than it was a year ago, there is no deflation. But there are plenty of deflationary symptoms, and the Federal Reserve Board is worried about a visitation of the real thing…

– “For months [Greenspan’s] deputies and he have vowed to whip deflation, even before it materializes. They have described the dollar – their dollar and ours – as a piece of paper of no intrinsic value that can be produced ‘at essentially no cost.’ They have pledged that, if need be, they will push down not only the funds rate but also longer-dated Treasury yields…What would this mean in practice? Lower government yields and more credit creation to start with.

– “By pegging the ten-year note at, say, 2.5%, the Fed would have to buy all securities offered at 2.5% or higher. The Fed, of course, is no ordinary acquirer. It creates the dollars it spends. For all intents and purposes, it waves a magic wand. By vowing to meet deflation with inflation, the Fed is only doing what it has mainly done since its inception. Precious-metals funds…would provide protection in case the Fed waved its wand a little too hard.”

– Although MOST economic news these days may be “less bad,” some of it is still just plain old “more bad.” A predictable result of the nation’s dire employment picture is that consumers are not consuming. (We may have mentioned this phenomenon once or twice before).

– U.S. retail sales “unexpectedly” fell 0.1 percent in April to $309.5 billion, according to the Commerce Department. Excluding automobiles, sales dropped 0.9 percent, the biggest decrease since the September 2001 terrorist attacks. Sales at clothing and accessory stores were especially soft, slumping 3.2 percent.

– What happens when over-extended U.S. consumers stop over- extending themselves? The U.S. auto industry provides the grim answer. In the month of April, General Motors boosted its average incentives per vehicle by 16.7% to a hefty $3,402.

– “Financing deals and cash rebates on new cars and trucks rose to record levels last month,” the Lansing State Journal reports. “Despite heavy incentives in April, Ford, GM and DaimlerChrysler AG’s Chrysler Group all saw their sales decline compared with a robust month a year ago. Nearly every automaker had some kind of incentive last month, contributing to a rise in the average industry outlay per vehicle to $2,508 from $2,207 in March…The average Big Three outlay surged 13.8 percent to $3,310 a vehicle.”

– Unfortunately, automakers are stuck with their outsized incentive programs. Eliminating incentives – like asking a long-term houseguest to pack up and move out – could be a tricky maneuver. Luring customers into dealerships, says GM’s CEO Rick Wagoner, “is getting more expensive and requires even more creativity.”

– Meanwhile, unsold cars and trucks are piling up in inventory. “U.S. automakers are sitting on an overflow of unsold cars and trucks that appears to be the largest backlog in U.S. auto history,” the Miami Herald reports. “About 3.93 million unsold vehicles are sitting on dealer lots, in transit from the plants where they were made or at hushed-up overflow sites like the Michigan State Fairgrounds. All told, about 630,000 more unsold cars and trucks are sitting around than a year ago. Since March, inventories have been at all-time highs.”

– The sky-high inventory levels are likely to mean hefty production cuts and job losses…Can you say “vicious cycle”?


Bill Bonner, back in Paris…

*** The transport strike continues. The subways are working….but not reliably. And Parisians are getting weary of it.

At least, that is how it seems from your editor’s point of view. He spends 3 hours a day walking back and forth to the office. It is a lovely walk, which he welcomed a first; but he is getting tired.

Yesterday, walking home along the Faubourg St. Honoré, he bumped into – literally – a group coming out of Sotheby’s. The bodyguards charged out of the door and acted as if they were escorting a child molester through an angry mob with a rope. The middle-aged man at the center of the entourage was striking; he looked as though he might actually be a child molester. He had straight white hair in a ponytail, a black jacket with a skinny little tie, tight pants, and large dark sun glasses.

“Snappy dresser,” your editor commented to his daughter, after the group was loaded into a large Mercedes.

“Dad,” Maria explained, “don’t you ever watch TV or read the papers? That was Karl Lagerfeld. He is not just a snappy dresser. He’s probably the snappiest dresser in the world.”

“Well, I’m sorry I stepped on his shiny shoes…”

The Daily Reckoning