Less to the Dollar than Meets the Eye

China and Japan have stopped buying U.S. bonds…leaving just the hedge funds to support America’s teetering towers of debt. Watch out below!

You can’t keep a bad currency down, or at least that’s what the dollar bulls would have you believe. After reeling off an 8% rally against the euro since the beginning of 2005, and making a new seven-month high, global currency traders seem to be telling us the buck is back.

Not quite. The dollar has its pros and cons. We’ll take a look at three of each in moment. But in truth, there is less to the current dollar bull market than meets the eye.

What’s more, investors could see a surprising rally in the euro in early June. And for the remainder of 2005, look for strong performances from Asian currencies, grains, and – of course – gold.

But first, what’s so good about the dollar? There are three plausible reasons to be a dollar bull. The first and most compelling is that the dollar is not the euro. In beauty pageant terms, the dollar is a grotesquely fat currency wrapped in a skimpy bathing suit. One does not need a lot of imagination to see the flaws. But if the dollar is shapely in an obese way, there is little in the slender euro to please the investor’s eye.

The Dollar: Crushing Defeat for the Euro

This past Sunday, May 29th, the French went to the polls to vote on the European Constitution – and rejected it. The Dutch follow three days later. And early last week, Gerhard Schroeder’s Social Democratic party lost elections in Germany’s North Rhine-Westphalia region. Political defeats for the key proponents of the European Union – Schroder and French President Jacques Chirac – are virtual defeats for the euro as a world reserve currency to rival the dollar.

What’s more, as a paper currency backed by over-spending governments, the euro is no more fundamentally sound than the dollar. In fact, there are many bad things one could say about the euro, including "non". But if markets are even moderately efficient, much of the bad news is already "priced in" to the euro. How much higher can the dollar go by virtue of not being the euro?

"But the dollar has already crashed!" dollar bulls declare. True, the dollar has come out of its two-year pub brawl…fighting with the euro and the yen…looking considerably worse for the wear. But it’s still standing, we are told. And it still looks an awful lot like the only currency in the world capable of being a real reserve currency.

Finally, the dollar has rising interest rates on its side. Tuesday’s release of Federal Reserve meeting minutes indicate the U.S. central bank is intent on raising interest rates at a measured pace. The prospect of rising U.S. yields is in contrast to the lowest German interest rates since ’96…that’s 1896, according to currency strategist Chris Webber.

With a growing spread in interest rates favoring holders of the U.S. dollar, why wouldn’t the dollar continue to rally?

The Dollar: What It’s Not

But for each and every reason to "buy" the dollar, there’s an opposite and more powerful reason to "sell" it. First, however, let’s remind ourselves what the dollar isn’t.

Just as the dollar bulls believe it has rallied because it is not the euro, so too will it fall because it is not gold. The Philadelphia Gold and Silver Index recently "violated" two multi-year up-trend lines. Gold stocks are breaking down out of their bull run, or so it would appear.

What has changed fundamentally? Nothing, of course. The dollar bulls are treating gold’s rally since 2001 as part of a run-of-the-mill cyclical rally in commodity stocks that has now run it’s course…as if 25 years of under-investment in mines, refineries, and productive capacity can be overcome by a nice rally in commodity stocks!

In the greater monetary scheme of things, of course, the dollar is still what investor Doug Casey calls "the unbacked liability of a bankrupt government." Gold, for its part, is no one else’s promise to pay. It’s yellow, inert, and a store of value that cannot be inflated away in Brussels, London or Washington. No short-term rally in the dollar can change that.

That brings us to the second reason to doubt the dollar bulls and remain firmly in gold – America’s deficits are not getting any smaller. And there are more ominous events to consider, too.

The U.S. Treasury’s latest report on International Capital Flows shows that since last August, the Japanese have reduced their holdings of U.S. Treasury bonds by $19.4 billion. Not a huge decline. But importantly, they are not increasing their buying of U.S. bonds. Across the Sea of Japan, and the Chinese have increased their holdings, but not by much, from $201.6 billion in August ’04, to $223.5 billion in March ’05.

The most notable increase in fact comes in London, or rather, the United Kingdom, including the offshore tax havens of Jersey and the Isle of Man. These holdings of U.S. Treasury bonds DOUBLED over the eight months to March. Across the Atlantic, meanwhile, Caribbean Banking Centers – or what I call offshore U.S. hedge funds – have also increased their holdings of U.S. Treasury bonds. The Caribbean is to Wall Street what Britain’s offshore havens are to the City of London. Since August, the U.S. hedge funds have increased their Treasury holdings by 44%.

But unlike the U.K.’s steady accumulation of U.S. Treasury debt, the Caribbean’s holdings actually fell between August and December, down to $71.4 billion. Then, since December, US hedge funds have increased their offshore Treasury holdings by a whopping 92%.

The Dollar: What Not To Forget

Were the City and Wall Street funds out to support America’s consumer spending habits? Not likely. In the great hunt for yield, 4% on a U.S. bond is better than zero percent in Japan. But here’s the important fact for dollar bulls: hedge funds, unlike Japan or China, have no interest in a strong or a weak dollar. They are merely out to make money where they can.

And that’s fine. But here’s what investors cannot afford to forget: hedge funds will sell when a better trade comes along OR, when they are forced to liquidate.

The mainstays of the US bond market, China and Japan, aren’t buying. Hedge funds are. But their support for the dollar, which has the effect of keeping interest rates down, is merely a trade, not a policy. When the hedge funds sell, or quit buying, who will pick up the slack? No one.

Interest rates will go up. Puff goes the American housing market. Down goes the dollar.

All of which is to say that there is a lot less support to the dollar than meets the eye. The dollar is simply GM in waiting. U.S. bonds are distressed debt owned increasingly by fund managers desperate to eke out a few basis points here and there. This is not the bedrock of a strong rally in a currency.

The dollar is a long-term sell. But if not the euro, what will it fall against next? Well, while the dollar rally story is shallow, the commodity bull story is still deep and rich.

When the dollar falls again – which it will – it will also fall against Asian currencies, especially in anticipation of a yuan revaluation by Bejing. It is possible, of course, that the dollar can remain stronger for longer than anyone expects. But the whole currency regime can come crashing down much more quickly than anyone expects as well.

It doesn’t happen often. But it does happen, and when it does, it happens despite the fact that most people think the world will always work the way it works today.


Dan Denning
for The Daily Reckoning

May 31, 2005

P.S A twenty-five year period of under-investment in productive capacity in commodities is not simply erased by an eighteen-month bull market in commodity stocks. The world still needs new refineries and more liquid natural gas terminals. There are still lots of global bellies to feed and cars to be fuelled. The drivers of commodity demand – large, industrializing populations in Asia competing with Westerners accustomed to high wages and high standards of living – are still going strong, even if commodity stocks are not at the moment.

Dan Denning, editor of Strategic Investments, is one of America’s most respected "big picture" analysts working today. His new book, The Bull Hunter, details how the collapse of the U.S. credit bubble will see Asia emerge as the No.1 market for profit-hungry investors over the next three to five years.

Markets were closed in America yesterday.

In global trading, the dollar fell – to $1.24. Is this all there is?

The papers are all screaming about the new "crisis" in Europe, following the French vote on Sunday – especially the U.S. papers. You’d think the dollar would move more than a penny. That it did not is either telling…or misleading.

We sat down with the newspapers and strong cup of coffee this morning. One or the other of them gave rise to a rush of thoughts, which we write down hastily lest we forget:

*** that ideas are shaped by theory
*** that theories arise largely as they are needed – to explain and justify what is happening
*** that without the right theory at the right time a man is blind to what is going on around him
*** that the U.S. press bends to the demands of empire, without recognizing it
*** that Europe is not in a crisis at all….that it is probably better off after the "no" vote…
*** that Americans’ theory has totally misled them into thinking they are getting richer, when in fact they get poorer everyday
*** that Europe is actually growing faster and getting richer than America….
*** and that this would be a good time for an investor to switch out of dollars and into euro…or gold.

Our conclusions will be familiar to you, dear reader. But even long suffering Daily Reckoning readers will find something new in the logic that leads us to them. Once we stopped worrying and began to admire the American empire were able to see all sorts of new and amusing features. Things that had not made sense to us previously were still absurd, but less mysterious.

"Huge setback for stronger Europe," said a Wall Street Journal headline. The Journal has been perhaps the leading rag for the imperial agenda. Its editorial pages never met an overseas military adventure they didn’t like or a military expense they didn’t want (someone else) to pay. Of course, this makes perfect sense. The Journal is America’s business paper and is clever enough to understand what business America is in and how it works. The business of empire is providing order and stability so that markets can function. It is fundamentally a policing business…a military business…a business that relies on force, rather than persuasion.

That is the theory (idea) that drives the Wall Street Journal and the current administration. It is also the theory that has shaped modern America, though few people realize it. American economists see the trade deficit either as a plus…or don’t see it at all. We are just sopping up a "glut" of savings worldwide, says Ben Bernanke. The trade deficit is a result of the fact that Americans’ debt is increasing twice as fast as their income; yet, this information has no place in the theory of imperial finance. So it is invisible. It doesn’t seem to matter. Nor does the fact that profits in the manufacturing sector have collapsed have any place in the imperial financial model. The U.S. economy is superior, they believe. They see their job as discovering how it is superior. There is no model of traditional economics that could explain it; they are forced to rely on empty words, such as "dynamic," "flexible," "innovative," and so forth. The words may mean nothing, but at least they sound good.

Almost all Americans who read yesterday’s news saw the French vote as a setback. They could not imagine that a weak central government might be a good thing, because a strong central government is necessary to imperial ambitions. America has a strong central government; America is the world’s only superpower. Therefore, strong central government must be superior. You don’t see Europe invading Iraq…or Afghanistan. It has no strong central government. It has no strong military. It has no imperial ambitions. The Europeans were so traumatized by two wars in the last century; they’ve had enough of military adventures – at least for the present. Instead, they’ve turned inward – to focus their energies on providing public holidays and public health care. You can see this simply by reading the paper. The American press looks outward and sees opportunities to build a better world. Editorial pages explain what to do about China’s money…or Africa’s health problems…or Japan’s economy…or even Europe’s government.

European papers tend to look at their own problems – failures of the health care system, national elections and political fractions. In London, the papers went wild after a man was beaten up and left for dead by a pack of "yobs." The Labor government felt it necessary to address the issue of lawlessness in the ‘Queen’s Speech,’ promising to re-establish law and order. Yet, the murder rate in London is only 2 per 100,000…compared to 70 per 100,000 in Washington, D.C. Even in Iraq, an American soldier has less of risk of getting gunned down in the streets, with a death toll averaging about 60 per 100,000 since the end of the war. But in Washington, crime is for the back pages of the paper. It is considered ignoble ‘naval gazing’ to worry about such matters in America. Instead, the front pages are devoted to bringing American-style law and order to Iraq and Europe! We can barely contain ourselves when we think about it, dear reader. Our diaphragm convulses in laughter; our sides begin to hurt.

More news, from our team at The Rude Awakening:


Eric Fry, reporting from Manhattan…

"As French voters declare ‘non’ to the European Constitution, a slumbering gold market might finally roll out of bed…"


Bill Bonner, back in London…

*** "House prices still rising." "Foreclosures Increasing." Both headlines are in the weekend papers. Which one will dominate the headlines next year?

*** A note from Dr. Kurt Richebächer:

"What has been the economic reality in the United States in the past four years, with real GDP growth of 10.4% and an increase of overall real wage payments by 3.9%?

"At any rate, it is the worst employment performance on record for the United States in the postwar period, and also the worst in the world. We owe the following details and the chart below to the Economic Policy Institute in Washington.

"Since the start of the recession, 46 months ago (March 2001), the U.S. economy has added a negligible 62,000 jobs. Private-sector employment, however, is still down 703,000, contracting by 0.6%. Though the job numbers improved in 2004, the growth rate for nominal hourly earnings -2.6% -was the lowest in the history of this wage series, which began in 1964. At the same time, consumer price inflation accelerated from 1.9% in the prior year to 3.3%.

"Last year, this pattern of decelerating wage rate growth versus accelerating inflation rates led to the first inflation adjusted decline in hourly wages since 1993. Over the four years since 2000, average weekly earnings have edged up overall by a paltry $1.08, to $276.70. That is an increase by a fraction of 1% over a period of four years."

The Daily Reckoning