The Loser in a Win-Win World

The Daily Reckoning PRESENTS: It’s a weird and dangerous situation we’re in. Global interest rates are rising and liquidity is tightening. It’s getting more expensive to borrow money all over the globe. And who’s going to feel it the most? Dan Denning explains…


“But why is it the Asian central bankers continue to support the dollar, the American economy, and huge American structural deficits? Don’t they have better places to invest their money, like their own economies, for example?”

“Of course they do. But most central bankers are idiots. That won’t change. But I tell you this, the exit from the dollar carry trade is beginning. Dollar-denominated assets – especially U.S. bonds and real estate – will fall. The money will pour into emerging markets. But it will also benefit gold and other hard assets.”

That was the gist of a few hours of conversation I shared with Dr. Marc Faber recently. The good “Dr. Doom” had spoken in Melbourne a few days earlier to a packed but mostly lethargic room of professional money managers. For most of the investment world, warnings about the imminent breakdown of the dollar’s status as reserve currency are the perfect verbal garnish for braised lamb and red wine. But for some people – let’s call them contrarians, for lack of a better word – it’s a tremendous opportunity.

I want to thank Dr. Faber for taking the time to share a bottle of white wine with me before he flew to Iowa for another speech. He’s been a valuable contributor to Strategic Investment for years. It was the first time we’d met in person. And despite his reputation as Dr. Doom, he’s quite charming and, of course, enormously insightful.

One of the really important things Dr. Faber pointed out is that the nominal value of the Dow should not be your measure for investment success. It’s possible for the Dow to stay the same or even go up in nominal terms, but fall relative to gold. And if the Fed begins to use some its other policy tools – buying bonds to inject cash in the system or even directly buying stocks, should it come to that – the Dow could go to 36,000 and gold to $5,000.

Sure, the Dow would triple. But gold would better the Dow, both relatively and absolutely. Dr. Faber put it this way in one of his recent articles:

The Dow has been in a bull market since October 2002 in dollar terms, but it has been in a bear market in gold terms. This is an important point to understand. In case we should experience continuous monetary inflation, which could lift, over time, all asset prices such as stocks, real estate, and commodities, some asset classes will increase more in value than others. This means that some asset classes while rising in value could deflate against other asset classes, such as happening with the Dow against gold since year 2000.

However, a steady flow of liquidity can lift all boats higher over time. Take, for example, the dismal bear market the Dow endured up until 1982. In real terms, the index did nothing for nearly 10 years. Adjusted for inflation, it did worse.

And then we entered the sweet spot. And it lasted for 20 years. It was a good run for a specific asset class: American stocks. It was so good, in fact, that Alan Greenspan’s Fed didn’t want it to end. No one did, really. It is nice getting rich. And a lot of people, on paper at least, got rich on Alan Greenspan’s watch.

The Fed’s lenience under Greenspan resuscitated stocks. But while stocks struggled to make new post-bubble highs, the housing market became the nation’s asset class of choice. It was the new way to get rich quickly. And so for the last four years, we have seen that rarest of investment phenomena: simultaneous bull markets in all asset classes.

With low global interest rates, everyone got what they wanted. Japan exported at a profit and Japanese savers earned a nice return by buying American bonds. The Chinese financed their customers and used the profits to secure resource needs. And Americans? We got $30 khaki trousers and low mortgage rates. It’s a win-win-win-win-win-win world.

Who will be the biggest loser? It’s a weird and dangerous situation we’re in. Global interest rates are rising. That means liquidity is tightening. It’s getting more expensive to borrow money all over the globe. This could, at least in theory, reduce the many “carry trades” that have been a feature of global capital flows in recent years.

A carry trade is borrowing in a currency where interest rates (borrowing costs) are low, and investing in assets where yields or interest rates are high. A popular one, for example, would be to borrow money in Japan and pay 1% interest on it while investing the borrowed money in 10-year U.S. Treasury bonds, which are currently yielding north of 5%.

If you’re scoring at home, that’s 4% profit, providing the currencies involved maintain their exchange rate. But a currency only retains its value if its government is not a deadbeat borrower. And it looks like the rest of the world is catching on that U.S. government bonds, even at higher yields, are a sucker’s bet. The shift out of debt-based assets into real assets is on, and on with a powerful vengeance. Want some evidence? Try this:

? Gold and silver are at 20-year highs

? Oil is back above $70

? Ten-year U.S. Treasury notes are over 5% and 30-year mortgage rates are over 6%.

What’s happening? Those stupid investors and central bankers in Asia are getting smarter. They are buying fewer government and mortgage-backed bonds and investing more in commodities. Global capital flows are shifting away from the United States and – for the time being – directly into commodity and resource stocks and funds and ETFs.

The lack of foreign buying of U.S. bonds will drive bond prices down and yields up. And more importantly, the fire hose of liquidity will flow directly into commodity and resource funds – usually the ones easiest for institutions to buy.


Dan Denning
for The Daily Reckoning
April 26, 2006

P.S. In total actual U.S. dollar reserves, China has nearly $700 billion tucked beneath the mattress…and Japan, more than $685 billion. Even Taiwan, Singapore, and South Korea have a combined $157 billion hidden away.

But how long will foreign investors keep this up? Well, investors hang on while their positions make money. Or when the risk remains low enough to justify the return.

If the risk premium rockets upward, or those returns dry up, smart investors run for the exits. And when they do – that’s when the inevitable cycle that could wipe out your investments really begins.

Yo no soy de estos pagos, soy de Arbolito
Lugar de mis amores, pueblo chiquito.

(I’m not from round here, I’m from Arbolito.
It’s a small place, but when I’m away I never forget it.)

– Traditional Argentine gaucho song

We are not from these parts, either, dear reader, nor did we forget you. But, we were not able to write to you yesterday, because we could get neither an Internet signal nor a dial tone – not even a hot bath. Life can be a little hard, out on the high plains. Over the past week and a half, it has been more than a little hard to stay in touch.

When we wrote last on Tuesday, we were explaining why we bother you with the details about our trip to Argentina. After all, The Daily Reckoning is – most of the time – about money, but there is more to money than just making it. For many people, indeed, making money is the easy part. Unmaking it is much more interesting and dangerous. A man can go through his life working away at his business with a fair amount of dignity, but only give him a little money, and he is almost sure to make a fool of himself. Usually, he spends so long making it that by the time he finally has some, he has no idea of what to do next. He lacks the taste, the experience, and the judgment to part with it gracefully or with dignity.

Instead, he is likely to squander his money on gaudy houses and expansive cars…reckless investments…bimbos…or even a ranch in South America.

But in your editor’s mind, a big spread in Argentina was designed not to expose him to humiliation, but to protect him from it. Way out in the foothills of the Andes, he reasoned, how much trouble could he get into?

Besides, imagine the many sad consequences that could arise from holding on to stocks or bonds: in a few weeks, your investments might be cut in half – or worse. Is the dollar not doomed? Are America’s businesses not losing ground to foreign competitors? What will happen to U.S. bonds when Asian lenders figure out that they will never be repaid? What would be the point of holding them? What pleasure could you ever get out of them?

When it comes to raw, mountain desert land – without electricity or central heating – what could possibly happen that would make the place less valuable?

And so, out here, we have gotten ourselves into the cattle business, and we give you the economics of it, lest you be forced to learn it for yourself:

The cattle are all grass fed. Hay is stacked up for the wintertime, but the hay comes from the bottomland on the ranch, too. Almost nothing is purchased, except some supplements and obligatory vaccinations, which only cost a few dollars per head.

On the other hand, you need some gauchos to mend the fences and go find the cattle, give them the required medicines, cut their ears, burn their hides with a brand, round them up and load them on trucks to be sold. From what we could get out of Francisco, a herd of 1,000 cows spread out over thousands of acres of bad land takes a crew of at least three. Each gaucho costs the farm about 1,200 pesos a month or about $400. So, setting aside taxes and other miscellaneous costs, you’ve got to spend about 60,000 pesos a year in labor (not counting the farm manager).

From a herd of 1,000 cows, you get about 500 calves a year, which you can sell for about 150 pesos each, which brings you revenue of about 75,000 pesos. But then you have to pay the farm manager and buy him a pick-up truck. So, as near as we can tell you’ll lose money forever…unless the Chinese starting eating Argentine beef for breakfast, which is what every cattleman all over the planet is counting on more than he counts on the eternal life of the soul or Social Security.

But according to Francisco, if we do it right – that is, if we invest more money in larger reservoirs to catch the summer rains and in more and better cows – we’ll be able to breakeven. At least we won’t lose money, which is all we ask from any investment.

Thus have we come to Salta Province, and thus were we taking a tour of the property we had bought – on horseback…the only way to see it. And thus, also did we end up bedding down for the night under the skies.

At high elevation, even the skies seem more open. The stars seem brighter and there seem to be many more of them. It was a delight for us just to lie in our sleeping bags and stare up at them as they came out. First, they were just a few fuzzy flickers. Then, there were hundreds of them, more distinct. Finally, there were so many that they all ran together like a kind of bright, shining dust. There was the Milky Way, of course. Below it to the south was another batch of stardust we had never seen before, and then another we did not recognize…and another.

We could barely close our eyes. Partly because of the celestial lighting, partly because we were uncomfortable in our new sleeping bag, and partly because of the day’s events, which like a rich meal, needed to be digested before we could settle into sleep.

The next morning, Francisco and Jorge had saddled up the horses even before daylight, each one of them sporting a montura padded with a sheepskin. You are comfortable in them for the first couple of hours. After that, however, you begin to squirm in the saddle, to twist and turn and try new ways of riding. You even stand up in the stirrups to avoid the bounce, which is how your author ended up spending two days in bed, unable to walk or move, with no telephone or radio, at least an hour’s drive from the nearest doctor.

Do you see, dear reader, how one decision leads to another, each of which, individually, is perfectly reasonable, but all of which, taken together, lead ineluctably to an unexpected and disagreeable result?

Jorge, on the other hand, is a man who seems settled equally in his thoughts and his saddle. He barely moves in either. When we speak to him, in Spanish of course, he looks as though he is working hard to figure out what it is we are saying, but is respectfully reluctant to believe we might be saying anything as idiotic as it sounds.

Translating our own phrases, we realize what our conversation must have sounded like:

“Buen dia,” says Jorge.

“I wait that you had a good day both,” we reply.

“Are you ready to ride out, señor?”

“We are ready to share. Let’s go with God.”

“Are you feeling okay today, patron?’

“True. I smell perfectly.”

Jorge knits his eyebrows slightly. His smile fades a bit. He must have been wondering what it would be like to work for such a madman. But, he keeps his thoughts to himself and urges his black horse down the hill and out onto the open range. The rest of us follow behind: Elizabeth sitting up straight like a real horsewoman; Edward on his mule, wearing a white hat and a tan poncho made by the same people who made one for Pope John Paul II; the rest of the family and Francisco bringing up the rear.

Spreading his pancho out so that it covers almost his whole body, Edward seems completely happy. The mornings can be chilly, even in the summertime, but warmed by the heat rising from the mule on which he trots along next to Francisco, Edward seems in his element. In London, it sometimes seems we are living with an animal that has never been fully tamed. His instincts are out of place; his energy has no way to express itself that isn’t annoying. But out here, he can run around, jump on a horse, ride for hours, and shout at the top of his lungs. In his own way, he is as much at home on the range as Francisco.

Francisco, of course, is a real gaucho, with a certificate to prove it. He even attended a gaucho school, and is currently the president of the local gaucho union.

“Gauchos have a union?” Henry turns the statement into a question by raising the pitch of the last word.

“Si. But it is not a union like other unions. We do not go on strike or ask for higher wages. We just teach people the gaucho skills. That’s why we have a school for gauchos…so the skills are not lost. We also try to preserve the history and culture of the gauchos. You know, in each part of Argentina, the gauchos are different. Here in the northwest, we are not like the gauchos of the pampas – not at all. We wear different clothes, and we do things differently, too. Down there, they barely have to ride a half an hour to find their cattle. Here, we go out for days. And here, it can be much colder. I once rode around this entire valley for 15 days, riding 14 hours a day.”

We were all duly and properly amazed. We had been riding only for a couple hours, but were already ready to stop for lunch.

Tomorrow, we explore Indian ruins…in the meantime; let’s turn to our currency counselor to see what the happenings are in the land of modern technology and conveniences…


Chris Gaffney, reporting from the EverBank world currency trading desk:

“The tone of the market is currently dollar-negative and good data from the United States will be overlooked, just as negative data was swept aside during last year’s dollar rally.”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


And over to our team in Baltimore…

*** “The shift out of debt-based assets into real assets is on, and on with a powerful vengeance,” Strategic Investment’s Dan Denning tells us.

“Want some evidence? How about: the fact that gold and silver are at 20-year highs? And oil is back above $70…and ten-year U.S. Treasury notes are over 5% and 30-year mortgage rates are over 6%.

“What’s happening? Those stupid investors and central bankers in Asia are getting smarter. They are buying less government and mortgage-backed bonds and investing more in commodities. Global capital flows are shifting away from the United States and – for the time being – directly into commodity and resource stocks and funds and ETFs.”

[Ed. Note: More from Dan, below. In the meantime, check out his latest report that details how you can profit when our friendly neighbors in the Far East decide that the United States may not be the best place to have their money right now.

*** The DR has made it into the 21st century…for the most part.

With our editors becoming increasingly popular on the media circuit, we decided to take the plunge into an unknown (to us) zone: Podcasting.

For those of you who don’t know, Podcasting is a pretty cool idea. It’s an audio file, a MP3, most likely, in talk show or interview format. The show isn’t live, so you can listen to it whenever you want.

We recently put Addison’s interview with Bloomberg TV on our Podcast page – and check what else we have. We only have a few right now, but we’ll definitely be adding more to our library in the coming months.

The Daily Reckoning