naked capitalism

Nouriel Roubini has officially left the “hedging your bets on the economy” camp. He has declared the markets to be frothy because super low dollar borrowing rates have turned the greenback into the funding currency for the carry trade.

Far more important than the peppy rally in the stock market is the resumption of early 2007 style risk taking in the credit markets. As Gillian Tett of the Financial Times noted last week:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

In other words, everyone seems to be in on this bubble except most borrowers in the real economy. But that wasn’t the main objective…it was to reflate asset prices to save the global banking system…by rerunning the same movie that drove it off the cliff in the first place (well, this is a sequel, so there are some minor plot changes, like the dollar rather than the yen as the basis for the carry trade).

From Roubini in the Financial Times:

Since March there has been a massive rally in all sorts of risky assets… and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals…. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally….Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble….

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy….This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

The Journal has a less apocalyptic story on the very same topic: “Dollar Calls the Tune for Stocks, Bonds, Oil“:

A joke making the rounds among stock investors is that they’ve all become currency traders. In recent weeks, the relationship between moves in the dollar and stocks has been incredibly tight; as the dollar rises, stocks fall and vice versa.

And it isn’t just stocks. Links between the dollar, corporate bonds, energy prices and gold have grown closer. Traders and analysts point to one factor as the cause: the Federal Reserve’s efforts to flood the financial markets with dollars. They say the Fed has created an unusual environment where investors essentially have two choices — hold onto dollars or buy something, anything else.

The connections between assets have been growing as investors become more fixated on how and when the Fed will turn off the spigot.

The intensity of the links “tells me there is a lot of nervousness and a lot of fast money,” says Michael O’Rourke, a market strategist at BTIG.

As a result, some believe the markets are in a new bubble, driven by interest rates essentially at zero, which will pop sooner rather than later. That camp includes Pimco’s Bill Gross, who last week wrote that the six-month rally in riskier assets, spurred on by the Fed and U.S. Treasury, “is likely at its pinnacle.”

Submitted by Edward Harrison of Credit Writedowns.

Earlier today I wrote a post featuring comments by Marc Faber as I like to do from time to time.  In this particular case Dr. Faber was waxing prosaically about an eventual bankruptcy of the U.S. government.  His money quote was:

“Next station is when the U.S. government goes bust.”

I love this guy. Quite frankly, the man is a quote machine.  He makes a lot of outrageous statements that get him noticed.  Here are a few that I have featured in the past:

• Oct 2009 – “Monetary policy in the United States will stay expansionary”
• Sep 2009 – “The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society.”
• May 2009 – “I am 100% sure that the U.S. will go into hyperinflation”
• Mar 2009 – “The feds poured the gasoline and lit the match. Now they’ve joined the fire department”
• Nov 2008 – “I advise every American to hold his gold outside of the United States“
• Mar 2009 – “Don’t underestimate the power of printing money.”

The last one is my all-time favorite.  And there are many more available at Credit Writedowns and elsewhere.  Dr. Doom is very entertaining indeed – which is why I quote him so often.  But, is he right?

That’s a good question – one I will take up indirectly by introducing the latest piece by Martin Wolf, another author I have featured at Credit Writedowns from time to time. You may have seen me tweet this earlier today. I had intended to add it to the links for tomorrow, but Niels Jensen, who I also feature often, convinced me to write it up as an ‘antidote’ to Faber.

Here’s how Wolf begins his article:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

This is exactly what the Chinese are doing. They are preparing themselves for a non-dollar future. This is why the Chinese are buying gold. This is why the Chinese are settling trade in Yuan. And this also why the Chinese are getting a bunch of other countries onside.  But they are not looking for a dollar crash as I indicated last week.

Then, there is the part about Dollar weakness being a sign of inflation. Here’s what Wolf has to say about this idea:

The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth.

I hope this argument sounds familiar because it is one I made when I asked is the Fed just jawboning? The U.S. wants – it needs a lower dollar to avoid deflation. Quantitative easing is not solving the deflation question. The U.S. government wants a strong dollar? Well, policymakers say one thing and wish for another. The U.S. insistence on focusing on global imbalances at the G-20 should tell you what policy makers really want. This is why the dollar is falling.

The problem of course is that the dollar’s recent rout is not necessarily helping the U.S. because the dollar is overvalued vis-a-vis a host of pegged currencies. And while those currencies are under pressure to drop the peg, they are resisting because they do not want to move toward a more re-balanced global growth paradigm unless forced to do so.  Unless these countries (read China) do something on the currency front, expect more of this, this and this – protectionism.

Then, the question arises, if everyone hates the dollar, what are they moving to? Wolf says:

Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain.

This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

I liken this argument to George Soros’ comments on dollar weakness: “The dollar is a very weak currency except all the others.” Right now, there is no alternative to the dollar.  Some people are fleeing U.S. assets if they can. But the alternatives are limited and this limits how far the dollar will fall. And this is unfortunate because the monetary system now in place is in need of change.  Without it, we are likely to see nationalistic policy responses to economic weakness, which will induce conflict.

Wolf says:

I arrive, by a somewhat different route, at the same conclusion as Mr Bergsten: the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong. This is not because the dollar’s role is now endangered. It is rather because it impairs domestic and global stability. The time for alternatives is now.

Apropos alternative monetary systems, we might start with Paul Davidson’s ideas, which I first highlighted in November.  So there is no hyperinflation, no U.S. national bankruptcy, and  no dollar crash coming. But, the financial crisis demonstrates we are living on borrowed time and need a new monetary system. The time is now.

Source

The rumours of the dollar’s death are much exaggerated – Martin Wolf

Wolfgang Munchau, in today’s Financial Times, makes the case that a certain amount of dollar weakness is a good thing and consistent with global rebalancing. On one level, this is a sensible and defensible view. But this view is implicitly based on the idea that the dollar will somehow find its “correct” level, more or less.

But currencies are known for their propensity to overshoot and stay for long periods at levels not warranted by fundamentals. The yen is a prime example. Even with Japan’s lousy domestic economy, its large (until recently) trade surpluses would have argued for an appreciation of the yen. However, the currency stayed super cheap because the yen had become a funding vehicle. It was only when the carry trade unwound and domestic currency speculators exited their foreign bets that the yen rallied, and is now at levels that seem similarly unwarranted by the fundamentals. To his credit, Munchau does not see some welcome weakness of the dollar as a long-term solution; he highlights the need for structural reforms.

So Munchau is correct, there could be a happy ending here, but I’d be loath to bet on it. For instance, some took cheer that the US trade deficit narrowed. But that was due largely to oil imports contracting due to price increases. $70ish a barrel oil is hardly expensive by recent standards. If a recovery to that level can lead to a fall in demand, it says the economy is more fragile than most want to admit.

From the Financial Times:

Imagine a world with a small current account deficit in the US, a somewhat larger deficit in the eurozone and a not too excessive Asian surplus. In such a world, economic commentators would no longer bang on about global imbalances and would have to find a different subject.

In the long run, such a world would require significant reform of the international monetary system. In the short term, a fall in the dollar’s exchange rate would help get us there. And I note with some satisfaction that it is happening.

A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ….a strong dollar is the last thing the US economy needs right now.

There are two further factors that support a weaker dollar. The first is, of course, the double-digit public sector deficit, which has already unnerved investors and which is not going to come down with any haste. The second is monetary policy….

The latest published comments from Bill Dudley, president of the New York Fed, confirmed my suspicion about the Fed’s asymmetric bias when he said he was more concerned about deflation than inflation and that interest rates would stay low for a long time. This is 2003 and 2004 all over again, except this time the chances are higher that it will end in inflation rather than in a housing and credit bubble.

What about the rest of the world? Would the Europeans, for example, not fight tooth and nail against a weakening dollar? Not necessarily. Just look at the situation from the perspective of the European Central Bank. Ideally, it would like to exit early by withdrawing liquidity support and raising interest rates, but it is severely constrained because many European banks are still dependent on low interest rates and ECB life support operations for their survival.

Fiscal policy is also extremely loose and likely to remain so. From the ECB’s point of view, a strong euro is probably the most effective insurance against resurgent inflation, at a time when interest rate policy remains constrained.

A strong euro would nicely take care of Germany’s persistent current account surplus. The surplus countries will never adopt policies to get rid of their surpluses. The exchange rate will have to do the job for them. Last week’s announcement of a surprise fall in German exports during August tells me that the hopes of another export-led recovery, as in 2006, are unrealistic. I expect a much reduced current account surplus for Germany in the next few years and, for the eurozone, a sizeable, probably not excessive, current account deficit.

The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. I am not trying to make a short-term prediction. Foreign exchange markets are crazy, and I have been wrong too many times. But what persuades me that the dollar has further to devalue is the observation that, for once, politics and economics are pushing in the same direction.

Exchange rates cannot solve the problem of global imbalances…. Reform of the global monetary system is necessary for sustained balance. I agree with the views of Fred Bergsten, director of the Peterson Institute for International Economics in Washington, that the world will ultimately have to move to maximum targets for current account imbalances.

In a forthcoming article in Foreign Policy, he proposes a current account deficit ceiling of 3 per cent of gross domestic product for the US. He also argues that a reduced international role for the dollar would be in the best strategic interests of the US as continued imbalances would end up producing intolerable instability, no matter whether they are financed or not….

It is important not to confuse the international role of a currency and its exchange rate at any particular time. But in the case of the dollar, there is a link. A fall in the dollar’s exchange rate would be a very useful contribution to global balance. A reform of the global monetary system is needed to ensure that imbalances do not return. We are not there yet, not even close. But some of the parameters are slowly falling into place.

A Bloomberg headline tonight is uncharacteristically alarmist: “Dollar Reaches Breaking Point as Banks Shift Reserves.” However, while the article is correct to point to lack of enthusiasm for the dollar, it presents, but then fails to integrate, a key point: foreign central banks are not cutting dollar holdings. In fact, they are still increasing buying dollar assets. But they have shifted their marginal purchases in favor of the euro and yen. That shift is playing into current dollar weakness.

We could be approaching a short-term inflection point. Sentiment on the dollar is very bearish, and its long-term outlook is not promising at all. But this could point to either another leg down (the beginning of a disorderly slide that many observers worry about) or could also produce a snapback rally if an unexpected rise led to short covering (particularly if equities markets rallies were to fade and lead investors to seek cover until the dust settled in Treasuries).

From Bloomberg:

Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades.

Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase.

World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991.

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays in New York. “It looks like they are really backing away from the dollar.”

The dollar’s 37 percent share of new reserves fell from about a 63 percent average since 1999.

Some believe that developing economies may be selling dollars:

Developing countries have likely sold about $30 billion for euros, yen and other currencies each month since March, according to strategists at Bank of America-Merrill Lynch.

That helped reduce the dollar’s weight at central banks that report currency holdings to 62.8 percent as of June 30, the lowest on record, the latest International Monetary Fund data show. The quarter’s 2.2 percentage point decline was the biggest since falling 2.5 percentage points to 69.1 percent in the period ended June 30, 2002.

But some think a reversal later is possible:

Central banks’ moves away from the dollar are a temporary trend that will reverse once the Fed starts raising interest rates from near zero, according to Christoph Kind, who helps manage $20 billion as head of asset allocation at Frankfurt Trust in Germany.

“The world is currently flush with the U.S. dollar, which is available at no cost,” Kind said. “If there’s a turnaround in U.S. monetary policy, there will be a change of perception about the dollar as a reserve currency. The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”

However, despite the noise from the hawks at the Fed, the official pronouncements have all indicated that the Fed expects to keep rates low for quite some time.

Whoops, that was the old brand, and it was to be led by Japan. The results were less than happy since Japan was not prepared to take “no” for an answer.

But this time around, necessity as well as opportunity are leading China, Japan, and Korea to discuss moving forward on closer economic ties. In fact, the driver for talks appears to be more than a tad of desperation of the Japanese.

The US has been opposed to anything more than symbolic movements on this front. For instance, in the 1997 Asian crisis, Japan wanted countries in the region to lead rescue efforts. That idea was opposed, forcefully, by Robert Rubin, Larry Summers, and Timothy Geithner, who was then at the IMF but slotted to join the Treasury. And we know how that movie ended. The IMF “reforms” were the same template they had used for Mexico, and was inappropriate in key respects for high-savings Asian countries. The Asian tigers’ resentment of punitive and painful programs led them to institute currency pegs at artificially low rates so they could build up their reserves. China held its peg during the crisis at US request, reinforcing its use of pegs (and one can further argue that the low rates implemented in the crisis countries gave China plenty of cover to maintain its peg even as its currency became increasingly undervalued).

It is still not clear how serious this move is. There has been talk for some time of beefing up ASEAN (for instance, having it have its own development bank as an alternative to the World Bank). This initiative is outside ASEAN and is in the brave talk stage. The biggest potential obstacles is long-standing distrust among the principal actors. That may be compounded by China trying to assert a leadership role, which is understandable given its economic position, but diplomacy is not yet one of China’s strengths.

From the Telegraph :

The three countries, dismayed at falling levels of trade and investment from the US and Europe, met in Beijing to plan for more structured levels of co-operation.

The move came as HSBC warned there is likely to be a “shift in the world’s centre of economic gravity from West to East”. The bank has already decided to move its chief executive, Michael Geoghegan, from London to Hong Kong next February to prepare for Asia’s ascendancy.

Wen Jiabao, the Chinese prime minister, and his Japanese and South Korean counterparts, Yukio Hatoyama and Lee Myung-bak, said the three countries were “committed to the development of an East Asia community”, similar to the European Union.

The idea, which is being strongly pushed by Japan, could eventually lead to a free trade block and co-operation on public health, energy and the environment….

The proposals are in their early stages, and the three countries emphasised that it was a “long-term goal”. Liu Changli, a professor at China’s North East Finance University, said a free trade area could be in place “by 2020, on a best-case scenario”. He added: “Add another five to 10 years for an economic union and a further five to 10 years after that for a true economic, military, political and cultural union”.

The proposals come as Japan is struggling with the collapse of its export sector, a key motor of its economic growth. Since Mr Hatoyama was elected at the end of August, he has been searching for a way to kick-start the economy and alleviate the country’s debt, which currently stands at 283pc of GDP, the highest of any G20 nation….

South Korea’s ties with China have also weakened, with substantial Korean populations in Beijing and Shanghai returning home because of the downturn.

Both countries now see China’s booming economy, which is set to grow by at least 8pc this year, as a beacon of hope. China, for its part, has a long-term strategy of reducing its dependence on the West and building political and economic ties with Russia, the Middle East, Africa, Latin America and Asia. It has already signed a bilateral free trade agreement with ASEAN, the coalition of South East Asian nations, which is due to come into full effect next year.

However, any attempts by the three nations at closer integration are likely to be opposed by the US, which is concerned about any waning of its influence in the Pacific.

Japan’s role in this is a clear statement of diminished US power. Japan is a military protectorate of the US. For at least the last three years, if not longer, Japan has been playing a very careful game between the US and China. It appears to have decided it has little to lose in seeking to throw its lot in with China.

An unannounced but evidently coordinated effort to arrest or at least slow the fall of the dollar is underway. The Financial Times indicated that Asian central banks were aggressive dollar buyers on Thursday, but the information came via currency traders rather than an official pronouncement. Thailand, Malaysia and Taiwan made substantial purchases; Hong Kong and Singapore also intervened today. The action may also have a secondary objective of rejiggering their currency values versus China’s, since China repegged the renminbi against the dollar.

However, these efforts were seen by traders as merely an attempt to control the fall in the dollar rather than halt it. And other markets responded to the dollar weakness. Oil prices rose nearly $3 today, gold hit a new high in dollar terms, and copper and tin spiked upward. The dollar is strengthening overnight on Bernanke’s empty promise that the central bank will raise rates when the economy recovers.

The dollar’s weakness exposes a series of dilemmas and a lack of obvious remedies. Normally, a country experiencing a financial crisis takes measures to depreciate its currency so it can use an export boom to help pull itself out of its economic mess. However, Paul Krugman, among others, have pointed out that trade has collapsed, so even if one were to break glass and trash currency, it isn’t as effective a solution as it would normally be. And even if that approach might work, with so many countries affected by the crisis, it’s too easy for currency depreciation to lead to beggar-thy-neighbor competitive devaulations.

Although the US keeps mouthing its “strong dollar” assurances, many observers believe that the Obama Administration is content to let the dollar slide because the resulting inflation will help erode the value of debt and more robust exports will help growth. But that seems a trifle optimistic. First, some economists, such as Jim Hamilton, argue that it was the commodity price runup of early 2008 that pushed over-indebted consumers over the edge. Commodities inflation, when it inures to the benefit of foreign producers, is not a boon to the US. Second, the US has ceded a lot of manufacturing industries. How long would the dollar have to stay weak for the US to repatriate significant amount of, say, furniture and shoe fabrication? These are two industries where some incumbents insist the US could remained competitive in high-end and even some mid-level manufacturing (offshoring was driven not just by cost savings but also by a desire to please Wall Street analysts). It takes time to establish operations and hire and train staff. No one is going to make investments like that unless they are confident the dollar will remain comparatively weak.

Third, rising inflation is not a panacea. While it reduces the value of debt currently outstanding, it also makes it costly to sell new debt (unless the borrower is convinced inflation will rise even higher). Even if the principal will be paid back in depreciating dollars, the cost of debt service rises with higher interest. And having lived through the inflation-ridden bond markets of the early 1980s, no one wanted to be borrowing then. Reasonable credit quality companies were facing 15+% coupons.

Even before we get to anything resembling that level of interest rate, the Fed and Treasury have a big bind. Higher domestic inflation means higher interest rates. Higher interest rates mean higher mortgage rates. That kills housing. Higher interest rates also means all those private equity owned companies that are stuffed up to their eyeballs in debt and need to refi between now and 2013 find it more costly. Many will not survive higher debt service. Big bankruptcies and related job losses are not too good for economic recovery. The Treasury has also gotten addicted to super low interest rates (and if my correspondents are correct and the average maturity of Treasury debt has shortened, the US is more exposed to interest rate increases than it might otherwise be). In other words, even a modest increase in rates could have a much nastier economic impact than conventional wisdom assumes.

And we have another possibility. At the G20, the US started to take up the “we want to be an exporter when we grow up” theme. Ahem, so who is going to be the net consumer if the US gives up that role? Now I will be the first to concede that having a world where more countries had robust consumer sectors and were less export dependent would be a much better arrangement, but getting there is at least a 10 year, probably more like a 20 year transition. Yet the powers that be here are acting as if the US can beef up its exports and get to a net neutral or a net exporter position much sooner. So was that unannounced Asian intervention benign, or was it a bit of a warning shot, that the rest of the world reluctantly accepts that the dollar probably needs to be cheaper, but will only let that go so far?

You cannot make this stuff up. The Saudis are lobbying for foreign aid in anticipation of declining oil revenues. Hat tip reader Michael:

Saudi Arabia has led a quiet campaign….demanding behind closed doors that oil-producing nations get special financial assistance if a new climate pact calls for substantial reductions in the use of fossil fuels.

That campaign comes despite an International Energy Agency report released this week showing that OPEC revenues would still increase $23 trillion between 2008 and 2030 — a fourfold increase compared to the period from 1985 to 2007 — if countries agree to significantly slash emissions and thereby cut their use of oil…..

The head of the Saudi delegation Mohammad S. Al Sabban dismissed the IEA figures as “biased” and said OPEC’s own calculations showed that Saudi Arabia would lose $19 billion a year starting in 2012 under a new climate pact….

Al Sabban accused Western nations of pursuing an agenda against oil producers, under the guise of protecting the planet.

When markets were more agitated than they are today, one source of background worry was the Baltics. The countries went on a debt binge, borrowing heavily from Swedish banks. And while the amounts at issue are hardly earth-shaking by credit crisis standards, there is always the possibility that unexpected knock-on effects could lead to more serious consequences than now appear likely. Not that the impact is not meaninful to parties immediately involved, namely Sweden and Lativia.

John Hempton provided background earlier in the year:

Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.
In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can’t happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro.

Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit.

Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn’t like more or less continuous mild recessions…

Now there is one exception…And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money.

The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.

Foreign benefactors have just put the choke collar on Latvia. The government was unable to roll over its debt this week. From MarketWatch:

Latvia’s central bank warned Wednesday of “another wave of distrust” beginning to roll over the Baltic country, as the government received no bids for one of its three auctions for debt securities, heightening worries over its financial situation and the sustainability of its currency peg.

The Bank of Latvia, in an uncharacteristically dramatic statement for a central bank, said the lack of confidence can potentially bring higher interest rates and exacerbate conditions for entrepreneurs….

Latvia has been battling to emerge from a deep financial crisis. Sweden on Tuesday put pressure on the tiny Baltic nation to fulfill required spending cuts, threatening to withhold payments due at the turn of the year from a 7.5 billion euro rescue loan put together by Nordic countries.

Sweden, in other words, finds itself a major actor, along with the EU and the IMF, in negotiating a rescue package that extends new loans only if austerity measures are implemented.

But Latvia does not appear to be ready to accede to Sweden’s demands. The immediate cause for concern is that Latvia will simultaneously devalue its currency and provide a mechanism for its consumers to partially default on mortgages held by foreign banks. From another MarketWatch story:

The Baltic country is squabbling with Western — mostly Swedish — leaders over spending cuts, and it’s a very real possibility that the country may be forced to devalue its euro-pegged currency if emergency global funds don’t arrive.

Were Latvia to devalue, that would hit economies in neighboring countries like Lithuania, and Swedish banks would rack up additional losses on the loans they have made throughout the region.

The real nightmare scenario would be the Swedish banks then pulling down other European banks, and then triggering Credit Crunch: Part 2.

There is, of course, a long way before that unwieldy scenario comes to pass. Latvia hasn’t devalued — yet – and, even if it does, that doesn’t mean it would drag the Swedish banks under.

Latvia just had a $17 million bond auction fail, as in no bids. Which is understandable given the real possibility of a near-term devaluation.

The Guardian comments less than enthusiastically about the central bank’s idea of how to cut the Gordian knot, that of reducing mortgage borrowers’ liability en masse (deep principal mods, as we would call them here, on mortgages held by foreign banks):

The Latvian government was struggling to avert a financial meltdown today as ministers convened emergency talks with Scandinavian banks to discuss a bold and controversial plan to slash mortgage-holders’ liabilities to lenders.

The scheme could mean billions in losses for the big Swedish banks most exposed by the small Baltic state’s financial and economic crisis.

Valdis Dombrovskis, the embattled Latvian prime minister, said he was confident he could get his proposal through the parliament in Riga, but was still examining the legal implications of the scheme. But the powerful Latvian central bank delivered an unusually blunt attack on the prime minister, saying that his budget and bank policies were feeding a fresh “wave of distrust” towards the small and highly vulnerable state.

Banking sources in Riga warned that the radical proposal on mortgages, which could see borrowers repaying only a fraction of their loan, would backfire, deterring foreign investment, bringing already low bank lending to a complete standstill and wrecking international confidence in Latvia.

Dombrovskis said the foreign banks, which hold controlling stakes over 90% of the Latvian banking sector, shared the blame for the crisis and would also have to share the costs. “Some balance has to be found between the interests of borrowers and the interests of lenders,” the prime minister told the Guardian. “The real incomes of people are diminishing and it is getting more difficult to repay loans.”

Dombrovskis’s surprise proposal came amid growing international concern about Latvia after he revealed plans to cut public spending next year by only half the level agreed with international creditors earlier this year as part of a €7.5bn (£6.9bn) rescue package put together by the EU, the IMF and the Nordic countries. Sweden, currently chairing the EU, reacted by threatening to withhold more than €1bn in credit scheduled for next year.

The FT also weighted in:

The finance ministry denied there had been any weakening in commitment to Latvia’s currency peg with the euro amid a renewed round of speculation that the country would be forced to devalue the lat.

Riga announced tentative plans on Tuesday to cap the amount that banks would be allowed to collect from mortgage holders in a move that analysts said would make it easier for Latvia to devalue.

This has revived concern among international investors about the heavy exposure of Nordic banks to the Baltic region and the risk of contagion if devaluation in Latvia forced other eastern European countries with fixed exchange rates to follow suit.

The Latvian proposals would allow banks to collect only the current value of a property rather than the original value of the mortgage, insulating homeowners from the 70 per cent drop in property prices since their peak.

The move would remove one of the biggest obstacles to devaluation by ensuring that holders of euro-denominated loans, which account for about 80 per cent of mortgages in Latvia, would not face a sharp increase in debts if the peg with the euro was broken.

When a country starts denying that it is going to devalue, it is almost inevitable that it winds up doing just that.

On the surface, the Latvian crisis appears far too small to trigger another round of upheaval. But it could serve to reveal how weak European banks really are. They entered the crisis with lower equity levels than their US peers, and the biggest have just as sizable derivatives exposures. When you add to that the fact that they have realized even fewer of their losses than the US banks, a seemingly minor eruption like Latvia could serve to reveal that the banking emperors across the pond are wearing no clothes. While the odds of Latvia precipitating a larger set of problems are low, they are not zero.

Many US commentators blithely asset that the US does not need to worry about the reserve currency status of the dollar, since there is allegedly no ready substitute. Yet those arguments ignore the fact that there has already been movement away from the greenback. The Globe and Mail in early 2008 noted:

A UBS Investment Research report says that while it would be wrong to write off the U.S. dollar as the global reserve currency, its roughly 90-year iron grip on that position is loosening. “The use of the U.S. dollar as an international reserve currency is in decline,” said UBS economist Paul Donovan.

“The market share of the dollar in international transactions is likely to decline over the coming months and years, but only persistent policy error – or considerable fiscal strain – is likely to cause the dollar to lose reserve currency status entirely.”

The UBS report maintains that the gradual slide of the U.S. dollar is being driven not by the world’s central banks, but by the private sector, as individual companies increasingly abandon the greenback as their international currency of choice.

“The private sector’s use of reserves is more important than official, central bank reserves – anything up to 20 times the significance, depending on interpretation,” Mr. Donovan said. “There is evidence that the move away from the dollar as a private-sector reserve currency has been accelerating since 2000.”

Another chip away at the dollar’s standing is a effort underway by the Gulf States plus China, Russia, Japan and France to denominate oil sales not in dollars but a basket of currencies. Note this is not completely novel; Iran’s oil sales to Japan are quoted in yen.

From the Independent (hat tip reader John D):

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars…

The Americans, who are aware the meetings have taken place – although they have not discovered the details – are sure to fight this international cabal which will include hitherto loyal allies Japan and the Gulf Arabs. Against the background to these currency meetings, Sun Bigan, China’s former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East. “Bilateral quarrels and clashes are unavoidable,” he told the Asia and Africa Review. “We cannot lower vigilance against hostility in the Middle East over energy interests and security.”

Yves here. The explicit linking of security issues in the Middle East and the desire of a lot of countries to more away from the dollar as reserve currency is troubling, and the Independent also reads this as a thinly veiled threat:

This sounds like a dangerous prediction of a future economic war between the US and China over Middle East oil – yet again turning the region’s conflicts into a battle for great power supremacy…. The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold…

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. “One of the legacies of this crisis may be a recognition of changed economic power relations,” he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China’s extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America’s power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Brazil has shown interest in collaborating in non-dollar oil payments, along with India. Indeed, China appears to be the most enthusiastic of all the financial powers involved, not least because of its enormous trade with the Middle East….

The Chinese believe, for example, that the Americans persuaded Britain to stay out of the euro in order to prevent an earlier move away from the dollar. But Chinese banking sources say their discussions have gone too far to be blocked now. “The Russians will eventually bring in the rouble to the basket of currencies,” a prominent Hong Kong broker told The Independent. “The Brits are stuck in the middle and will come into the euro. They have no choice because they won’t be able to use the US dollar.”

Chinese financial sources believe President Barack Obama is too busy fixing the US economy to concentrate on the extraordinary implications of the transition from the dollar in nine years’ time. The current deadline for the currency transition is 2018.

The US discussed the trend briefly at the G20 summit in Pittsburgh; the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

“These plans will change the face of international financial transactions,” one Chinese banker said. “America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate.”

Iran announced late last month that its foreign currency reserves would henceforth be held in euros rather than dollars. Bankers remember, of course, what happened to the last Middle East oil producer to sell its oil in euros rather than dollars. A few months after Saddam Hussein trumpeted his decision, the Americans and British invaded Iraq.

By George Washington of Washington’s Blog.

As I have recently pointed out, there are strong arguments for ongoing deflation.

But even deflationists think that – after a period of deflation – we might eventually get inflation. For example, in October, I guessed 1 1/2 to 2 years of deflation, followed by inflation.

Moreover, noted deflationist Martin Weiss – after predicting for 27 years straight that we’ll have deflation – has now changed his mind, and thinks inflation is a greater short-term threat than deflation.

For these two reasons – and to make clear that the inflation versus deflation debate is complicated and includes many factors – this essay will focus on the arguments for inflation.

Faber and the Dollar

PhD economist Marc Faber said in May:

“I am 100% sure that the U.S. will go into hyperinflation.”

Faber said he thinks – in the medium-term – we could have high levels of inflation (and see this and this).

Faber’s argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).

Government Printing

The government has injected trillions of dollars into the economy in the form of TARP bailout funds and other programs. Indeed, the government’s own watchdog over the TARP program – the special inspector general – said that number could be $23 trillion dollars in a worst-case scenario.

The basic argument for inflation is – as everyone knows – that the government has injected so much money into the economy (through bailouts, quantitative easing, purchase of treasuries, etc.) that there will be a lot more dollars chasing the same number of goods and services, which will drive up prices. In other words, the supply is the same, but demand has increased.

Indeed, the U.S. has also provided huge sums of dollars to foreign central banks. Could dollars given abroad cause inflation inside the U.S.? Yes – because some proportion of those dollars will be spent by citizens in those countries to buy stocks, commodities, goods and services within the U.S.

Three well-known advocates of the inflation argument are Rogers, Buffet and Schiff.

Specifically, billionaire investor Jim Rogers said we are facing an “inflationary holocaust”.

Warren Buffett said:

The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

And Peter Schiff has argued for years that hyperinflation will wipe out the value of the dollar, so people should get all of their money out of dollars and into foreign currencies and assets.

But is all this government printing and quantitative easing really enough to cause inflation?

The back-of-the-envelope figures I’ve seen bandied about say no. Because of the massive destruction of credit (which – as Mish has repeatedly pointed out – must be included in discussions of inflation versus deflation), the government would probably have to print one-and-a-half to two times as much as it already has in order to create inflation.

The government could still do so. Yes, it would be suicidal for the dollar and might cause foreign buyers of U.S. treasuries to stop buying, but the boys in Washington could – if they were crazy enough – increase the money printing and quantitative easing to the point where inflation actually kicks in.

Will they do so? Summers, Geithner and Bernanke have proven themselves willing to do a lot of crazy things over the past year, so I wouldn’t rule the possibility out altogether.

Indeed, when the Option Arm, Alt-A and commercial real estate mortgages start defaulting in earnest, there will be a lot of pressure on Washington to “do something”. But again, doubling the amount of money printing would turn the dollar into monopoly money, and so there will be a lot of pressure not to turn America into Zimbabwe.

Devaluing the Dollar

Many commentators also argue that the U.S. is intentionally devaluing the dollar in order to increase trade.

And – as everyone knows – the dollar might tank even if the boys don’t intentionally devalue it into oblivion. Just look at the amount of printing and easing which has already been done, the tidal wave of debt overhang, and the lack of fundamental soundness in the giant banks, the financial system, and the U.S. economy as a whole.

Moreover, some people argue that the dollar carry trade will drive inflation. Specifically, they argue that we’ll get “spec-flation”, meaning that investors will buy dollars and – in a carry trade – use the dollars to invest abroad. This will devalue the dollar, creating inflation.

And, importantly, the U.S. is quickly losing its status as the world’s reserve currency. Therefore, the “premium” on the value of the dollar for its status as reserve currency will also fade, and the value of the dollar decline.

For these and other reasons, Faber and other inflationists would argue that the dollar will continue to substantially decline and inflation will therefore kick in (Note: Mish is still a dollar bull, and so doesn’t concede this point).

Unemployment

I have previously argued that the rising tide of unemployment will contribute to deflation for some time.

However, Edmond Phelps – who won the Nobel Prize for Economics in 2006 – and PIMCO Chief Executive Officer Mohamed El-Erian both say that the “natural unemployment rate” has risen from 5 to perhaps 7 percent.

What is the natural unemployment rate? It just means that if unemployment falls below that a certain percentage, then inflation will be created.

So if the natural unemployment rate has risen, that may mean that we will get inflation sooner (when unemployment falls to 7%, instead of when it falls all the way back to the previous peg of 5%).

End of Foreign Bond Purchases?

Tiger Management founder and chairman Julian Robertson warns that – if foreign purchasers stop buying U.S. treasury bonds – inflation will strike:

If the Chinese and Japanese stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent,” he said. “It’s not a question of the economy. It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves in a situation where we’re totally dependent on those two countries. It’s crazy.

Bottleneck Inflation

Finally, Andy Xie argues that “bottlenecks” can cause inflation. Specifically, Xie argues that inflation in a single key market – say oil – can cause inflation, even in a weak economy.

Conclusion

As I have argued for a year, we will probably have a period of deflation followed by inflation. I still believe that.

When inflation will kick in is the million dollar question. The inflation camp argues that inflation will kick in any second now without any warning. In the deflation camp, David Rosenberg argues for years of deflation, and Dr. Lacy Hunt argues for decades of deflation.

Bottom line: In my opinion, the question is when, not if.

But in investing, being too early is being wrong. Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.

Note: Remember that we could also get mixed-flation. In other words, inflation in some asset classes and deflation in others. Indeed, given that speculators drove up the price of oil last year, it is possible that – especially in a stagnant economy – speculators could drive up the prices of some asset classes and drive others down.