Dollar Down, Gold Up: Great News?

If only. Yesterday's turn in the dollar and thus gold seem like a possible watershed. Maybe it's all working the way it's supposed to. Maybe the stimulus has finally put the hydraulics under inflationary forces and we can pull back from the abyss of deflation to the rocky-but-familiar world of stagflation. Gold is smack up against the top of the downward channel...

...and the dollar index is well through the 100-day MA, a bit below where I thought it would fall.

Admittedly, when I predicted 82-84 for the dollar index, I was hoping the Fed would wait to cut rates and coordinate with the fiscal stimulus. Nevertheless, if the promised stimulus and the Fed actions to date have indeed started to re-inflate the economy, I would be very, very happy to have been wrong. Stagflation is painful, but with Paul Volcker coming back into government and a far more developed and globalized financial system, I'm sure America can deal with stagflation. It's not a great environment for left-of-center politics, but it's not 15-20% unemployment, either.

I fear, however, that I am still right and that the dollar is still headed higher in the next few months (therefore gold will be headed lower). I just don't believe we have beaten the deflation. Here are three of the many reasons:

1) The Trade-Weighted Dollar Index

The Atlanta Fed's measure shows the pace of trade-weighted dollar appreciation relative to world currencies slowed from October to November. Still, it has regained an astonishing 4 years of losses in 4 months. October's gain in this more-comprehensive dollar index was the biggest ever. That is remarkable by any standard.

2) Alt-A, Triple-A Prime and XL Insurance

I like to think of them as: “The Ghost of Christmas Past, The Ghost of Christmas Present and The Grim Ghost of Christmas Future.” The Alt-A disaster is known. It's past for us intellectually. But while it is already in the process of being written off, we are still living through the ramifications, and there are plenty of ramifications still to come. One of the most recent - the destruction of the AAA-rated, Prime non-agency RMBS market - is a nasty lump of coal under the Christmas tree, reminding us how the contagion spreads from past to present. I could have made Commercial MBS my future spook, but that would have been too easy and frankly not scary enough.

If the various fixed-income markets, major firms and hedge funds weren't domino-dropping fast enough any more to give you a frisson, consider the fact that XL Insurance (XL) has entered the familiar, fatal pattern of “big mistakes”, then desperate, public pleading for a buyer, then downgrades, then...??? XL's woes and the recent crisis in catastrophe bonds suggests – suggests, mind you – the possibility that the loathsome procession of pecuniary perfidy, perscrutation and subsequent panic might soon plague one of modern finance capitalism's true “holy places”: Bermuda.

That would be a financial calamity, not least of all for the many combinations of the words “short” and “Bermuda” which would inevitably result. To go from the ridiculous to the substantial:

3) Unemployment and, frankly, the Republicans

Unemployment is a nightmare which undermines valuations of all asset classes. And the way the Republicans in Congress seem determined to waste everyone's time suggests to me that the sharp acceleration in unemployment is likely to continue for a minimum of three quarters.

This is not a partisan critique, but an economic one. We know there are really only two strategies in a crisis like this. One is strict “Austrian School”, the other is “Keynesian”. Either the savings rate or spending must be increased - dramatically. Facing the bailouts, Republicans in the Congress may cleave rhetorically to that far-right, anarcho-capitalist version of “Austrian School” economics, but in practice they are clearly unwilling to cut spending drastically enough to meaningfully increase the savings rate. Republicans will continue to be the big, deficit-spending interventionists they've always been – just like the rest of the American government – so they really need to stop the nonsense and do what they can to decelerate unemployment growth. They have not yet accepted this.

Yes, I admit that - in normal times – the waging of smaller battles to “starve the beast” are a legitimate political statement even within a deficit-spending context. These are not normal times. In a crisis like this, half-measures are the worst thing possible. It is both facetious and destructive to pretend that a laissez-faire strategy is a political possibility right now. Republicans seem to prefer a political fight with the UAW. Yet while risking hundreds of thousands of lost jobs just to score points against organized labor, they have no votes and not even any plan to cut the trillion or so dollars of spending necessary in order to meaningfully raise the savings rate. Their grandstanding simply delays the stimulus plan and deepens the crisis.

These three dynamics – and things like the Madoff scandal – suggest to me that the deflation is just beginning and that the stagflation which would happily give lie to my predictions is a mirage.

You'll note I leave out the hyperinflation scenario. First, the idea that this crisis is just a “de-leveraging” - a deflationary blip within an inflationary trend - is nothing more than silly. I'm sorry, but the data just don't confirm it. The rise in the yen may have a lot to do with de-leveraging, but it cannot explain what we see the dollar-based economy. De-leveraging does not cause whole markets to stop functioning properly.

Second, the rampant conversation about hyperinflation is trivial, non-rigorous and not at all serious. If this really is the beginning of a hyper-inflation, what asset class you hold or don't hold will be the least of your problems. A dollar hyperinflation would be a financial Armageddon of proportions that would undermine the entire concept of a financial asset and inevitably spur the most massive government intervention in human history. Nobody wants that. People who think they are prepared for a dollar hyperinflation are just talking a lot of nonsense. Nobody is prepared.

P.S. A “behavioral economics” note: Because the action in the dollar and gold are “confirmations” of a very widely-held, and widely-propagated belief, those interested in this kind of thing should look for the “surprise” development which will allow market players to change their view without, as it were, changing their view.

Disclosure: No positions.

Comments

[SW Richmond:]

"De-leveraging does not cause whole markets to stop functioning properly."

Sure it does. De-leveraging means high-leverage credit-money disappears, crashing once-inflated asset prices, shredding books, and causing wholesale reevaluation of businesses. This is exactly why the Treasury and the Fed are so obsessed with getting banks to lend again.

Deleveraging also means self-defensive liquidations to pay off debt, and in a fractional reserve system, paying off debt actually destroys credit-money, which is deflationary.

Deflation is what would happen absent intervention. But we have a Fed determined to reinflate, and that is why I am betting on either reinflation or currency destruction (hyperinflation), which are the two possible outcomes. The worse your predictions of coming deflationary pressures, the larger will be the Fed's inflationary response. They cannot and will not hold anything back; the Fed is totally committed.

Can one "prepare" for a hyperinflation? Not adequately, no, but one can buy things in advance that one knows one will need anyway, virtually without risk. Lose my job in a deflation? I already have "it". Currency useless in a hyperinflation? I already have "it". See?

Your thoughts on confirmation-bias are wise, and that is why I read your article. I didn't find anything to convince me I'm wrong. I guess I'll have to keep looking.

2008 Dec 17 08:49 AM

[D. McHattie:]

This is a well-written article with clear analysis. However, your article is ultimately about the direction of gold and the dollar and I think you could be right about deflation but still wrong about the direction of gold and the dollar.

What if gold is surging as a 'flight to safety'? What if it is this same force that is causing the dollar to decline as investors are just uncertain whether the fed will succeed in devaluing the dollar or not?

We could have rising gold prices and a falling dollar all while experiencing monetary deflation (shrinking money supply) if the demand for dollars fall even more than the supply.

Just throwing some ideas around.

2008 Dec 17 09:30 AM

[applesauce:]

Great article , especially the last paragraph where you in essence have a coin with win on both sides. I'll take that flip.

2008 Dec 17 10:22 AM

[OldLimey:]

Mr. Bailey: Thank you for taking the time to write a well-argued piece. I'd like to address two of your statements in particular.

"...risking hundreds of thousands of lost jobs just to score points against organized labor..."

I'm not going to wade into a US political debate, but what you've written here seems to assume that a Federal bail-out and massive job losses are mutually exclusive. If US taxpayers are prepared to underwrite the Detroit cash-bleed ad infinitum, that would be true; but surely what's going to happen is that with or without the help of Chapter 11 (probably with), and notwithstanding the inevitable near-term Federal bridge, the US auto industry is in for a massive strategic and operational restructuring which will inevitably lead to significant redundancies and the 'downsizing' of retiree benefits. What is being choreographed is not a dance along the the line between continuation of the status quo and overnight closure, but how to present and manage the inevitable rescaling of a significant part of what remains of US manufacturing industry. Congressional shenanigans are, in this context, a side-show.

"....the idea that this crisis is just a “de-leveraging” - a deflationary blip within an inflationary trend - is nothing more than silly. I'm sorry, but the data just don't confirm it."

SWRichmond has cogently tackled this one above, but let me ask you two questions:

1. What data? We've been in an inflationary trend for decades (because that's what our masters prefer), and whether we're even in a deflationary blip at all at the moment depends upon how one defines 'money' (specifically, how much of the crud Wall Street has been creating until recently is assumed to be part of the monetary base).

2. If you were looking at the US federal debt or the state of household finances today, wouldn't some sort of controlled inflation be your preferred - in fact, your only - way out from under? Do you think the Fed can't inflate to order? I reckon they can. Do you think they can control the party when it risks getting out of hand? Recent evidence suggests not - unless Mr. Volker is unleashed again, but somehow I can't see that with midterms due in 2010.

2008 Dec 17 10:23 AM

[axelrod608:]

Does anybody out there have any detailed information about the GOLD CARRY TRADE of Ft Knox gold ? Does the US retain any ownership of "its" gold ?

Good article, but it's hard to take seriously any discussion of unemployment using the feds numbers, which are massaged more than kobe beef. Last time I checked, Shadowstats was showing real unemployment in the 15% range.

Last, if one extrapolates possible losses on the mountain of level 2 and 3 "assets" hiding off corporate books, it appears that reflation will take many years and many tens of $trillions. We need to bring accounting standards into the 21st century.

2008 Dec 17 10:32 AM

[dlaw:]

Thank you all for the comments.

SWRichmond, I think the central misunderstanding of this crisis - that the Fed suffers from, that everyone suffers from - is the belief that there is simply a lack of demand for assets. In fact, the behavior of the fixed-income markets is far more consistent with a "no-trade equillibrium". That makes a lot more sense in that the private American financial system essentially filled the world market with trillions in counterfeit securities - thus counterfeit money. When the counterfeit was discovered - instantaneous asset deflation.

But you ask the important question: can the Fed re-inflate faster than the private system can deflate. If I saw the banks lending, I would say the Fed might succeed with. I don't see them lending.

DC McHattie, I'm sure you are completely right and gold absolutely IS a "flight-to-safety" trade. The difference between treasuries and gold is simple. I am absolutely certain that treasury bonds will keep making their payments. I am also certain that gold's future value will be a function of beta. I just think that the temptation to sell gold and buy assets which pay cash will become too great.

OldLimey, here's how I see it: We can put these auto workers on what is effectively "unemployment" *with* the help of some revenue from their dying companies or we can put these workers on unemployment **without** the help of some revenue from their dying companies.

As for your question "What data?" that's exactly my question. What data is there that supports the de-leveraging thesis? What are the numbers? How could they possibly be enough to explain the credit market behavior?

Axelrod, I'm sure we still own our $300 billion in gold, but that's all it is - $300 billion. Double it and it still doesn't add up to much.

And I could not possibly agree more with your comment about unemployment figures and accounting standards. Basically, every aspect of our financial system is so completely dishonest that we are all guessing as to what is really happening. I - like you - suspect that the quality of bank assets is actually so bad that the destruction of money is far bigger than we understand.

2008 Dec 17 01:43 PM

[BrunoT:]

While you perhaps can't be totally prepared for hyperinflation's disruptive effects, I agree with the other poster that there are MANY things one can do to create an environment where one is better off.

1. Own tangible assets like gold, (oil, ag commodities, etc) not fiat money.
2. Buy major purchases now so you have "it". Not a terrible idea to buy two of some things and store the 2nd if practical. (buy 2 slightly used cars instead of one)
3. Obtain the biggest fixed rate low interest (currently about 5.75%)mortgage you can on your home located in a rural area away from high crime so that at least that burden goes away in a hyperinflation, as you can pay if off with a week's salary.
4. Guns, ammo for home protection, food and other supplies for times when the distribution network breaks down.
5. Again, buy things that don't spoil now when they're as cheap as they ever will be.

Yes, things will be rough. But if you have no effective house payment, no car payment (or a fixed rate one that also evaporated with hyperinflation) and a newer car that will last you through a 10 year depression, gold in your hands to trade for goods, a properly rotated stock of food and other non-perishable supplies to tide you through disruptions, you'll certainly be better off than 99% of people out there.

Most Weimar Germans did survive. True the "good times" that followed weren't my cup o tea. But assuming we avoid a dictatorship the economy will readjust even if it collapses.

2008 Dec 17 02:33 PM

[Socialism c...:]

"...but with Paul Volcker coming back into government and a far more developed and globalized financial system, I'm sure America can deal with stagflation. It's not a great environment for left-of-center politics, but it's not 15-20% unemployment, either."

So sure you are? This "developed and globalized" system is a BIG part of the problem!! Overefficiency -- placing the collective good ahead of the individual -- dehumanizes the individual. Hence, globalism, where corporations go for cheapest labor, exploiting humans in less-developed countries, and putting those here out of work. Optimization at its worst. Globalism is the enemy of localization -- the latter being the ability to fine-tune on a local basis, since economic conditions vary on a smaller scale than globalist policies allow!!

"Either the savings rate or spending must be increased - dramatically. Facing the bailouts, Republicans in the Congress may cleave rhetorically to that far-right, anarcho-capitalist version of “Austrian School” economics, but in practice they are clearly unwilling to cut spending drastically enough to meaningfully increase the savings rate. Republicans will continue to be the big, deficit-spending interventionists they've always been – just like the rest of the American government – so they really need to stop the nonsense and do what they can to decelerate unemployment growth. They have not yet accepted this."

Anarcho-capitalist?? Really?? What is more anarchist than interventionism, which results in not being able to know how to value anything? When you reward bad decisions and failure by throwing bailout money at them, at cost to those who were wise, how do we determine valuations for the WISE and SUCCESSFUL companies??...the ones we should be investing in!?!? Regarding stimulus' and debt loads...the Austrian school is the ANTI-anarchist!! It would say that individuals and businesses ought to operate on cash, not debt -- that is an orderly flow of business, as opposed to the bubble-building credit-based economics of the Keynesian Democrats!! Do you not see that the Feds are now ramping up the SAME conditions that CAUSED this mess -- EASY MONEY?? As opposed to allowing deleveraging and deflation so that we can get back to "normal" pricing and spending what we have "in pocket"??

Methinks your politics are dictating your economic philosophy, when it ought to be the other way around!! You should be looking at what economic theory actually makes sense...and supporting policies that espouse that theory!

As for Republicans in particular -- I will grant you that the Bush admin has NOT trimmed spending nor size of government -- and being a fiscal conservative, I am quite dismayed at that trend in the Repub party. The real conclusion though, is that NEITHER party will do so -- once in power, does either ever want to relinquish that power BACK TO THE PEOPLE?? No. It is up to us to take it back. By demanding and attaining reform.

I say, let's start with abolishing the income tax: see fairtax.org for a start!!

2008 Dec 17 06:47 PM

[UK farmer:]

this idea you can have new loans repaying old debts, that are new debts- backed by state borrowings guaranteed by unspecified future tax revenue, which our rulers are discounting the face value of, and further promising to print us out of deflation- these trillions are incomprehensible and uncalculable to most, if not all of us- the problem would seem to be that not only assets loose value and become worthless, but so can paper money.and credit
So deficits are money, replacing credit that was money, in some sort of balancing act which is new and untried- is there a name for an upside down ponzi scheme, with the individual at the base ?
The only consistent thing about any of this is that it is definitely nobodys fault

2008 Dec 28 02:53 PM