The Vicious Cycle of a Falling Dollar

When it comes to the direction of the US dollar over the long run, all I can shout is "Watch out below!"

There's no doubt of the general direction and the powerful trend of the US dollar. It begs a very important, very relevant question:

So what's up with the strength in bond yields, oil, and other commodities? Two factors seem to be at work. First, China has begun a legitimate turnaround. In fact, some analysts see a “V”-shaped bottom forming.

However, while that's great for the Chinese, it doesn't do us much good. If rising demand from China drives oil prices higher, the effect resembles a tax hike for the American consumer. True, we might get some ancillary benefit from Chinese growth, but it will be minimal compared to the cost of higher interest rates and energy prices.

The second factor that could be pushing bond yields and energy higher is the unprecedented increase in the U.S. monetary base – the sheer ocean of liquidity being poured into the financial system. Investors, who realize that the value of an asset often comes from its limited supply, are growing nervous about currencies in general. As the world's reserve currency, the U.S. dollar will bear some of the brunt of that nervousness.

Put yourself in the shoes of a foreign investor. Which would you choose to own – a currency that is being printed faster than any other in history, or an asset that is rare and difficult to produce? No wonder investors are demanding bigger yields from T-bills and turning to commodities as stores of value. Certainly China has been investing in stockpiles of commodities, far above what they need.

Recently I received another very thoughtful missive by the editor of The Complete Investor Dr. Stephen Leeb. He's not always correct but he always makes me think. Here is what I thought was the best part of his letter:

"If foreign investors are moving away from the dollar and into commodities, they will give the U.S. economy one additional obstacle in its struggle towards recovery. Not only must we contend with deleveraging from the consumer side, in the form of banks still refusing to lend, but now we face higher interest rates, which will affect mortgages, and higher energy prices, which restrain economic activity.

"Speaking of interest rates and mortgages, the Fed has one more tool it can use to encourage home buying. It can directly buy up long-term bonds. This would push bond prices higher, and restrain yields and interest rates, making it easier for people to service a mortgage. In fact, the Fed has been doing just that.

"However, there is a risk. If the Fed finds it must ramp up its bond purchases, it will lead to more dollars being pumped into the financial system. That, in turn, will give investors even more reason to sell them. The result would be a vicious circle [cycle].

"We hope we are wrong about this, and that the markets are actually discounting a surge in consumer demand. If so, we will be pleasantly surprised. But that's not how it looks.

"Turning to energy, we feel obliged to make some comment on the current administration's policies. So far, the government has directed a piddling amount of money towards alternative energy development, with the bulk of funding going to energy conservation.

"Now, in one sense, there's nothing wrong with saving energy. However, in the context of a worldwide economy, it carries a few problems.

"America today still considers itself to be the world, which is a fatal error. Instead, one must recognize that the U.S. is part of an integrated worldwide economy.

"If Americans buy fewer gas guzzlers, that may make U.S. cities healthier. However, conserving resources which we will need to build an alternative energy system – one that is absolutely vital for the future – is a mistake. Here's why...

"If Americans conserve oil, that will keep worldwide oil prices low. Low oil prices make it easier for developing nations like China and India to grow their economies – and raise their oil consumption. That will drive prices higher in the long run anyway, but in the short run it is a zero-sum game in which we lose and they win.

"Instead, what we need is a positive game in which everyone wins. Our nation needs to get on its horse and begin building alternative energy. Otherwise, we will soon be faced with higher taxes, in the form of higher energy and commodity prices that will make it more difficult to build the alternative energy infrastructure that we will need down the road. The development of alternative energy infrastructure and technology now (which can also be exported) will deliver far greater benefit to the entire world."

Great points, Dr. Leeb. No wonder I subscribe to The Complete Investor .Oil prices will most likely rise in the long-term, no matter what happen with the Green Revolution, as demand exceeds supply.

Right now, as Dr. Leeb and many other conscientious economist and scientist agre, we must discourage the growth of total worldwide demand (not just American demand) and develop alternative energy sources while we can still afford to. That is the key, get sustainable energy sources going while there is still interest and the resources to do so.

Now a comment about the US stock market. In the short-term we are not particularly bullish on the stock market. We see the market caught in a trading range. Within the next month or so, we expect a top will form. After that, prices will fall and possibly retest their lows.

As for gold and silver, Thursday's movement showed silver closing above $15 and gold right around $960. This doesn't speak well when it comes to investor confidence in the value of the dollar. Some analysts speak of some impending profit taking just around the corner for the precious metals.

But in an interview from Hong Kong, noted market analyst Marc Faber went way out on a limb and said he sees the U.S. entering a “hyperinflation&... that will be “close to” Zimbabwe.

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.”

Faber added that, “I don’t think that gold will run up right away. I never sold gold and I’m still buying gold … [because it] has been an adequate hedge against inflation … If you bought it in 1980 at the price of $850, then it hasn’t been a good hedge against inflation, but if you bought it in 1999 at $251, then it has done very well.”

Inflation? No way, Nadler says. He might as well have been responding to Faber when he said: “Where is inflation? A speck on the horizon.”

Nevertheless, the funds continue to pile into metal. Hedge funds and other large speculators increased their net-long position in New York gold futures last week, by 7.7% over the previous week, according to CFTC data.

Candidly speaking, with massive layoffs coming in autos, auto-parts and the accelerating demise of hundreds of banks, unemployment data will keep rising, and within a brief time, credit card and other consumer debt defaults will start escalating.

There's a truck load of really bad, toxic-smelling "delayed news" that's about to hit the fan. My most reliable sources tell me that there is more downside coming for the S&P in the coming weeks and months, and the "vicious cycle" of the break-down of the dollar is far from over.

The US Treasury faces a rapidly rising risk of a really embarrassing auction of new debt that may shock Wall Street. And gold stocks as measured by the Market Vector Gold Miners ETF (NYSE:GDX) indicates gold isn't done rising. The following chart doesn't even show the addition 4% jump the GDX made on May 28th.

You can see more of these kind of charts by looking at a great closed-end fund like ASA Ltd (NYSE:ASA) or by seeing a chart of a medium-size gold producer like IAM Gold (NYSE:IAG).

This is a time to be a stock picker, a very patient stock picker. Stick with quality and stick with what you know and believe in. Own enough shares of commodities and commodity producing companies.

And make sure you use any pullback in gold and silver to add to your position. Gold remains our number one inflation hedge, and silver, which may in the long-run outperform gold, is every bit as important.

Disclosure: I own some ASA and IAG

Comments

[Jimbo:]

Like 396040, I am enthusiastic about natural gas. But the current administration has made the genius, CHU, Secretary of energy. This Nobel dipstick has said he was "agnostic" about natgas. This administration of Utopians seems to believe they can run the economy on Pixie Dust. Congress and the Administration seem hell bent on stopping ANY domestic energy development in hopes of driving the development of "alternatives". Some of these alternatives may prove out eventually, but, in the meantime, we may ruin our economy in the name of "purity".

May 30 03:46 PM

[Living4Divi...:]

China isn't dumping the dollar or dollar assets (YET), instead it is recycling the money from the sale of long-term bonds and parking it into short-term U.S. Treasury notes. This is a concern, because these notes are easier for China to "dump" should inflation pick up in the U.S., this highlights China’s concerns that inflation will erode the dollar’s value in the long run as America amasses record debt.

According to Senior Chinese officials, China is committed to maintaining the dollar peg, for now, and continue to support the dollar by sterilizing trade surpluses. Due to the global recession and reduced demand for chinese exports, China has had to do a lot less sterilizing lately.

China is rightly worried about inflation in the U.S. and the impact that inflation would have on China's holdings of long-term U.S. bonds. While China still seems committed to the dollar peg, China is diversifying its foreign exchange reserves by using it's surplus dollars to purchase short-term US bills, as well as real assets that are inflation resistant such as commodities and capital investments.

May 30 05:13 PM

[Living4Divi...:]

Agreed


On May 30 12:20 PM EUARTE wrote:

> What we fail to realize that is the present government of the United
> States is not interested a strong dollar. It is interested in delusions
> of green. This is what will doom the dollar far into the future.
> This is dishonesty and self delusion. This is not a bright future
> for dollar economies and American workers and retiree's living abroad.

May 30 05:14 PM

[Living4Divi...:]

On May 29 12:10 PM bricki wrote:

>
> On top of this inflation is the weed wacker of the green shoot of
> personal savings. When the consumer realizes (and he will, he's not
> that stupid) that his savings have a negative real interest rate,
> we will see personal savings reverse and consumer consumption jump
> back to the bad old ways.

Bricki - isn't that what the government wants? Spend, spend, spend ! This will stimulate the economy, more people will have jobs. This is the heart of keynesism.

May 30 05:17 PM

[H. T. Love:]

On May 29 12:35 PM HardwoodFlooring wrote:

> <snip>
> Bricki, you bring up a great point about the Alt-A shocker. We are
> just working through the bust. Now we have classic recessionary
> issues hitting the mortgage/housing market (i.e. unemployment).
> If you couple that with interest rates increasing on John Q. Public
> who is still in an option arm things will get worse not better on
> the housing front (in terms of sales/build etc/ move-up market).

And this last week it was reported that the defaults on conforming non-subprime mortgages has begun to spike up. This trend, I believe, is just starting and will add to the woes.

As some *perceived* "bottom" in housing prices and foreclosures was being touted on the comedy/financial channel(s), another shoe is falling.

> <snip>

HardToLove

May 30 05:51 PM

[H. T. Love:]

Dirk,

"4. CPV solar has been demonstrated at 50% efficiency and is capable of generating all of the US needs in a 100 mile x 100 mile patch;"

I think solar has a place. But I've not seen this question puzzling me addressed by anyone.

What are the unintended consequences of solar farms? Increased shading of land should produce environmental effects from both the change in thermal effects directly from the land and also from the heat removed directly in the conversion from sunlight to electricity.

Do you have any references to discussions on that?

If it were me, I would prefer a distributed generation system taking advantage of rooftops. More expensive, but a comparatively smaller direct impact since the land is already shaded.

Thoughts?

HardToLove

May 30 06:02 PM

[Living4Divi...:]

I forgot to commend Marc Courtenay on his superb article.

I agree with you that the Dollar has many fundamental headwinds.
There is another motivation to devalue the dollar: Making the U.S. Dollar cheaper makes American exports more competitive and helps raise employment in export industries.

Our creditors are no dummies. The first step is to cut off new credit. This is already happening: Treasury Department data shows that investors in China have sharply curtailed their net purchases of bonds in January and February. The next step is that
creditors start demanding higher interest rates. The interest on the debt becomes unmanageable and the government has no choice but to monetize the debt by printing money. This devalues the currency and inflation/hyperinflation erodes the real debt. This hurts savers.

Savers are being punished to redeem the sins of debtors and speculators.

May 30 08:03 PM

[wheelbarrel...:]

Disagree - Chinese hasn't stopped BUYING US debt but it in no means they are not using dollars from their treasury to buy things like 70% of the worlds copper, tons of gold etc


On May 30 05:13 PM Living4Dividends wrote:

> China isn't dumping the dollar or dollar assets (seekingalpha.com/symbo...),
> instead it is recycling the money from the sale of long-term bonds
> and parking it into short-term U.S. Treasury notes. This is a concern,
> because these notes are easier for China to "dump" should inflation
> pick up in the U.S., this highlights China’s concerns that inflation
> will erode the dollar’s value in the long run as America amasses
> record debt.
>
> According to Senior Chinese officials, China is committed to maintaining
> the dollar peg, for now, and continue to support the dollar by sterilizing
> trade surpluses. Due to the global recession and reduced demand for
> chinese exports, China has had to do a lot less sterilizing lately.
>
>
> China is rightly worried about inflation in the U.S. and the impact
> that inflation would have on China's holdings of long-term U.S. bonds.
> While China still seems committed to the dollar peg, China is diversifying
> its foreign exchange reserves by using it's surplus dollars to purchase
> short-term US bills, as well as real assets that are inflation resistant
> such as commodities and capital investments.

May 30 09:21 PM

[wheelbarrel...:]

Now there's a great idea - instead of throwing away billions(trillions) to the banks and failed businesses liek GM just give everyone a 25k credit for solar and you get a whole lot of stimulus in many different forms


On May 30 06:02 PM HardToLove wrote:

> Dirk,
>
> "4. CPV solar has been demonstrated at 50% efficiency and is capable
> of generating all of the US needs in a 100 mile x 100 mile patch;"
>
>
> I think solar has a place. But I've not seen this question puzzling
> me addressed by anyone.
>
> What are the unintended consequences of solar farms? Increased shading
> of land should produce environmental effects from both the change
> in thermal effects directly from the land and also from the heat
> removed directly in the conversion from sunlight to electricity.
>
>
> Do you have any references to discussions on that?
>
> If it were me, I would prefer a distributed generation system taking
> advantage of rooftops. More expensive, but a comparatively smaller
> direct impact since the land is already shaded.
>
> Thoughts?
>
> HardToLove

May 30 09:24 PM

[optionsgirl:]

All the Federal govt needs to do is get out of the way and give tax breaks for R & D and infrastructure build out. Instead, they are busy hatching Waxman Markey cap and trade legislation to hamstring our futures.

May 30 09:45 PM

[Moon Kil Woong:]

You don't need to put yourself in the shoes of a foreign investor. Even as a domestic investor, would you buy long term treasuries? At this rate they might as well pull them off the market.

Lastly, a vicious cycle requires more than one component to make it a cycle. There is no cycle. The cause is the effect. If you make too much funny money its worth less. Plain and simple. No foreign conspiracies, etc. Those are all effects of the Fed and Treasuries fatally maligned policies for the past decade that are only getting worse.

I agree with the author that commodities should benefit. Also currencies that can't devaluate more like the Yen (The Japanese are scratching their heads saying, "Zirp been there... done that and now were stuck there. So why is the US copying quantitative easing? Especially when they don't have a surplus to afford it.")

May 30 10:50 PM

[PeteK:]

There's nothing to worry about.
When the dust settled,
everybody will jump back to the US Dollar.
Besides, who would they trust anyway ?

May 30 11:58 PM

[inflation:]

Inflation may be a speck on the horizon right now. But lets remember that just 6 months ago there was no way that GM was going to have to file bankruptcy. That's why we were pumping 10's of billions of dollars into the company. So, the spec can become very big very quickly.

May 31 10:08 AM

[Vox Rationalis:]

wheelbarrelsofcash wrote:

> LOL so what about M1-M3? Anyone have the current M3 info right now?

Aside from the currency component of M1, the Fed has no direct impact on any of these. More about each money measure here: seekingalpha.com/insta....

Now, here's the data you ask for, from the FRED database.

M1: August 4: 1411.8 billion; May 18: 1590.2 billion
Increase: 12.7%

M2: August 4: 7687.1 billion; May 18: 8327.5
Increase: 8.3%

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