Dollar Update: Inflation Forces Are Brewing 32 comments
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The dollar is struggling. It hasn't suffered a knockout punch, but it is definitely weak and appears to be in a declining trend. These charts are two different ways of looking at the value of the dollar. The first is arguably the best way to measure the dollar's value relative to the currencies of all our trading partners (it's trade-weighted and inflation-adjusted). It's telling us that the dollar today is only about 6% above its all-time lows. The second chart measures the dollar's strength against gold, and it is telling us that the dollar is within inches of all-time lows (gold being inches from its all-time dollar highs). Gold has in fact gained against all currencies in the past few years.
As a supply-sider, I believe that strong currencies are always better than weak currencies. As a next-best alternative, I'll take a stable currency. Currency stability means that over time purchasing power will be stable. Stable purchasing power does wonders for one's investment perspective, since it eliminates an important source of risk (i.e., inflation) to investment. Stable and strong currencies thus tend to be magnets for the world's capital because they offer lower hurdle rates to investment. Those countries that attract capital tend to have strong economies and relatively high living standards, thanks to strong investment.
As my previous post indicated, a weaker dollar has enhanced the returns to overseas investing. All of the world's equities markets are rising, but when measured in dollars, the U.S. market is a laggard and foreign markets are the frontrunners (e.g., the Brazilian stock market is up 140% from its November lows when measured in dollars). In my way of seeing things, a weak dollar acts like a headwind to recovery, since it reduces the amount of investment capital we might otherwise receive from the world. Obama's big-government spending and tax increases won't kill our economy, and neither will a weaker dollar, but they do amount to serious headwinds that will significantly increase the amount of time necessary for the U.S. economy to recover its previous potential.
The dollar enjoyed a brief period of strength in the latter half of 2008 (through mid-November), thanks mainly to a global flight to quality. Being the world's reserve currency meant that the dollar was the safest port in what proved to be a Perfect Storm. The demand for dollars exceeded the Fed's willingness to supply dollars late last year, and so the dollar's value rose against most other currencies and rose against gold as well.
Now things are reversing. Global demand for dollars is declining as the prospects for the global economy improve. Meanwhile, the Fed remains extremely accommodative, willing to supply an almost unlimited amount of dollars. Loan demand has not been very strong, however, so the vast majority of the reserves the Fed has pumped into the system remain idle. Instead of borrowing more, it seems that an awful lot of people and firms are still trying to deleverage. But as the recovery progresses and confidence returns, the demand for dollars is likely to fall relative to the Fed's willingness to supply dollars (and loan demand is likely to pick up), and that will erode the dollar's value, at least in terms of gold if not vis a vis other currencies. A weaker dollar will be a key indicator of an excess of dollars, and that is the essential ingredient for rising inflation. Ultimately, a weaker dollar increases inflationary pressures, regardless of how weak or below-trend the economy is.
Measured against gold, all of the world's currencies are in trouble, with the possible exception of the yen, which has only dropped 13% against gold in the past two years. Like many others, I believe that gold is a good way to measure the value of a currency in absolute terms, since gold has done a good job of maintaining its purchasing power over long periods, and countries who have pegged their currencies to gold have invariably experienced very little or no inflation. It would appear that all the world's major central banks are following the Fed's lead, aggressively supplying bank reserves in an effort to avoid a banking crisis. That's fine for the moment, but the price we're likely to pay will be higher inflation all over the world in the years to come, particularly if central banks are slow to withdraw their liquidity injections.
Given the trends so far this year, I think prudent investors need to be prepared for rising inflation in coming years and for sub-par U.S. growth (i.e., 3-4% growth, instead of the 6-8% that we would expect if this were a headwind-free recovery). TIPS are a conservative way to protect money from inflation, since they are adjusted directly for inflation and they pay a coupon (i.e., real interest rate) to boot. Gold and commodities are more aggressive, and much more risky, ways to protect against inflation, since a) they pay no interest rate, and b) they are well above their recent lows and their potential gains or losses are significant. Emerging market economies should continue to do better than industrialized countries, since they benefit from a weaker dollar and rising commodity prices, and many of them (e.g., Brazil, Chile, China, Peru, Singapore, Thailand) have managed to keep their currencies quite strong relative to the dollar in recent years. Equities in general should do well, since markets are still braced for recession and fear continues to distort investment decisions. The things to avoid like the plague are the "risk-free" investments such as T-bills, T-notes, and T-bonds.
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This article has 32 comments:
Am I wrong? Why?
I suspect the buyers of gold have been motivated by false notions of inflation via 'monetary policy.' That could make gold the next bubble to burst as the world continues to suffer through a massive shortage of aggregate demand that's all about fiscal policy that's overly tight for current levels of excess capacity.
On Aug 30 08:30 AM Warren B. Mosler wrote:
> Banking is in no case 'reserve constrained' with the Fed always setting
> price and lending limited by creditworthiness, capital ratios, risk
> appetites, etc. but not reserves. QE accomplishes nothing through
> the 'reserve channel' as has been repeatedly demonstrated.
>
> I suspect the buyers of gold have been motivated by false notions
> of inflation via 'monetary policy.' That could make gold the next
> bubble to burst as the world continues to suffer through a massive
> shortage of aggregate demand that's all about fiscal policy that's
> overly tight for current levels of excess capacity.
>
>
The Treasuries market is the biggest bubble in financial markets history and when it blows, there will be hell to pay for the US.
The gold chart tracks the recorded price of a set weight of gold in US$ since 1978.
USA wage earners have experienced a massive collapse in family earning power as prices of goods and services rose ten times while family after tax income doubled even with twice the number of family members working for wages. They had to borrow to maintain even a falling living standard.
Economists on fat government payrolls did real well as they thought of new government programs to destroy lining standards of all who were not government benefit recipients.
Keynes wrecked the British by 1950 and the USA by 2010.
Yes bad policies destroy human organizations.
Would you be willing to explain why you believe this?
Thanks
On Aug 30 08:06 AM Hihoze wrote:
> Why equities over T-Bills. If Treasury notes are the plague then
> how are stocks any better since the value of stocks is measured in
> dollars? Treasury notes are tied to intrerest rates and those rates
> go up with inflation. Will stocks do the same or better? Only if
> the dollar becomes toilet paper will a stock certificate become more
> valuable.
>
> Am I wrong? Why?
On Aug 30 09:09 AM JMBishop wrote:
> If it's all a confidence game, then Bernie Madoff should not be in
> jail. What's so good about gold? It has no real economic value except
> as jewlry. Fiat currency demands that we place our confidence in
> either the government or the market place of real goods and services.
> Quantitative easing has eroded my confidence in the government because
> this monetary policy has made difficult economic decisions about
> the market place of real goods and services even more difficult to
> make. Everytime I try to make an investment decision, I fear the
> government will step in and change the current dynamics of the market
> place to something diametrically opposed to my decision. Not letting
> the "too big to fail" fail will devolve into a bigger disaster than
> if these mega financial entities had been allowed to fail. The government
> like Bernie Madoff has destroyed any confidence that we were formally
> inclined to.
On Aug 30 08:06 AM Hihoze wrote:
> Why equities over T-Bills. If Treasury notes are the plague then
> how are stocks any better since the value of stocks is measured in
> dollars? Treasury notes are tied to intrerest rates and those rates
> go up with inflation. Will stocks do the same or better? Only if
> the dollar becomes toilet paper will a stock certificate become more
> valuable.
>
> Am I wrong? Why?
I know this is not sexy, fun or thought provoking, but right now it is simple, safe and diversified. I am also in the process of updating all of my protection tools like wills, P/C, Life, DI, Liability.
Afriend tells me I am now offically a turtle, withdarwn into my shell. So be it, but I feel less emotionally beat up or fearful.
My two cents.
Assume your are the Fed and you owe someone $100 as debt for goods & services. First, you start by printing free money, which puts more dollars in circulation. People then buy more goods & services, which increases their demand causing their price to rise.
The rise in price results in less purchasing power of the dollar, i.e a weaker dollar. The consumer price index then rises, which is real inflation. As debt increases (right now it's out of control), more treasuries are issued, and the value of the dollar decreases accordingly.
Let's assume the Fed prints so many dollars that the dollar becomes worth 50 cents ($0.5). If you owed someone $100 dollars to be paid back over 3-5 years, then when the dollar is worth 0.5, you will essentially be paying back $50, which is called "inflating away the debt."
I think fundamentally, your analyses and conclusions are correct. However, there is room to expound on the huge debt problem and how galactically mind-boggling the inattention to an unbalanced budget is, plus a decade of debt on the horizon. Portfolios now need to include "support" components such as TIPS, gold or PM, some bonds, 10-15% cash reserves for emergencies, and 50-60% depression-proof equities whose earnings and dividend yields have been steady or increased. Inflation and a weak dollar creates interest from foreign investors to purchase well-managed US companies. Such companies are out there, you just have to find them.
What will be key for investors is knowing when to cut and run if commercial real estate tanks in 2010/2011 as predicted, the jobless rate does not decrease, unemployment benefits become exhausted in almost every state that is broke now, cap & trade is passed, taxes increase....
On Aug 30 08:06 AM Hihoze wrote:
> Why equities over T-Bills. If Treasury notes are the plague then
> how are stocks any better since the value of stocks is measured in
> dollars? Treasury notes are tied to intrerest rates and those rates
> go up with inflation. Will stocks do the same or better? Only if
> the dollar becomes toilet paper will a stock certificate become more
> valuable.
>
> Am I wrong? Why?
Yes there is a lot of caution shown in the above comments - seems reasonable to me.
Second, the USD is the world's senior currency and in a deflationary crash it will strengthen. We already saw this begin to happen during the 1st wave of the crash. The second wave of the crash was actually a rally which weakened the dollar. Now we will see an even stronger run into the dollar as the third wave of the crash rolls in. This one is going to leave a mark.
With regard to "Equities in General" does this include "growth companies" OR "Value Companies? and/OR "Growing Dividend Income" securities, ETFs or Mutual funds?
And presumably is it OK to buy TIPs - but NOT the non inflation protected T bills, Notes and bonds?
And how about US Short term - no more than 5 years) Corporate - High quality and/or Junk Debt orConverts?
"Emerging market economies should continue to do better than industrialized countries, since they benefit from a weaker dollar and rising commodity prices, and many of them (e.g., Brazil, Chile, China, Peru, Singapore, Thailand) have managed to keep their currencies quite strong relative to the dollar in recent years. Equities in general should do well, since markets are still braced for recession and fear continues to distort investment decisions. The things to avoid like the plague are the "risk-free" investments such as T-bills, T-notes, and T-bonds."
means of exchange - deflation.
advice for investors - trade.
advice for the citizenry - a new money system.
Re-read Friedman's Program For Monetary Stability, and then read the Chicago Plan for Monetary Reform.
The Money System Common.
Treasury's, bonds, or any fixed income investment have a yield/interest rate. Bond price moves inversely to yield/interest rate.
Very simply, if interest rates go up, then bond/treasury prices go down. For example if you own a 3% bond/treasury and interest rates go up to 5%, then who in their right mind would buy your 3% bond, when they can buy a new one at 5%? Thus for you to sell your 3% bond you have to reduce the price so it effectively pays/yields 5%. That is how you lose money on bonds/treasuries.
Of course you can always keep getting your 3% if you hold your investment to maturity and never sell it, but you will still be losing as you will only be getting 3% interest and all new investors will be getting the new 5%.
The point is do you really think that interest rates will stay at historic lows (Fed disc rate of 0-.025%)? Of course they will not. Interest rates will rise significantly in the coming years. We might even be headed to Jimmy Carter type interest rates of 15%+. And if they do any fixed income investors at today's low interest rates will suffer massive losses if they have to sell their fixed income investments, or alternatively they will be getting tiny interest and other investors will be getting big interest.
That is why it is equally as dangerous to be a fixed income investor in today's low interest rate environment, as future losses could be very large. The only protection one would have is to invest very ST, such as 1-year. That way you can cash-in at maturity in 1-year and
reinvest at whatever the rate is then (probably higher). Why do you think the Chinese are buying mostly ST US Treasuries now and avoiding LT Treasuries... they are not financially illiterate.
TIPS supposedly provides some inflation protection, but do you really believe that TIPS rates will adjust to what real inflation is? The government has consistently underreported real inflation for decades now. Shadowstats.com has some great information on real inflation comparisons.
On Aug 30 08:06 AM Hihoze wrote:
> Why equities over T-Bills. If Treasury notes are the plague then
> how are stocks any better since the value of stocks is measured in
> dollars? Treasury notes are tied to intrerest rates and those rates
> go up with inflation. Will stocks do the same or better? Only if
> the dollar becomes toilet paper will a stock certificate become more
> valuable.
>
> Am I wrong? Why?
When oil went through the roof, airlines actually reduced capacity as they lost money on each flight, even though they tried to raise prices to a "high" level. That reduced demand.
When the economy tanked demand for seats fell enough so that even the reduced capacity was excessive, and prices fell. That's where we are now. Reduced but still excess capacity and falling fares. Deflation if you will. When demand returns meaningfully, prices will start back up.
The effects of excess liquidity in the system now seem to be in the prices of stocks, fixed income, oil, and gold.
My interpretation of events in China is that Chinese may be at the point of letting the dollar peg go. It is clearly not sustainable and at some point they are going to have to kiss it goodbye. This may explain in part why the stock market is plunging. Dumping the peg would have a significant impact on earnings from US exports, but then again, how much worse can things get? An appreciating Yuan would give them wider acceptance of their currency and much more purchasing power for the commodities they need to develop their economy. Of course this would provide a double whammy to the US on Oil and other commodity imports. The US of course would be more competitive on the price of its exports, but because they are not really positioned to supply global markets, this wouldn't have much impact in the short-term, but collapse of purchasing power is likely to prove disastrous for their internal economy.
How would the Fed react? Well, it might just have to put interest rates or perhaps the US Government could start borrowing in Yuan. It seems likely that the US economy is going to undergo much more further contraction, just as we start to see how much contraction has been hidden behind Government statistics. It is, however, not inconceivable the economy could contract whilst inflation goes wild. It happened in Zimbabwe, and the level of competence in regard to financial management is probably about on par.
On Aug 30 09:42 AM Tim Ayles wrote:
> I agree that inflation will be here in a few years. In the next 1-3
> though, we still have liquidity issues believe it or not. The amount
> they are printing is being dwarfed by the amount of de-leveraging
> going on. The world has never seen inflation during a credit contraction,
> and they never will. You can worry about inflation once you see credit
> expansion happening again. I published an article on SA title: Inflation
> - It's a Crowded Trade. Everything you as reasons for a collapsing
> dollar are well known and repeated by the masses. I think the masses
> will be shocked at a massive rally in the dollar we are about to
> see.
Until then, this is an experiment, run by people who do not understand the drivers or the results.
Ease taxes, ease regulation, ease the fear of more taxes and regulation. It will be like magic. Until then, we are flying in the dark.
quote:
Brazil and Argentina have signed a deal that will let the two nations do away with US dollar as an intermedium in their bilateral trade.
The agreement was signed by Brazilian President Luiz Inacio Lula da Silva and his Argentine counterpart Cristina Fernandez de Kirchner on Monday in Brasilia.
The accord is viewed as an important step toward a common currency among the members of Mercosur -- a South American trading bloc comprising Argentina, Brazil, Uruguay, Paraguay, and soon Venezuela.
www.presstv.ir/detail....
=============
We all know of the several non-dollar deals China has made with trading partners. However, many don't know of the behind the scenes moves to support the IMF SDR's as a global currency. Brazil, China, Russia, India and others are buying IMF bonds with their dollars. That gets the dollars out of their hands and at the same time, supports SDR's. The IMF has also said that instead of all loans being in dollars, they will use other currencies as well.
There is a concerted effort to end the dollar as the world's reserve currency but, slow enough not to collapse it. However, that is a dangerous game as just one slip could start the dominoes tumbling.
Demand in the U.S. is not what will determine rising CPI. It will be the world spending dollars for commodities sold in dollars. For example, grains are sold in dollars and could rise due to crop problems around the world that may overwhelm bumper crops in other places. Food stockpiles are dangerously low, globally.
Thus, we could see our food prices soar even if we are in a depression. At the same time, any global recovery, with or without us will send energy demand back up and with a weak dollar, cause our oil prices to rise.
For each 1% drop in the dollar, oil normally goes up $4. Only because supply has been so heavy in relation to demand has oil not risen further than it has. But, any recovery globally will change that. This year, for the first time, emerging nation demand for oil has outstripped developed nations demand for oil.
The U.S. is also dependent on Mexico for about 11% of the oil we import. Yet, Mexico is in such steep decline they have cut exports to us already and may have to stop all exporting of oil in a few years if they can't get new fields developed.
The entire global economy is in a transition phase and we have to be prepared for a lot of changes. Our own GAO has warned Congress for years that our fiscal policy is unsustainable and we face the loss of our standard of living. (4 years in a row before this crisis even hit, that warning was given).
With respect to gold, I don't see this conclusion. As the economy recovers there will be, by definition, other investment opportunities. Those opportunites will draw demand away from gold not support for it. As a store of value, not an earning asset, gold should suffer in a recovery.
The increasing money supply is an inflation force that is struggling against the deflationary force in excess capacity. I don't think that we will see inflation until we have worked off the excess capacity. People don't have pricing power right now because there are 10 competitors in almost every business willing to keep prices where they are to hold market share.
Over time, we will weed-out the competition, and then you will have inflation. The first place where we will see inflation is oil and gas. That is something that doesn't have a lot of excess capacity. It is also something that is imported which will be affected by the declining dollar.