Relative Strength of Countries

There is a current fixation on the U.S. deficit which has received mass media attention in recent weeks. The fear mongering has caused a frenzy in gold, commodities and other inflation protecting asset classes. Unfortunately, currencies do not trade strictly on the country’s ability to pay its debt or its government’s monetary policy. Instead, every currency trades against every other currency. These relationships make currency trades a tangled web of monetary policy/response and relative fiscal discipline. When placing a trade on the dollar, the trade is for the United State’s relative standing against every country in the world. This means that you cannot simply state that the United State’s negative current account balance, massive deficit, and loose monetary policy make the dollar weak because the situations of some other countries look even worse. With that as the backdrop, I would like to show why it seems that the current fear over the dollar is a bit overblown.

The US government balance looks horrendous, but so do others. Source: IMF

The world is filled with a mix of spenders and consumers. Citizens or governments of specific countries can save and invest or borrow and consume. The US government has been running at a deficit for decades, as have a lot of other countries in the developed world. This can almost be viewed as a privilege for those with stable governments and diverse economies.

Debt to GDP for UK, US, and Japan. Source: IMF

What is even more sobering than current deficits are the comparisons of gross debt to GDP. The sad truth is that Japan is much closer to a sovereign default than the US can even imagine. Its demographics are shifting from a nation of savers to an older generation of retirees being supported by a small working class. Their government stimulus through the 90’s and this decade have put them on a perilous trajectory towards financial ruin and it is the reason that David Einhorn, hedge fund manager of Greenlight Capital, is betting that Japan is in the midst of a “death spiral”.

Demographics look grim for Japan. Source: John Mauldin

If you happened to think that the United States had a terrible problem with the baby boomer’s retiring then I suggest you look at the dependency ratio’s above created by John Mauldin. The dependency ratio tells you how many old age retirees above 65 are depending on 100 working citizens. Assuming that birth rates remain where they are today, Japan’s number of elderly will jump to over 75 retirees for every 100 workers by 2050.

On a relative basis, things could be a lot worse for the United States. On a realistic standalone basis, things look pretty terrible for the United States. There will be a lot of tough choices that need to be made in the coming years as budget deficits grow and looming entitlement dilemmas need to be solved, but I do have faith that those in control at the federal reserve will do everything in their power to stop an inflationary disaster. Ben Bernanke has stated in the past few weeks that the United States needs to address its deficits and the FOMC has shown hawkish fear over future inflationary pressures. This is not to say that the federal reserve and the US government will not continue a gradual weakening of the dollar to fund current and past deficits. Monetization of debt will occur, but it will not be the path of Argentina.

If we believe that a currency crisis is not at hand, then certain trades may make sense given the economic conditions. Interest rates will not stay at their relatively low level. That is why I recommended selling call options on TLT. Commodities (not just gold) diversify an investment portfolio and add protection against inflation over time. I do not expect inflation to kick in during the near term with 10% unemployment and tight consumer credit. As a short-term play for an anti-crisis view of the dollar, look at selling call options on oil or gasoline as the slow winter demand will tug on the fear driven prices.

Disclosure: Short TLT, Short USO.

Comments

[TraderRob:]

Yes, the other developed nations you mention will also experience a great deal of pain ahead as their debt laden consumer bases handed the bill up, in the U.S. case to the "push over uncle" Sam. There are however other countries in the world who are either (a) saving nations with trade surpluses to finance the recessionary stimulus spending they have implemented or (b) who have commodity based economies which will endure a currency crash better than others.

I agree that it makes since to be short USO at this level because the WTI contracts have gotten way ahead of themselves, but the dollar will weaken further after a short term bounce when the carry trade expires, at which time the short USO trade should be exited.

There will however also be a time when production based economies split from precious metals and Gold and Silver find their way to levels far above current prices while Crude Oil, Copper, Steel all plateau and potentially fall.

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Nov 06 09:35 AM

[junkyarddog:]

I'm not exactly sure what to make out of this:

1) The US is in terrible shape.
2) But the US is not in "such terrible" shape because others are in similar predicaments.

So, let me throw the question out there: are we EVENTUALLY looking into a financial collapse in the entire world?

Nov 06 09:59 AM

[jburns:]

A bushel of wheat is a bushel of wheat. It bakes the same number of loaves of bread if it sells for one dollar a bushel or 100 dollars a bushel. Commodity prices rising are a reflection in the reckless monetary policies being implemented around the globe. Commodity values remain fairly static in their usefulness. It is the pieces of paper used in their barter that are loosing value. The U.S. may be "less worse off" than other countries and therefore the dollar may gain in proportion to other currencies, but since all the worlds printing presses are printing at full capacity, it will take more fiat money as time goes by to purchase something that has a fixed value in usefulness terms.

Nov 06 11:15 AM

[John Galt:]

This is why gold is going up.

Yes, our government is printing dollars and spending like mad scientists, but so is Brittan, China and other countries. If every country tries to devalue their currency, how do you know which one to pick if they all lose value? That's why investors are flocking to gold.

Nov 06 11:23 AM

[tripleblack:]

Inflation is increasingly a comparison between global currencies, rather than a percentage within a commodity or a single nation.

It is when the various OTHER players pull out of the rigged game that the "old methods" take over.

I am of the opinion that the current "liquidity alliance" will hold for only a limited period, perhaps 3 more months. The cracks in the alliance are already big enough to run a supertanker through...


On Nov 06 11:23 AM John Galt wrote:

> This is why gold is going up.
>
> Yes, our government is printing dollars and spending like mad scientists,
> but so is Brittan, China and other countries. If every country tries
> to devalue their currency, how do you know which one to pick if they
> all lose value? That's why investors are flocking to gold.

Nov 06 11:34 AM

[Surly Trader:]

The point in making the comparison between the US and other countries is NOT to say that the U.S. dollar will continue to strengthen against hard commodities. In a world of fiat currencies with loose monetary policy, all currencies will weaken against hard assets over time. My point is to bring to light the *focus* on the US dollar as the currency that is going to be destroyed. That focus has played a big part in the fall of DXY. To me it is rational to think that all currencies will weaken over the long run, but to also think that in the short run the focus on the US dollar has caused short term anomalies in the currency markets and certain assets(oil).

Nov 06 12:15 PM

[user396040:]

Some very good points. On a relative basis our deficit and debt levels do not look too bad.

Nov 06 04:47 PM

[TWIS&TWINS:]

I find it somewhat disheartening that we are resorting to comparing ourselves to countries like Japan (a nation in a "death spiral") to lessen our fears.

Furthermore, if we are using the Debt/GDP metric to say we have X amount of dollars to pay off X amount of debt, my first question would be: "Why are only Federal Public Debt and Intragovernmental debt used as determinants of total debt?" Underfunded federal, state and local pensions, private debt, corporate debt plus unfunded liabilities should be taken into account, as the citizens responsible for federal government debt are also responsible for the others.

Is GDP an accurate reflection of the money we have to pay off these debts? I don't agree that 100% of government spending is "productive" and thus does not contribute as much as is calculated. Hedonics? Imputations? Geometric Weighting? How do we adjust for inflation? Core CPI, headline CPI or the GDP deflator? Why do we need three different measures of inflation-- none of which are accurate?

We have more debt and less productivity than a cursory glance at the Debt/GDP ratio might imply. I wonder what the ratios would be (for the U.S. and others) if a closer look was taken...

Nov 06 10:33 PM

[Northern Da...:]

>With that as the backdrop, I would like to show why it seems that the current fear over the dollar is a bit overblown.<

No it isn't. It's not overblown at all. Everything is relative to something else, isn't it? When we talk about the USD weakening, what exactly are we talking about here? We're talking about the fact that it's weakening against "all other currencies in the basket". If all the other currencies are weakening as well, that's irrelevant. As long as the USD is weakening against a basket of currencies that in toto is weakening, it simply means that the USD is weakening at a greater rate than all the others. How is that overblown? That's not overblown, that has damned serious consequences for the good people of the USA.

I can certainly see why very few countries in the world want a strong currency if they do a lot of business with the USA. There's no better example of that than Canada, who doesn't even appear on the list, even though Canada and the USA enjoy the single largest and friendliest economic exchange of any two countries on the planet. I think Canada is probably excluded from the list because it's just considered a big quiet well run country who's slippin' under the radar, full of corporations and inhabitants who are friendly, competent and known to be a hell of a lot of fun at a kegger. The sad fact is that Canada is the one country who will get slammed the hardest if the USA doesn't pull out of a nose dive, and fast.

But when currencies are compared only to each other, one loses the sense of how it affects us all, in the form of inflation. All currencies can be falling at the same time, and while the relationships between them certainly matters, the relationship between currencies and commodities (any kind of real stuff) matters a whole lot more. That's the main reason China is stockpiling gargantuan heaps of "stuff". They're holding more devaluing currencies than any other country on earth, and who can blame them for not wanting any of it?

Bodes well for not only gold and silver, but for darned near anything including dirt, I'd say.

Nov 07 04:59 PM

[TexasRedNeck:]

Very interesting comparison of countries that are trying to destroy their citizen's wealth. How about a look at countries that are trying to protect their citizens hard work..Both Australia and Switzerland have outstanding debt VS GDP of under 20%. It will be interesting to see which economies will do better over the next 20 years. I know where I am putting my money.

Nov 07 05:35 PM

[E Nuff Sed:]

A bushel of wheat is not a bushel of wheat if it is genetically modified by MON - its is 2 bushel of wheat. I do agree with you though.


On Nov 06 11:15 AM jburns wrote:

> A bushel of wheat is a bushel of wheat. It bakes the same number
> of loaves of bread if it sells for one dollar a bushel or 100 dollars
> a bushel.

Nov 08 06:40 PM

[E Nuff Sed:]

Looks like India is the place to be. Most number of young people coming on line in the next 40 years.

Nov 08 06:41 PM