In recent weeks, I have felt compelled to address this subject in more depth, but after repeated attempts, have simply abandoned the effort, as I haven't been convinced my thoughts were communicated in a way that would really allow the reader to understand the matter. Every attempt I make seems to move from A to B to C and comes out as a disjointed and circuitous presentation that is just as likely to confuse the reader as inform him.
In a book review on Nassim Taleb's most recent effort - Antifragile - Michiko Kakutani gives the book what I see as a rather scathing review. Consider this excerpt from the NY Times review:
In Mr. Taleb's view, "We have been fragilizing the economy, our health, political life, education, almost everything" by "suppressing randomness and volatility," much the way that "systematically preventing forest fires from taking place 'to be safe' makes the big one much worse." In fact, he says, top-down efforts to eliminate volatility (whether in the form of "neurotically overprotective parents" or the former Fed chairman Alan Greenspan's trying to smooth out economic fluctuations by injecting cheap money into the system) end up making things more fragile, not less. Overtreatment of illness or physical problems, he suggests, can lead to medical error, much the way that American support of dictatorial regimes "for the sake of stability" abroad can lead to "chaos after a revolution."
This is the central argument - the naked Christmas tree, as it were - in this highly discursive book, which proceeds to hang every sort of intellectual garland and philosophical ornament on its branches. Not only is "Antifragile" wildly ambitious and multidisciplinary, addressing issues in the realms of politics, economics, social policy, philosophy and medicine, but it also suffers from a kind of attention-deficit disorder, jumping from subject to subject, while continually looping back on itself. It's a book that could have benefited enormously from some judicious editing.
I haven't read the book, but understand the reviewer's sentiments. We want things presented in crisp, concise ways, and don't feel comfortable when complex matters don't conform to that ideal. Clearly from the interviewer's perspective, Taleb's work suffers from the same lack of focus that I find when trying to explain the subject matter of this essay. Yet, at the same time, to simply avoid the subject because of its interrelated complexity seems a bit of a cop out.
As a side note - and admittedly unrelated to the subject matter of this essay - Taleb's investment advice views are identical to my own, as reflected here:
From time to time there are some fairly specific illustrations of antifragile strategies: for instance employing what he calls the barbell technique to make investments, by putting, say, 90 percent of one's funds "in boring cash," and 10 percent "in very risky, maximally risky, securities." This avoidance of the middle ground would avoid the "risk of total ruin" in putting 100 percent in "the so-called 'medium' risk securities."
The statement above on putting 90% in cash and the other 10% in high-risk plays is exactly the kind of strategy I have employed for about 15 months now and the one I have advised others to follow. The reason for this advice is that we are indeed in a very fragile situation today, and it seems few really grasp why this time is different. It is different though, and in a way that almost no one speaks of, and I can only assume the reason for that silence is because only a few really understand the matter.
The destabilizing consequence of dethroning the US dollar
I am going to start with a very simple graphic that illustrates the flow of dollars under the current system, using the US and China for this purpose:
(click to enlarge)
The above graphic is a very simple one-dimensional example of how the United States manages to maintain high GDP levels solely as the result of the "exorbitant privilege" we have as the world's reserve currency. What you can see from the graphic above is that as we buy goods from China, we create positive GDP domestically, but if we weren't the world's reserve currency provider, we would have the same economic impact as any other net importing economy.
In other words, our ability to continue to buy goods would be hampered severely as we depleted our supply of the reserve currency. If we are importing more than we are exporting, our reserve currency - the currency we must have to engage in international trade - is slowly eroded to the point where we eventually run out of it and are dependent on the issuer of that currency to engage in central bank liquidity swaps or other strategies that move the currency back into our domestic economy and that allow us the opportunity to continue to buy goods and services.
I will delve into the matter of that dependency in a moment, but first, back to the graphic. What you see is that in the case of the US, the money we spend simply comes back to the US as China uses those dollars to buy US Treasuries. The result is that we are allowed to operate at a huge deficit domestically in that we find no shortage of nations willing to buy our debt.
The unsophisticated simply assume that the Chinese are doing us a favor, or in the view of some - they are actually achieving a major and sinister coup over the US by acquiring our debt, but that is just not the case. Consider, for instance, the advantages China has by buying our debt. First, it allows the loop to continue, meaning that the Chinese continue to support their own economy by sending back those dollars we sent to them. After all, we will simply create more debt, distribute it into our own economy and buy more goods from China. In the meantime, China still retains one of the most liquid and secure assets in the world - US Treasuries.
The quid pro quo is that the United States is allowed to continue to support its domestic economy with continuous deficit spending. Those who dislike this arrangement assume that China has the upper hand in this dynamic. That is simply not true, though. If China doesn't facilitate this process, the ability of the US to continue to buy from China declines to lower and lower levels, and the United States represents a huge pool of demand. The point is China needs our consumption to continue at current levels just as much as we need the money we send them back to continue to support our domestic economy with deficit spending.
What changed in 2013 and why?
Actually the change - in thought at least - didn't occur in 2013, but what did change in 2013 is that the BRICS countries, led by China, started bypassing the US dollar with bilateral trade agreements with other countries. It was a real shot across the bow for the United States in that for the first time in decades, the status of the US dollar as the world's reserve currency was being threatened.
What China and the other BRICS seem to desire is a more equitable system of international trade that is not dependent on the US and its policy makers for global reserve currency liquidity. In 2013, they moved from simple rhetoric to real action by entering into bilateral trade agreements with 23 nations to date - nations that, by some estimates, represent 60% of global GDP.
Change that will dethrone the US dollar is also supported by the United Nations, the IMF and the World Bank: Here is how the matter was explained in a ZH article back in 2011 as it relates to the World Bank view at that time:
The World Bank expects the US dollar to lose its solitary dominance in the global economy by 2025, as the euro and the renminbi establish themselves on an equal footing in a new "multi-currency" monetary system.
The implications are wide-ranging. For instance, Mr Dailami said this power shift would lead to big boosts in investment flows to the countries driving global growth, with a significant increase in cross-border mergers and acquisitions activity, and a changing corporate landscape in which "you're not going to see the dominance of established multinationals".
In addition, a different international monetary system will gradually evolve, wiping out the US dollar's position as the world's main reserve currency.
"The current predominance of the US dollar would end sometime before 2025 and would be replaced by a monetary system in which the dollar, the euro and the renminbi would each serve as full-fledge international currencies," the report said, highlighting what it considered the "most likely" of three scenarios for the currency markets in 15 years.
I chose that quote for a reason - the World Bank view back in 2011 was that the time window for this to occur was 2025. The actions taken in 2013 by China and the other 23 nations that have entered into agreements that effectively bypass the dollar suggest the pace for this transition has quickened. Perhaps part of the reason for this has to do with what has taken place since 2011.
The consequence of China's efforts to bypass the dollar in international trade means that China no longer receives dollars in the same quantity, and therefore, China's purchase of US Treasuries will be significantly reduced going forward. The impact to the continuous loop reflected in the graphic above, then, is that the US can no longer count on the Chinese to do their part.
The consequence, then, is the US suffers in that demand for US Treasuries falls and China suffers in that the ability of the US to continue to run high deficits to stimulate GDP growth and import Chinese goods is compromised. Here again, we get into the area of unintended consequences in that the efforts to dethrone the dollar have both good and bad impacts to the Chinese economy.
In the long term, abandoning the dependency on a sovereign currency as a reserve currency promises to stabilize an otherwise fragile arrangement. In the short-term, though, the disruption in the loop illustrated at the beginning of this article is highly detrimental to China and to the United States. This short-term destabilization in all economies is the primary point of this article and deserves further discussion, but the point here is that the BRICS - led by China - seem resolved to the idea that short-term pain is worth the long-term gain.
Understanding the positive side of abandoning the US dollar
In 1944, the United States held all the cards at Bretton Woods and effectively forced the world to accept the US dollar as a reserve currency. It was agreed that the dollar would link to gold and offered some degree of stability for as long as it lasted, but it didn't take long for the flaws in that arrangement to be exposed.
The truth is money supply needs to expand to accommodate economic growth and population growth, yet gold's value is its relative rarity, meaning that as dollar supply expanded - both domestically and globally as the world's reserve currency - it became apparent to all that the US couldn't really honor their commitment to redeem dollars for gold. Finally, in 1971, Nixon put an official end to what had ended years earlier from a practical perspective.
That had the potential to end the dollar's reign, but the US exerted its influence on the world, and the system that emerged from the collapse of the Bretton Woods system was a free floating currency system with the world's crude oil being traded in dollars. We went from the Bretton Woods system to the petrodollar system, and the US retained its "exorbitant privilege" as the world's reserve currency.
With the advent of the emerging markets as significant players and the transition from domestic companies serving the needs of their local economies to international companies serving the needs of the world, the playing field changed dramatically. This shift in the global paradigm created instability in the system in that those economies who were net exporters had an excess of dollars to deal with, and those economies who were net importers struggled to maintain the needed reserve currency levels that allowed them to purchase the goods they needed to sustain their own economies.
The free floating system produced unintended consequences in currency pricing in that a strong currency relative to the dollar hampered export sales for those countries that thrived by being net sellers of goods. On the other hand, those countries who were net importers benefited from a strong currency relative to the dollar in that they had a bigger bang for the buck, so to speak, when converting their local currency to dollars in order to buy goods.
As the issuer of the world's reserve currency, it was the United States that had the responsibility of implementing monetary policy that supported economic growth globally, and yet at times, that obligation was in direct conflict with the appropriate monetary policy that was needed to advance the domestic economy. It was Robert Triffin - in the 60s - who clearly articulated the nature of that incompatibility.
LONDON, Jan 30 (Reuters) - Investors on Thursday shrugged off central bank efforts to shore up battered emerging markets, selling stocks and bonds and further weakening tumbling currencies.
It added pressure on more countries to raise interest rates to seek a halt to a major capital flight.
Fears about emerging economies intensified after the U.S. Federal Reserve withdrew more of its monetary stimulus on Wednesday and a measure of Chinese manufacturing hit a six-month low earlier on Thursday.
The article speaks directly to the points I am making that are creating instability in the markets today. Go back to the graphic at the top for a moment and consider that China has deliberately impacted this loop in a way that means dollar demand is being impacted negatively. If China is no longer receiving dollars in large quantities, then they no longer need to buy US Treasuries. That means those dollars that still exist are no longer locked up in US debt, resulting in a tendency to produce a glut of US dollars.
It is reasonable to assume that some of the Fed's motivation for tapering back on QE has to do with the need to withdraw liquidity to counter the Chinese/BRICS move which increases the amount of dollars, since they are no longer locked up in Treasuries, and tends to push the dollar lower. The problem is that the Fed's taper combined with China no longer being a major buyer of US Treasuries creates a significant drop in US Treasury demand. The Fed seems stuck in this situation, as the dollar will weaken if they don't tighten, but if they don't continue to support US Treasuries, who will, as China is certainly not as big a player anymore. It seems to me they are in a Catch-22, where they are damned if they do and damned if they don't.
So back to the point - why would a non-sovereign reserve currency be advantageous? The answer is that a central bank's central bank could alleviate illiquidity issues in much the same way the Fed does with its member banks.
Those sovereigns with excess reserves liquidity could do short-term loans to those without sufficient liquidity, and this global central bank - probably the IMF - could also act as a lender of last resort to countries that find themselves without sufficient reserves to operate their domestic economies. The result would be a world that no longer experiences liquidity crisis situations, or at the least, the occurrence of these situations is dramatically reduced and systems would be in place to rapidly alleviate the liquidity issue.
Under the current arrangement, the Fed - in an effort to support the dollar - has created instability in the global marketplace. It is not an issue that is much discussed, although it is definitely being covered by the media, and the reason is probably because the implications are really not well understood by the average investor. Here are another 4 articles that speak to the issue:
- Fragile Five Fight Back
- South Africa's central bank hikes key rate to 5.5%
- Expert views - RBI surprises with 25 bps rate hike
- Emerging economies hike rates to defend currencies
Why it matters to stocks and bonds
The reason it matters to investors is that stock and bond prices have benefited greatly from QE and deficit spending. Not only has QE expanded M2, but a large portion of that M2 has found its way directly into stocks, pushing equity valuations higher and higher. The reason QE hasn't produced significant economic growth is in part the fact that the money created on the front-end of this process has been invested in risk assets rather than flowing into the economy to stimulate GDP growth.
Here is a simple graphic that demonstrates this dynamic:
(click to enlarge)
That is part of the dynamic that has pushed equities higher throughout the QE process, but there is another aspect of the spike in stock market valuations, and that is the carry trade. Easy money at low rates attracts sophisticated investors who use collateral to borrow money at low rates and invest in risk assets. A primary dealer bank may pledge a Treasury bond as collateral to borrow money and invest that money in stocks. It is a leveraged trade, and therefore, a very fragile trade in that adverse price movement can result in significant losses.
What tends to compound the fragile nature of the carry trade is that assets can be hypothecated and re-hypothecated multiple times, allowing even more leverage. In the United States, we only allow an asset to be leveraged to 1.4 times its value, but in the UK, no such restriction exists. Consequently, a bank could hypothecate an asset to a UK subsidiary, and thereafter, borrow much more than the 1.4 times limit imposed in the US.
The primary carry trade is the yen, and the correlation between the USD/YEN to stocks is relatively high in recent months. The following chart shows the S&P 500 (SPY) and the USD/YEN for the last 3 months:
(click to enlarge)
At issue here is whether or not the Fed can support the dollar against the yen, and it is reasonable to assume that so long as they can do so, all is well with equities. Here is another chart that does a better job of demonstrating the concerted effort to support the dollar against the yen. It is the 5-minute chart and shows that someone is aggressively buying the USD/YEN and ramping it sharply higher when the pair gets sold off sharply:
(click to enlarge)
The point, of course, is that the decision to enter into bilateral trade agreements that bypass the dollar is changing the dynamic of currency fluctuations that could produce a major unwind of the yen carry trade, and in particular, if the Fed loses control of the dollar. We are seeing major disruptions in several of the emerging market economies at present, and one wonders if these issues have been resolved with efforts to support those currencies with dramatic rate hikes.
And of course, the Fed's effort to support the dollar doesn't help the matter at all for these economies that are attempting to keep their own currency from going into free fall. That, of course, is the crux of the matter that so disturbs those who are opposed to the US dollar serving as the world's reserve currency, and demonstrates the validity of the Triffin dilemma argument.
Lest one think the move by China hasn't impacted the market, a look at the 10-year T-Note rate suggests otherwise. The spike in rate that occurred in May of 2013 coincides with the sale of US Treasuries by both China and to a lesser degree Japan that occurred at the same time. Of course, that is also the time that China moved from rhetoric to real action.
(click to enlarge)
What is most troubling, in my mind, is that there are macro pressures that are having significant impacts on many markets in recent weeks. Make no mistake, the Fed and other central banks are still in there fighting the battle and doing all they can to prop the dollar and keep the carry trade intact. After all, the consequence of losing control here is significant, as the markets are highly overleveraged, meaning a loss of control would likely create a very rapid unwind of the yen carry, and that could spell disaster for global equities - not just US equities.
I gave up some time back on the idea that the Fed would actually permit the process of free price discovery and am as convinced as ever that their efforts to avoid a repeat of the 1999-2000 crash or the 2008-2009 crash are continuing. That said - any attempt to avoid the cyclical nature of markets eventually ends with a much worse outcome than would have occurred had the manipulations not been employed in the first place.
My own view at this point is that the efforts to dethrone the US dollar are impacting markets and producing instability. Perhaps the Fed's last-ditch effort to avert a major market sell-off is the USD/YEN. So long as the dollar can be propped by central banks, a sell-off of any significance is improbable.
A look at the US dollar index might offer some clues. The red line on the chart below seems a critical support level. A move below the 79.00 level on the dollar index would suggest a breakdown in the dollar and much lower prices.
If that were to occur, my guess is we would see a sell-off in Treasuries (TLT), a sell-off in stocks and a sharp spike higher in gold (GLD) and volatility (VXX). One thing is certain - this bull market is getting a little long in the tooth, with very little left to prop it short of the carry trade.