Many of us wondered if the Jackson Hole Summit this year would offer anything of significance with Bernanke not in attendance. The primary focus for most was the hope that we would we get some clues on the matter of the Fed's timing on pulling back on the controversial QE program?
Surprisingly we did indeed get something of significance coming out of the Jackson Hole Summit but it was not what most expected. The following quote is the opening statement in a Reuter's article entitled Central bankers debate risks from withdrawing global liquidity:
Global financial stability is at risk as central banks draw back from ultra-easy policies that have flooded the world with cash, because emerging markets lack defences to prevent potentially huge capital outflows, top officials were warned on Saturday.
The Fed's talk of tapering is real and relevant to investors but it is only of secondary importance as far as this article is concerned. The primary focus of this article is whether or not the US dollar will remain the world's reserve currency. It is a very complex and highly controversial subject that gets almost no play in the press but an enormous amount of focus behind the scenes.
The harsh truth is that we have reached the end of an era and it is blatantly clear to those of us who understand the subject that Keynes was right when he stated at the 1944 Bretton Woods conference that a sovereign currency would not work as the world's reserve currency. The reasons are multi-faceted and complicated to say the least and I am not sure I can explain the complexity of the issue in terms the average investor will understand but at the request of a number of my readers I am determined to give it a try.
Before I venture into the subject - a highly controversial and divisive subject to say the least - I think it is important that I open up to my readers and tell you where I stand on matters political and economic. The subject discussed here is - as I stated - divisive and controversial and I don't want anyone to mistakenly assume my comments and views on this subject are informed by a socialistic or anti-American perspective as nothing could be further from the truth.
I am an avid capitalist and a proponent of a smaller and less intrusive government. That said, I also recognize that anything taken to its extreme is destructive and counter-productive. In other words I believe the government must have a role in reining in those who abuse the privileges afforded them in a capitalistic society.
I tend to think Henry Ford had it right. Henry Ford's genius was in part recognizing the need for an affluent middle class. He recognized that it was the masses that provided the fuel for a strong and growing economy. If he paid his workers enough they could buy what his company produced - automobiles - and in so doing all came out winner.
The world Henry Ford helped define - a world where middle class affluence was the objective - has been destroyed by the very thing that made it possible in the first place, free market capitalism. John Dalberg Acton's famous quote - "Power tends to corrupt and absolute power corrupts absolutely." - states the problem in a few short words. Here is the full text of Lord Acton's comment:
I cannot accept your canon that we are to judge Pope and King unlike other men, with a favorable presumption that they did no wrong. If there is any presumption it is the other way against holders of power, increasing as the power increases. Historic responsibility has to make up for the want of legal responsibility. Power tends to corrupt and absolute power corrupts absolutely. Great men are almost always bad men, even when they exercise influence and not authority: still more when you superadd the tendency or the certainty of corruption by authority. There is no worse heresy than that the office sanctifies the holder of it.
Here is another truism - again from Lord Acton:
The danger is not that a particular class is unfit to govern. Every class is unfit to govern. The law of liberty tends to abolish the reign of race over race, of faith over faith, of class over class.
Here's the point - our government leaders have failed us badly. As I see it the role of government is to stand in the gap and prevent those who assume power through wealth and success in the private sector from abusing that power. The idea that political influence can be so easily bought in today's world is a testament to the times and it is as bad today as it has ever been.
Here is a chart of the estimated average net worth of members of Congress courtesy of the Center for Responsive Politics:
To put this in perspective here is an excerpt from an article on the huge disparity between members of Congress and the average American today:
A typical American household has a net worth of about $66,740 - a value that has been declining since the start of the most recent recession. Between 2007 and 2010, the median net worth of American households sank 47.1 percent. Food stamp enrollment increased by 15.5 million since 2009 and recent job creation figures show that low-paying jobs have largely replaced higher paying ones.
At a time when the majority is struggling financially, the nation's leaders are accumulating more wealth.
Americans living below the poverty line rose to 49.7 million last year - a record high which equates to 16 percent of the population. A recent study also shows that the US income gap is worse today than it was in 1774.
And this from a Daily Ticker article:
We have this huge disparity that's only getting worse in terms of inequality in this country," says The Daily Ticker's Henry Blodget. "If it continues, the country will begin to break apart and get more and more antagonistic class warfare. It's something we have got to solve not only in Congress but in the American public at large."
Is Congress pursuing policies that benefit middle and lower income Americans? The Washington Post found that 73 lawmakers sponsored or co-sponsored legislation that could benefit businesses or industries that involved those Congressional members or their families.
"It's just outrageous that our legislators could be profiting directly from the legislation that they're making," says Aaron Task.
To sum it up - as much as I love America and as much as I believe in and embrace the capitalistic ideals that made this country great - we have reached a multi-generational juncture in history where changes must be made and will be made. Our leaders have failed us and whether that is the result of human nature that puts self advancement above all else or simply a matter of making really bad decisions and policies is perhaps not relevant.
I am in no way suggesting we assemble a vigilante lynch mob and go after our political leaders. After all, in my opinion they have succumbed to the same power induced delusions that most of us would probably fall prey to were we in their position. As Lord Acton so aptly stated:
"The danger is not that a particular class is unfit to govern. Every class is unfit to govern."
At the root of the problem
Now that you know where I stand we can get on with the discussion regarding the withdrawing of monetary stimulus that threatens "global financial stability". Why would a decision by the United States to withdraw monetary stimulus by slowing down or terminating QE create global instability?
The answer to that question is complex but we need to start with a discussion on the nature of a reserve currency. The US dollar is the world's reserve currency and providing a sufficient supply of US dollars to the world's sovereign nations is the principal function of the US as it relates to its role as supplier of reserve assets. To understand the implications one needs to understand what was decided in 1944 at the Bretton Woods Conference that resulted in what French Finance Minister Valery Giscard d'Estang termed "exorbitant privilege" - a privilege bestowed on the United States when the US dollar was established as the world's reserve currency.
Here is the condensed version of what happened at Bretton Woods back in 1944:
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.
Preparing to rebuild the main international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known at the Bretton Woods Conference. The delegates deliberated during 1-22 July 1944, and signed the Agreement on its final day.
Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (NYSE:IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.
The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF to bridge temporary imbalances of payments.
So the outcome of this new system was that the US dollar was designated as the world's reserve currency and the United States guaranteed that those sovereigns holding dollars would be allowed to exchange them at a rate of $35 for 1 ounce of gold. We all know how that worked out though - it didn't - and for reasons that were easily predictable by competent economists.
The motivation for a system of trade that was fair was well articulated by Cordell Hull, United States Secretary of State from 1933-1944:
Unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war…if we could get a freer flow of trade…freer in the sense of fewer discriminations and obstructions…so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace.
We of course didn't create that system Hull hoped for - we simply transferred preferred status from Great Britain to the United States. Great Britain no longer held exboritant privilege but the United States did. And the very thing that Hull hoped for - a system based on fairness - has to this day eluded us and we now find ourselves once again at the point where something is about to happen that will dramatically change the system.
In an article entitled - Bretton Woods and the Forgotten Concept of International Seigniorage - Dix Sandbeck expands further on the debate at Bretton Woods on the nature of the new reserve currency:
Keynes envisaged the bancor as an international trade currency and unit of account. Its management and issue was to be in the hands of an another planned international organization, the International Clearing Union (ICU). The value of the bancor was to be determined by the value of the different national currencies in a trade weighted basket. Values of currencies would be fixed, but could be changed by mutual agreement.
A fundamental aim of Keynes' plan was to install a truly multilateral system. No nation would be allowed to dominate; nations in surplus or in deficit would be disciplined alike. Shortly before the conference however, the Americans rescinded their support for the bancor. Presumably, they felt that the bancor scheme, with its control in the hands of the ICU, was a shrewd strategy to rob the United States of its greatest spoil of victory: unfettered post-war dominance.
Instead, the Americans insisted on a system where the US dollar would be fixed to a gold value of $35 per ounce, though convertible only for central banks. All other currencies were to be aligned to this dollar-gold anchor. If adopted, this would confer on the US an unprecedented supremacy Even Britain, at the pinnacle of her power had not enjoyed such a position. But at Bretton Woods the exhausted European nations were eager for the continued flow of dollars to finance the war and the impending reconstruction. No nation was in a position to challenge the American volte-face.
Seigniorage is the difference between the value of money and the cost of producing it. It is that concept that sets the US apart from every other nation in that it derives the benefit of the currencies purchase value and bears almost no effective cost at current interest rates. Here is how it works. The US government expands the debt ceiling at will and then borrows money by issuing treasuries.
Countries who are net exporters then buy those instruments from the United States in order to invest the dollars they receive in international trade. If you are a net exporter then you build a surplus of US dollar denominated assets. If you are a net importer the inverse is true.
The benefits to the reserve currency issuer is that they are allowed to borrow in great quantity relative to other sovereigns without the commensurate cost these other countries would incur were they to do the same. The reason is simple - if you want to import or export goods and services you do so using US dollars as the form of payment. In other words there is a high demand for dollar denominated assets for reasons unrelated to the interest rate paid on those assets.
A country like China then ends up with a surplus of dollars and here is why. A company in China exports goods and receives in return US dollars. That exporting company then needs to convert those dollars back to the sovereign currency and so the central bank exchanges those dollars for yuans. Now the central bank has dollars which it uses to buy US debt.
That isn't the way most investors see it though. Most investors see China as deliberately buying US debt for any number of sinister purposes. Others see us at the mercy of China and that may end up being true but not for reasons that are readily apparent.
China by the way has a unique arrangement that links the yuan to the US dollar and that would suggest that the yuan would not appreciate if China sold US dollars and bought the yuan but that is only partially true. The problem with China is multi-faceted. A strong dollar necessarily results in a strong yuan relatively speaking due to the yuan's link to the US dollar. In other words a strong dollar could end up having a modest impact on Chinese export demand. On the other hand a weak US dollar could have an inflationary effect on the yuan domestically.
Additionally, the Chinese use a novel approach to curbing inflation domestically. They simply raise bank reserve requirements in lieu of withdrawing liquidity. That creates an instant muting of the expansionary impact of the fractional bank multiplier. At the same time it can produce a serious liquidity crisis domestically in China when they attack inflation in this manner.
Another problem as far as China is concerned is rooted in the US blunders from a domestic perspective that create instability in the dollar and in US Treasuries. Blunders like consistently inflating investment assets as in the mortgage debt crisis that impacted global economies across the spectrum.
So what happens then that causes a crisis in the emerging market economies. Here is what Jim Rickards - author of Currency Wars: The Making of the Next Global Crisis - sees happening:
If the Fed does what they say they're going to do-which I don't think they will-but if they do… and they reduce asset purchases and U.S. interest rates go up, the capital outflows are going to come from the emerging markets back to the U.S., the carry trades are going to be unwound and that's going to leave these economies high and dry," says Jim Rickards, senior managing director of Tangent Capital.
And ultimately, those emerging markets "will have unsustainable projects and bank debt, and it could be the beginning of another emerging market crisis which as we know in 1997-1998 spread to major economies.
Rickards made the above statement back in June. There seems to be a pretty broad consensus view today that tapering will start this year. Furthermore, projected deficit levels this year suggest that new Treasury issues will be substantially reduced in fiscal 2013 meaning that the Fed's bond buying program at current levels will consume roughly 70% of new issue.
So even though there are a very few reasons for tapering there are perhaps a lot more reasons for not tapering. My guess is Rickards will end up being right and the US will not taper but for reasons that are again not so obvious.
When rates start to climb the dollar carry trade loses its appeal and not just in the emerging market economies. Borrowing short term to invest long term works as long as the yield curve remains attractive. But what happens to bonds when rates start to climb. Bonds at the long end of the curve lose value and that applies to all bonds - not just emerging markets. That of course exacerbates the problem as the selling pressure on bonds begets more selling pressure.
Is the Fed really to blame for recent bond weakness?
The following excerpt on the matter of foreign sales of US Treasuries suggests that there is a lot more than QE taper talk driving bonds lower:
(Reuters) - China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.
The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.
One can argue that China and Japan are selling US Treasuries as they fear the Fed is losing control of the bond market. One can also argue that they are doing so as they are no longer trading exclusively in US dollars.
Consider this from Al-Jazeerah on the matter of trade agreements not involving the US dollar:
Over the past two years, China has announced a string of yuan internationalization efforts that are systematically chipping away at the dollar's importance to global trade. Financial blog Zero Hedge reports: "One more domino in the dollar reserve supremacy regime falls. [T]he announcement two weeks ago that 'Australia and China Will Enable Direct Currency Convertibility' … was the culmination of two years of yuan internationalization efforts as summarized by the following":
"World's Second- (China) and Third-Largest (Japan) Economies to Bypass Dollar, Engage in Direct Currency Trade" "China, Russia Drop Dollar in Bilateral Trade" "China and Iran to Bypass Dollar, Plan Oil Barter System" "India and Japan Sign New $15bn Currency Swap Agreement" "Iran, Russia Replace Dollar With Rial, Ruble in Trade, Fars Says" "India Joins Asian Dollar Exclusion Zone, Will Transact With Iran in Rupees" "The USD Trap Is Closing: Dollar Exclusion Zone Crosses the Pacific as Brazil Signs China Currency Swap"
What we know is that the Fed hasn't begun the process of tapering back QE purchases yet the yield on US Treasuries has skyrocketed - doubling since the mid-2012 lows:
This can only be explained in the context of foreign sales of US Treasuries. In June foreign sales of US Treasuries exceeded the Fed's purchases by roughly $27 billion. In other words US Treasuries aren't falling as a result of taper talk but as a result of the selling pressure created by those countries no longer trading in US dollars.
If China, Japan, Australia, Brazil or one of the many other countries now by-passing the US dollar no longer receive US dollars in payment for exports then it creates an altogether different dynamic that tends to diminish the exorbitant privilege of the US.
Take Japan as an example. If they receive US dollars in trade settlements they either hold the dollar or interest bearing treasuries. In other words they buy US Treasuries pushing bond prices up and yields down. Do they want to do that? The answer is no but they have no choice. If they simply sell US dollars and buy yens they drive the yen higher and the result is a dampening of demand for Japanese produced goods. It hurts the domestic economy so they are forced to reinforce the exorbitant privilege of the reserve currency nation.
How are bilateral trade agreements affecting markets?
Let's look at the bond market to see if this dynamic is really occurring. Here is the bond market (NYSEARCA:TLT):
Once again we know why bonds have been weak of late - foreign sales of US Treasuries. And we know why that is occurring - bilateral trade agreements that don't result in US dollars being received to the degree they have in the past. It can be argued that the recent spike is the result of a safe haven bid for US Treasuries based on the prospects of heightened tensions in the middle east arising from the mess in Syria but will it last? Probably not as the overriding influence on bonds is the bilateral trade agreements that are bypassing the US dollar.
Now let's look at gold. Here is (NYSEARCA:GLD):
The price action of gold is not so easily explained. There are a number of issues in play. First, disinflation - not inflation - has been the predominant trend in the US of late. Here is a chart of the CPI:
This tends to explain the steady downtrend in gold from October of 2012. The recent spike higher in gold is better explained by the dynamics of the various bilateral trade agreements that are bypassing the US dollar. I have argued for some time now that QE is not inflationary unless the excess reserves created by the Fed's policies result in increased M2 creation through the fractional bank multiplier as banks make loans. That hasn't occurred and therefore M2 expansion has been muted since coming out of the Great Recession.
However, the various bilateral trade agreements that are bypassing the dollar will produce downward pressure on the US dollar even in a deflationary and deleveraging environment and this is a phenomenon few understand. It will also result in the loss of exorbitant privilege that has allowed the US to operate irresponsibly and with impunity for decades. In other words the US will no longer need to operate with high deficits in order to provide reserve assets as a condition of their currency reserve status. In truth they won't be able to operate with high deficits without consequence any longer assuming the trend to bypass the dollar gains momentum and it seems certain that will be the case.
Is the multi decade bull market in bonds at an end? It would seem so and not specifically as a result of US fiscal and monetary policy - rather due to the US dollar losing its status as the worlds primary reserve currency. If trade isn't conducted in dollars then those countries who are large net exporters will not receive as many dollars and therefore won't have the need to buy US Treasuries with those dollars. Furthermore, the dollars they do receive will be sold in lieu of being invested in US Treasuries putting downward pressure on the US dollar.
Debunking the capital flowing to US equities bull market argument
The idea that capital will flow to US equities as US equities are the best value is refuted by the fact that US equities will likely suffer a major hit as China, Japan, Russia, Brazil, India and others bypass the US dollar. What will occur instead is an end to the demand for US Treasuries that has driven bond prices higher and yields lower. This can occur at a much more rapid rate than many would imagine.
The result is an end to exorbitant privilege status for the US. Interest rates will continue to climb or normalize as some say and that will necessarily result in a deleveraging - a reduction in debt levels - that will cause M2 growth to stall out and perhaps decline. So the take away then is that even in a period of disinflation or deflation we could still see the US dollar fall relative to other currencies. It isn't supposed to work that way of course but then we don't have a period we can reference to inform us on what happens to the US dollar when it loses its reserve currency status.
There are two arguments for the bull case. First, the economy is improving and will catch up to stocks. Second, although PE ratios are high they are still nowhere near historical highs. I won't bore readers with all the reasons why the economy isn't improving but I do want to point out the flaws in logic made by those suggesting multiple expansion allows more upside room for stocks. The chart below makes the point:
The chart above shows that peak PE ratios occur at points where corporate earnings hit bottom. The chart above shows that in both market crashes in this century PE ratios spiked sharply higher and peaked at that point where corporate profits were at lows. Without overlaying the two metrics one doesn't readily get this point. Herein lies the flaw in logic by those suggesting that stocks have more room to climb based on the idea that PE ratios are substantially below historic highs. Clearly they are below historic highs but historic highs occur in a market crash as it relates to PE ratios.
To put the matter in full perspective here is a chart of the S&P 500 for the same time frame:
As I finish up with my comments I am listening to CNN speak of the goings on in Syria. Quite frankly I have been expecting a major sell off this week based on a shift in investor sentiment predicated in part on a risk off mindset as we ponder the matter of our involvement in another middle east action. I really expected the matter to die down a little after Obama deferred the matter to Congress. That hasn't happened though as the news coverage today has been almost exclusively on the Syrian matter.
Despite the pundits who have argued for months that the US economy was improving or that we have more to run based on multiple expansion even if the economy isn't improving I am convinced as I have been for over a year now that we will revisit the 2009 lows in the next few months. The inconvenient truth is that we have reached a multigenerational inflection point where changes will be made on a global scale.
Changes are happening and at a very rapid pace today. I never feel comfortable with the agendas of our leaders or the motives behind their actions and do all I can to look beneath the hood to ferret out those things others might be missing. I spend an inordinate amount of time doing just that - probably in the neighborhood of 100 hours a week. I'm not interested in re-hashing those things everyone else talks about as those things don't inform us on major inflection points in market price.
The industry as a whole is buy side biased and very few of us feel comfortable with the idea that things will deteriorate. It is not what we want and so we experience a sort of confirmation bias looking only at those things that support what we want to see happen. I see no sense in that mindset. What I do know is that we have bull and bear markets and that neither goes on forever. When we reach price extremes and do so at points where economic metrics seem to be diverging from price we must act rationally if we hope to survive and profit during the bad times.
Each of us has to judge for ourselves what will occur in the coming months and all I can do is inform readers of what I see and what I see is a major seminal moment that will come upon us with a suddenness that few expect. The big question is will a sell off be in the category of normal or will it be much more dramatic. I am confident that it will be the latter and wonder if maybe the time is now upon us.
Additional disclosure: I am also long SPY puts