It's The Dollar, Stupid

Includes: GDX, VDE
by: Econ Base

Last few weeks the world stock markets have been declining, drip by drip. Commodities including oil and gold were routed. euro and most foreign currencies declined relative to the U.S. dollar. The media has been all over the place trying to pin point the root cause. The problems in Greece and Spain, the French elections, the slowdown in China and the stance of the U.S. Fed have all been speculated as the cause. They are all right. But it is important to understand the world events in the context to the U.S. dollar. Here is a quick primer of the whole world in plain language:

1. Greece has large welfare expenses, but inadequate tax revenues. As a result they defaulted on interest payments and bond holders incurred losses. Fed up with austerity they are going through one election after another hoping money will come from somewhere to fund their expenses. But Germany, the main financier of the euro, is demanding spending cuts as a condition for more European Central Bank loans. The choice for Greece is two fold: Do as Germany wants, or exit the eurozone. If they choose the latter, Greece defaults on all euro loans by paying back no more than the reported 50% value in Greek Drachma currency. That is spooking the bond holders and citizens alike. They are all rushing to cash out and flee into the safety of U.S. dollar.

2. Spain is viewing what is going on in Greece and people are saying why wait? A bank run is in progress there.

3. Italy's and for that matter the rest of European country bond ratings have been slashed. France just threw out the capitalist Sarkozy and replaced him with socialist Hollande. This sounds like a repeat of Greece, except that the GDP of France is about 8 times of Greece. So the problem is multiplied in comparison.

5. Germany is the only fiscally sound eurozone country. But Germans are reluctant to unlimited bailouts. If they do their own economy is risked. If they don't the euro collapses. Either way, the U.S. dollar is a safe bet.

6. The U.K. has chosen the path of austerity to reign in its large deficits. As a result the British pound has not declined as the euro, but due to a slowdown in U.K., there is nervousness, and the British pound is not a preferred currency relative to the dollar.

6. China's economy has slowed down significantly, and as a result, the commodity exports from Australia have slowed down. The Australian dollar as a result has weakened relative to the U.S. dollar.

7. Most of the other weaker emerging markets such as India are having significant problems due to inflation. Their economies are not export driven, but instead consumer driven. Inflation is running rampant due to oil subsidies and high oil import bill. Their currency is weakening relative to the U.S. dollar.

Due to the strength of the U.S. dollar relative to world currencies, commodities, priced in U.S. dollars, are also dropping in sympathy. Oil prices and energy ETF's like VDE have dipped by about 15% from the recent peak. Similarly, gold has dropped from the peak of around $1900 to around $1550, a drop of 18%. The hardest hit have been all the gold miners such as GDX, dropping by about 25%. Commodities are dropping since world is experiencing a slowdown, but the predominant reason is the U.S. dollar's strength. The U.S. dollar is the least rotten among all currencies. The 10 yr. U.S. Treasury yield now stands at a mere 1.71%.

In such an environment, where the U.S. dollar is the king, what are the investors supposed to do? Should they flee to the U.S. dollar like the rest of the world?

Before answering that question, let U.S. look at Ben Bernanke's plans. As I wrote in previous articles, Ben Bernanke is afraid of deflation. He is on a mission to create growth via inflation and via a weak dollar policy. High unemployment rates of 15% in U.S. (accounting for under employment and discouraged workers departing the work force) means pressure on wages is non existent and therefore inflation is not a threat. To spur growth, he has been creating excess dollar supply through numerous quantitative easings.

Just like the 2008 U.S. financial crisis, the world again wants to hide in dollars. Ben Bernanke wants to create inflation. So we are where we were before. The politicians and their central banker friends want to print money and create growth. That way they can stay elected. Nothing has changed. Sarkozy's ouster is a reminder of what happens when a politician tries to reign in spending. The public too used to state handouts will oust such a politician from office.

The U.S. dollar will reign supreme till the financial crises around the world are resolved. But that may take a long time. A very long time. And there is a chance this may all end up very badly, if all the money printing creates a dollar crises. At that point commodities and hard assets such as gold and oil may be the only other alternative. Ten year CD's, physical bullion, GDX and VDE are therefore all good long term investments.

Disclosure: I am long GDX, VDE. Long 10 year CD's, physical bullion