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Dollar's wounds reopen
By W Joseph Stroupe
"Be careful what you wish for, you may receive it." The adage applies well to the US Federal Reserve as it enters what may turn out to be an entirely new and more dangerous phase of the financial and economic crisis that is still firmly centered in the US - notwithstanding the ongoing Wall Street rally and increased hopes that the worst is now over.
The Fed wished away the hysterical risk aversion reflex of global investors, which came to a head in autumn 2008, when big Wall Street banks collapsed, sending shockwaves around the globe. The position of Fed officials is, after all, that this is a crisis sparked mostly by panic-stricken investors who've artificially driven the value of America's innovative financial assets far below their true values, wrongfully smearing massive sums of such assets with the label, "Toxic!".
The Fed believed it could breathe new life into those assets and into America's asset bubble-based economy by getting credit flowing again and by replacing investor fear with investor confidence - which inevitably translates into a greater appetite for risk. A significant measure of risk appetite is now returning. But the problem is, the US dollar isn't getting the benefit. Instead, its wounds are only being reopened.
As of June 2, the dollar had hit new lows for 2009 against nearly all major currencies, dropping a full 1% against the euro on that day alone, totally ignoring Treasury Secretary Tim Geithner's statement during his visit to China that the US favors a strong dollar. On May 27, the yield curve on Treasuries steepened to a new record as the difference between the two-year and 10-year notes reached 2.75%, steepening to about 2.78% on June 2.
Global investors, both private and official(central banks) are voicing ever more loudly their intensifying fears over exposure to the dollar for anything but the short term and their collapsing confidence in the currency as a safe store of wealth beyond the short term.
Let's back away for a moment to look at this global crisis from a distance. When the US housing bubble began to burst in 2006, inherently risky, innovative financial assets backed by mortgage paper eventually began to be exposed for what they really were ("toxic" assets) and in late July 2007 the now-famous subprime crisis emerged.
The contagion of toxicity spread to infect virtually all such innovative assets, wiping out huge sums of wealth and plunging US banks and other financial institutions into crisis and ruin. The damage and destruction quickly spread to the real economy, as a severe and persistent credit seizure virtually shut down lending at all levels.
In the mounting storm, panicked, risk-averse global investors sold off emerging-market assets and investments deemed risky and massively piled into the dollar as a safe haven, lifting the currency. The Fed and other central banks began spending many trillions of dollars aimed at stabilizing the wobbling financial system and restoring confidence, which had utterly collapsed. The financial system was barely saved from a complete meltdown by such interventions, which continue to this very day.
Ominously, global investors, though giving the dollar the nod as a safe haven in the storm, stampeded into the short end, virtually shunning the longer-dated dollar assets altogether. That fact was a dead giveaway that the dollar's well-known loss of strategic global appeal as a safe store of wealth had not been in any way resolved, but only papered-over for the moment.
Reopened wounds
Now, as risk aversion recedes and risk appetite returns, global investors realize they over-sold their non-dollar assets and investments in the emerging markets when the crisis intensified last year. The emerging markets are widely seen as those that will emerge from the crisis first, and assets in these markets are very attractively priced. Hence, investors are now selling their dollars to buy back into such assets deemed much safer stores of wealth than the dollar in the face of the inevitable return of dollar inflation beyond the short term.
That is driving up yields on a host of dollar-denominated financial assets such as Treasuries and mortgage bonds and sending the dollar to new 2009 lows.
Emerging market indexes and commodities are surging as investor wealth pours in once again. Profligate US spending and skyrocketing deficits, hyper-loose monetary policies in this crisis, and collapsing confidence that the Fed will actually be able to withdraw such policies and excess liquidity when required, are all causing dollar inflation expectations to become deeply rooted in investor psychology.
The overpowering perception on the part of global investors that the Fed, Treasury and Administration are losing control of the US fiscal position, and that inflation (more likely hyper-inflation) is virtually becoming inevitable is threatening to wreak irreversible harm upon US finances and upon the dollar itself.
Angela Merkel, the German chancellor, issued on June 2 a stern warning along these very lines, a warning that was remarkable for its stark honesty and its unprecedented violation of the cardinal rule of German politics that says German politicians never comment on monetary policy of the central bank. Her break with that rule indicates Berlin is extremely concerned about the dangerous and risky hyper-inflationary and currency-debasing monetary policies being undertaken in this crisis. Chancellor Merkel launched her attack on the US Federal Reserve, the Bank of England and on the European Central Bank. She said:
In a similar vein, Richard Fisher, president of the Dallas Federal Reserve Bank, issued a warning on May 23 against monetizing US debt through Fed purchases of Treasuries, agencies and other assets. He warned that this risky policy is making global investors increasingly nervous. He further warned that the Fed's challenge is to reassure the markets that the Fed isn't simply making itself "the handmaiden" to fiscal profligacy, almost as if the promise itself is enough. He said:
In all likelihood, the Fed will be required to significantly step up its own purchases of the longer-dated Treasuries in an effort to keep escalating yields from getting out of control and completely negating its efforts to keep monetary policy hyper-loose. But such a dollar-debasing move (the printing of yet more huge sums of dollars) will only further convince investors that hyper-inflation is inevitable, and that realization will further weaken the appeal of the dollar today, sending it immediately lower.
It certainly appears as if the Fed doesn't get it; officials definitely seem to think they can reassure global investors merely by repeating the assurances quoted above, but without actually changing course in any meaningful way. They absolutely aren't listening to the wisdom and warning of Angela Merkel and those like her.
The question is whether central banks which already have large holdings of dollars, such as China's central bank, will dramatically increase their exposure to the risky dollar in an effort to stem its decline in order to keep their holdings from being eroded away.
Considering the record level of angst over their already-large exposure to the dollar, it appears highly unlikely they will significantly increase their exposure now, when dollar risks are dramatically increasing. Note the June 2 comments of the official state media, China Daily, in this regard, in its article entitled, "Geithner Sells a Devalued Dollar": Another reason for the dollar's weakness is the grim prospect facing US public finance. Investors are worried about the US government's record budget deficit. The Barack Obama administration may have to issue a mammoth $3.25 trillion of T-bills to fill the financial black hole of such a massive deficit. This is bound to scare investors away from the dollar-denominated long-term treasury bills.
When the interest rate is virtually zero and other traditional options have been exhausted, the Federal Reserve has no choice but to resort to "quantitative easing" and buying of T-bills. But it will swell the supply of base money, and thereby heighten the risk of devaluation of the dollar. Though the devaluation of dollar may be good news for US exports, it will erode investor confidence, and might even lead to the collapse of the dollar's hegemony.Savvy investors are doing precisely what Bill Gross, founder of the largest bond fund in the world, PIMCO (Pacific Investment Management Company), advised them to do on June 3. He warned that US finances are seriously deteriorating and that investors should rapidly diversify their dollar holdings before central banks inevitably do so. Gross has significantly reduced US government bond holdings of all flavors within his Total Return Fund, following his own advice to global investors.
Beginning of the end for the bubble?
The present trend of selling dollars to buy hard assets, though still a fledgling trend, carries significant risks of turning into a veritable stampede some distance down the present path. How so? How might this mounting trend out of the dollar into hard assets begin to significantly feed upon itself to become a stampede?
Assuming that the ongoing emerging market rally is for real, as evidence strongly indicates it is, then every dollar sold to buy into that rally weakens the currency further. As investors carefully monitor the ever-declining value of the dollar, they will seek to hedge their losses by selling dollars for hard assets, which will only further increase the supply of dollars and further weaken the currency.
Few investors will have the stomach for riding the dollar down too far if the dollar's decline accelerates too much, or even if it remains somewhat gradual but does not turn around soon. Thus, the cycle feeds upon itself, potentially becoming a stampede out of the dollar, risking a rupture of the Treasuries bubble and a catastrophe for US finances as yields and interest rates spike, out-of-control monetary tightening takes over and an even more massive credit seizure grips the US.
Since so much wealth is at present parked in short-dated Treasuries, investors who refuse to roll over their holdings into new Treasuries but instead demand to refund their Treasuries so as to buy something else, could place the US Treasury in a profound bind if the current fledgling trend does turn into anything remotely resembling a stampede.
That is especially so if global investors keep refusing to purchase the longer-dated Treasuries, thus denying the Treasury a critical source of dollars with which to issue refunds demanded by investors who aren't rolling over into new notes or bonds.
The real question here, when considering a possible rupture of the Treasuries bubble, is whether the ongoing dollar-selloff/dollar weakness cycle will feed upon itself to a sufficient degree that the dollar's decline becomes accelerated and chaotic, or whether it will possibly remain more gradual and orderly. The answer to that question depends upon investor psychology and events that may affect that psychology.
If a dollar panic gets underway, then we'll be looking at a stampede and a full-blown rupture of the Treasuries bubble, as well as a concomitant dollar crisis, renewed US financial collapse and a subsequent full-blown economic depression.
Thus, the stakes are unimaginably high for the US as regards maintaining global confidence in dollar assets. In a perverse sort of way, the global crisis we've already endured, one that emanated from the US, has produced just what the dollar needed - extreme risk aversion and a massive flight into the dollar. But the currency is now beginning to lose the contest for global appeal as investors begin to give the nod to hard assets. Can the dollar stem its losses and hold onto what remains of investor appeal? Could it even recover its losses?
By W Joseph Stroupe
"Be careful what you wish for, you may receive it." The adage applies well to the US Federal Reserve as it enters what may turn out to be an entirely new and more dangerous phase of the financial and economic crisis that is still firmly centered in the US - notwithstanding the ongoing Wall Street rally and increased hopes that the worst is now over.
The Fed wished away the hysterical risk aversion reflex of global investors, which came to a head in autumn 2008, when big Wall Street banks collapsed, sending shockwaves around the globe. The position of Fed officials is, after all, that this is a crisis sparked mostly by panic-stricken investors who've artificially driven the value of America's innovative financial assets far below their true values, wrongfully smearing massive sums of such assets with the label, "Toxic!".
The Fed believed it could breathe new life into those assets and into America's asset bubble-based economy by getting credit flowing again and by replacing investor fear with investor confidence - which inevitably translates into a greater appetite for risk. A significant measure of risk appetite is now returning. But the problem is, the US dollar isn't getting the benefit. Instead, its wounds are only being reopened.
As of June 2, the dollar had hit new lows for 2009 against nearly all major currencies, dropping a full 1% against the euro on that day alone, totally ignoring Treasury Secretary Tim Geithner's statement during his visit to China that the US favors a strong dollar. On May 27, the yield curve on Treasuries steepened to a new record as the difference between the two-year and 10-year notes reached 2.75%, steepening to about 2.78% on June 2.
Global investors, both private and official(central banks) are voicing ever more loudly their intensifying fears over exposure to the dollar for anything but the short term and their collapsing confidence in the currency as a safe store of wealth beyond the short term.
Let's back away for a moment to look at this global crisis from a distance. When the US housing bubble began to burst in 2006, inherently risky, innovative financial assets backed by mortgage paper eventually began to be exposed for what they really were ("toxic" assets) and in late July 2007 the now-famous subprime crisis emerged.
The contagion of toxicity spread to infect virtually all such innovative assets, wiping out huge sums of wealth and plunging US banks and other financial institutions into crisis and ruin. The damage and destruction quickly spread to the real economy, as a severe and persistent credit seizure virtually shut down lending at all levels.
In the mounting storm, panicked, risk-averse global investors sold off emerging-market assets and investments deemed risky and massively piled into the dollar as a safe haven, lifting the currency. The Fed and other central banks began spending many trillions of dollars aimed at stabilizing the wobbling financial system and restoring confidence, which had utterly collapsed. The financial system was barely saved from a complete meltdown by such interventions, which continue to this very day.
Ominously, global investors, though giving the dollar the nod as a safe haven in the storm, stampeded into the short end, virtually shunning the longer-dated dollar assets altogether. That fact was a dead giveaway that the dollar's well-known loss of strategic global appeal as a safe store of wealth had not been in any way resolved, but only papered-over for the moment.
Reopened wounds
Now, as risk aversion recedes and risk appetite returns, global investors realize they over-sold their non-dollar assets and investments in the emerging markets when the crisis intensified last year. The emerging markets are widely seen as those that will emerge from the crisis first, and assets in these markets are very attractively priced. Hence, investors are now selling their dollars to buy back into such assets deemed much safer stores of wealth than the dollar in the face of the inevitable return of dollar inflation beyond the short term.
That is driving up yields on a host of dollar-denominated financial assets such as Treasuries and mortgage bonds and sending the dollar to new 2009 lows.
Emerging market indexes and commodities are surging as investor wealth pours in once again. Profligate US spending and skyrocketing deficits, hyper-loose monetary policies in this crisis, and collapsing confidence that the Fed will actually be able to withdraw such policies and excess liquidity when required, are all causing dollar inflation expectations to become deeply rooted in investor psychology.
The overpowering perception on the part of global investors that the Fed, Treasury and Administration are losing control of the US fiscal position, and that inflation (more likely hyper-inflation) is virtually becoming inevitable is threatening to wreak irreversible harm upon US finances and upon the dollar itself.
Angela Merkel, the German chancellor, issued on June 2 a stern warning along these very lines, a warning that was remarkable for its stark honesty and its unprecedented violation of the cardinal rule of German politics that says German politicians never comment on monetary policy of the central bank. Her break with that rule indicates Berlin is extremely concerned about the dangerous and risky hyper-inflationary and currency-debasing monetary policies being undertaken in this crisis. Chancellor Merkel launched her attack on the US Federal Reserve, the Bank of England and on the European Central Bank. She said:
What other central banks have been doing must stop now. I am very skeptical about the extent of the Fed's actions and the way the Bank of England has carved its own little line in Europe.
Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds. We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years' time.
On June 3, Fed chairman Ben Bernanke himself issued a warning that long-term deficits threaten the very financial stability of the US. He further said:Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds. We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years' time.
In recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen ... These increases appear to reflect concerns about large federal deficits ...
He went on to somewhat minimize the role of investor concern regarding US spending, seeking to lay the record steepening of the bond yield curve off on other factors. It seems that Fed officials don't want to see the full and stark truth about how global investors are rapidly losing confidence in the US fiscal position and in the dollar. In a similar vein, Richard Fisher, president of the Dallas Federal Reserve Bank, issued a warning on May 23 against monetizing US debt through Fed purchases of Treasuries, agencies and other assets. He warned that this risky policy is making global investors increasingly nervous. He further warned that the Fed's challenge is to reassure the markets that the Fed isn't simply making itself "the handmaiden" to fiscal profligacy, almost as if the promise itself is enough. He said:
I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.
But investors are drawing that very conclusion as they judge the Fed, not by its reassuring words, but rather by its ever more risky policies and actions. And with huge new sums of Treasuries flooding the market as the Treasury issues trillions of dollars in new debt this fiscal year alone, investors are demanding higher yields/lower note prices before they purchase the assets. In all likelihood, the Fed will be required to significantly step up its own purchases of the longer-dated Treasuries in an effort to keep escalating yields from getting out of control and completely negating its efforts to keep monetary policy hyper-loose. But such a dollar-debasing move (the printing of yet more huge sums of dollars) will only further convince investors that hyper-inflation is inevitable, and that realization will further weaken the appeal of the dollar today, sending it immediately lower.
It certainly appears as if the Fed doesn't get it; officials definitely seem to think they can reassure global investors merely by repeating the assurances quoted above, but without actually changing course in any meaningful way. They absolutely aren't listening to the wisdom and warning of Angela Merkel and those like her.
The question is whether central banks which already have large holdings of dollars, such as China's central bank, will dramatically increase their exposure to the risky dollar in an effort to stem its decline in order to keep their holdings from being eroded away.
Considering the record level of angst over their already-large exposure to the dollar, it appears highly unlikely they will significantly increase their exposure now, when dollar risks are dramatically increasing. Note the June 2 comments of the official state media, China Daily, in this regard, in its article entitled, "Geithner Sells a Devalued Dollar": Another reason for the dollar's weakness is the grim prospect facing US public finance. Investors are worried about the US government's record budget deficit. The Barack Obama administration may have to issue a mammoth $3.25 trillion of T-bills to fill the financial black hole of such a massive deficit. This is bound to scare investors away from the dollar-denominated long-term treasury bills.
When the interest rate is virtually zero and other traditional options have been exhausted, the Federal Reserve has no choice but to resort to "quantitative easing" and buying of T-bills. But it will swell the supply of base money, and thereby heighten the risk of devaluation of the dollar. Though the devaluation of dollar may be good news for US exports, it will erode investor confidence, and might even lead to the collapse of the dollar's hegemony.Savvy investors are doing precisely what Bill Gross, founder of the largest bond fund in the world, PIMCO (Pacific Investment Management Company), advised them to do on June 3. He warned that US finances are seriously deteriorating and that investors should rapidly diversify their dollar holdings before central banks inevitably do so. Gross has significantly reduced US government bond holdings of all flavors within his Total Return Fund, following his own advice to global investors.
Beginning of the end for the bubble?
The present trend of selling dollars to buy hard assets, though still a fledgling trend, carries significant risks of turning into a veritable stampede some distance down the present path. How so? How might this mounting trend out of the dollar into hard assets begin to significantly feed upon itself to become a stampede?
Assuming that the ongoing emerging market rally is for real, as evidence strongly indicates it is, then every dollar sold to buy into that rally weakens the currency further. As investors carefully monitor the ever-declining value of the dollar, they will seek to hedge their losses by selling dollars for hard assets, which will only further increase the supply of dollars and further weaken the currency.
Few investors will have the stomach for riding the dollar down too far if the dollar's decline accelerates too much, or even if it remains somewhat gradual but does not turn around soon. Thus, the cycle feeds upon itself, potentially becoming a stampede out of the dollar, risking a rupture of the Treasuries bubble and a catastrophe for US finances as yields and interest rates spike, out-of-control monetary tightening takes over and an even more massive credit seizure grips the US.
Since so much wealth is at present parked in short-dated Treasuries, investors who refuse to roll over their holdings into new Treasuries but instead demand to refund their Treasuries so as to buy something else, could place the US Treasury in a profound bind if the current fledgling trend does turn into anything remotely resembling a stampede.
That is especially so if global investors keep refusing to purchase the longer-dated Treasuries, thus denying the Treasury a critical source of dollars with which to issue refunds demanded by investors who aren't rolling over into new notes or bonds.
The real question here, when considering a possible rupture of the Treasuries bubble, is whether the ongoing dollar-selloff/dollar weakness cycle will feed upon itself to a sufficient degree that the dollar's decline becomes accelerated and chaotic, or whether it will possibly remain more gradual and orderly. The answer to that question depends upon investor psychology and events that may affect that psychology.
If a dollar panic gets underway, then we'll be looking at a stampede and a full-blown rupture of the Treasuries bubble, as well as a concomitant dollar crisis, renewed US financial collapse and a subsequent full-blown economic depression.
Thus, the stakes are unimaginably high for the US as regards maintaining global confidence in dollar assets. In a perverse sort of way, the global crisis we've already endured, one that emanated from the US, has produced just what the dollar needed - extreme risk aversion and a massive flight into the dollar. But the currency is now beginning to lose the contest for global appeal as investors begin to give the nod to hard assets. Can the dollar stem its losses and hold onto what remains of investor appeal? Could it even recover its losses?
?) is part of that unpredictable scrum between (1) - (5) which we would be better off not gambling on.
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