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January 7, 2010
2010 Preview: The Wonderful Wizard of USD
By Brady Willett & Dr. Todd Alway

The same day President Richard Nixon closed the "gold window” Ron Paul entered politics. Dr. Paul has been fighting to end the Federal Reserve ever since - he has been supporting a bill to audit the Fed since 1976.  In 2009 Congressman Ron Paul’s bill to audit the Fed was included in the Wall Street reform bill and passed by the House. Only the Senate* stands in front of Congressman Paul’s heroic battle to audit the secretive act of the central bank wizards.

If the judges handing out awards for person of the year knew of Ron Paul’s story he would surely qualify.  Unfortunately, Dr. Paul did not receive last year’s Time person of the year award, and the honor was instead bestowed upon Fed Chairman Ben Bernanke. Mr. Bernanke, a banker, won the award because he supposedly invented novel schemes to save the financial world.

That Bernanke wins any award is, of course, the height of absurdity. After all, it is not as if Bernanke went door-to-door selling chocolate bars in order to amass the trillions in bailout dollars he and his accomplices committed to backstopping irresponsible debtors and shoring up artificially inflated asset prices. Rather, and at risk of over simplifying, he printed the money. As for the argument that Bernanke found new ways to inject liquidity into the financial markets, how quickly people forget that Bernanke’s predecessor, Alan Greenspan (another Time cover boy), was also a pioneer in this area.  To be sure, not only did Greenspan cut interest rates quickly and raise them super-slowly, he was also a key proponent of putting the Fed’s good name on the line on behalf of insolvent debtors (perhaps the most notable instance being LTCM). Moreover, thanks to Greenspan’s doctrine of self-regulation, financial institutions were permitted to acquire dangerous amounts of leverage, guaranteed-to-blow-up mortgages were widely written, and a cornucopia of highly secretive and highly speculative bets were made on highly unregulated markets. Bernanke’s direct intervention into specific markets notwithstanding – something that has been done many times before (i.e. Japan) – the ominously innovative pro-liquidity tricks established by Greenspan set the precedent.

Those that applaud Bernanke’s ‘new’ methods of printing money as ingenious are not unlike a crowd watching a David Copperfield show – it’s not really magic people, its sleight of hand! Surely Bernanke’s bag of tricks are not so ground-breaking as to blind everyone to the fact that manipulating long-term interest rates, purchasing more than a trillion dollars in mortgage securities, and (perhaps only indirectly) manipulating stock prices – that all this is unlikely to resolve the underlying structural problems that led to this mess in the first place?

But alas, befuddled by Bernanke’s art of misdirection, there is a widespread acceptance that if Bernanke didn’t do what he did, things would be much, much worse.  Quite frankly, the only statement deemed significant by the believing and bewildered crowd is, ‘The financial system would have collapsed without the Fed!’ All this despite the fact that a discerning observer can see that Bernanke is dealing cards from the bottom of the deck.

What about the notion that ‘the system’ itself is prone to the threat of collapse because of the Fed? For that matter, what about the fact that Bernanke has done nothing to alleviate but has instead likely exacerbated the ever escalating and menacing cycle of boom-bust?   Apparently these glances behind the wizard’s curtain are better left largely unexplored, at least until the next financial crisis…

Anti-U.S. dollar scheming ahead of the next crisis

With Bernanke and company taking on the role of hedge fund managers in 2009, and Obama embracing the idea of trillion plus dollar deficits, the world is increasingly questioning the longer-term sustainability of the U.S. dollar and the fundamental soundness of the U.S. economy. And with emerging markets acquiring greater clout, the U.S. centric vision that has dominated since Bretton Woods has become more tenuous. On the surface this tension has given voice to a more sustained verbal protest against U.S. dollar hegemony, greater protectionist forces, and the onset of creative dissent (i.e. Chinese companies refusing to honor derivatives contracts).  However, more concerted rumblings that threaten to shake the foundations of global power have also begun to emerge.

Perhaps the best example of this attempted realignment of global power can be seen in the BRIC countries’ attempt for greater control over the IMF decision making process. While these efforts have not as yet produced radical change, they did, albeit briefly, acquire the attention of financial market participants. Specifically, currency market volatility spiked as China and Russia touted the possibility of an IMF supported supranational reserve currency to replace the dollar, and the dollar dove when the IMF agreed to release a greater-than-token amount of Special Drawing Rights (The end result on this front was that in August 2009 the IMF released SDR of 161.2 billion).  Against the backdrop of soaring asset prices, the SDR developments didn’t catch many headlines.  However, it was an important stepping stone in that it sets up a precedent for future monetary alterations.

Many other smaller movements also threatened to undermine the hegemonic influence of the U.S. dollar.  In the case of the long discussed petrodollar, Saudi Arabia, Kuwait, Bahrain, and Qatar are set to launch the ‘Gulfo’ this year. While hardly an immediate threat to the U.S. dollar, the Gulfo, like SDRs, nonetheless represents a longer-term constraint to the U.S. dollar’s reach. 

Finally, there is gold, which broke all-time (un-adjusted for inflation) highs in 2009, and is expected by many to continue its surge higher. Having been net sellers since 1988, central banks began accumulating gold in 2009, and the auction of gold from the IMF, which many feared would suppress the price of gold, was quickly absorbed as 212 metric tons were purchased by India, Sri Lanka and Mauritius (the surprise being that many believed it would be China buying IMF gold). With China and other states pledging to purchase more gold to diversify reserves, the likelihood of a serious meltdown in the price of gold has been taken off the table. And with so many countries lining up to borrow enormous sums of money, the potential for a further melt-up in gold is present…

The overall contrast this suggests, if otherwise unclear, is that as Bernanke and U.S. policy makers are fighting to maintain the status quo, much of the rest of the world is questioning and preparing for the breakdown of hegemony. Should these anti-U.S. dollar preparations increase further they represent a potential catalyst for the next crisis.

The Boom Before The Bust?

Nevertheless, before Bernanke’s great illusion dissipates and greenbacks are being used as wallpaper, there may be an extended period of economic malaise, and perhaps even economic growth.  This conclusion is not drawn from any fundamental optimism relating to the U.S.’s long-term financial standing, but from current realities. To wit, the U.S. can still borrow at relatively low rates of interest, the Fed can still print dollars to counteract weakness in seemingly any financial market it wishes, and despite turning leverage-adverse the U.S. consumer still spends significantly more than any other collection of consumers on the planet. In short, the U.S. economy and financial markets may well be dying (on a relative basis), but they are far from dead.

It is the relative calm in the heavily manipulated U.S. financial markets that gives economists grounds for optimism.  At risk of parroting the optimists, here goes: a period of inventory rebuilding will combine with the direct stimulus offerings from President Obama to create jobs, and with interest rates near zero percent and the rebound in the financial markets set to continue, the prospect of a weak recovery sticking around for awhile is possible. 

As much as the world is preparing for the next crisis, the recovery story is plausible because no one is keen on provoking such a crisis.  Rather, the levers of change, while strong and growing, are still heavily dependent on U.S. economic might.

Understanding Why The Boom is Unsustainable

In this year’s Wish List report we highlighted what is probably the cheapest growth company in the United States. This company has grown its quarterly revenues 24-times over the last 10-quarters, produced net margins above 30% in each of the last 8-quarters, and currently trades at a P/E ratio of 4. Moreover, with 3M recently purchasing a stake in this largely unknown tech flyer there is, arguably, the potential for even greater growth in the future.  

Unfortunately, the company in question is a lot like the U.S. economy in that the excitement generated by easily manipulated statistics (the income statement is the least trustworthy financial statement) is not replicated in the company’s balance sheet. Rather, the stock in question is drowning in an accounts receivables quagmire of epic proportions: some customers are failing to pay, others are extending their payment schedule, and still others are borrowing first and planning to pay later. And yes, a la Bernanke, this company dilutes shareholders seemingly at every opportunity to help keep the growth story alive… 

Point being, the U.S. remains statistically attractive in that it is the world’s largest economy and has a liquid and dynamic financial system (feel free to define ‘dynamic’ as you see fit).  Moreover, and akin to the 3M investment in the company above, there is the feeling that since other large and seemingly sophisticated countries and investors appear to have faith that America will repay its creditors, all is well.  All of this makes perfect sense…but just don’t look at the U.S.’s balance sheet!

In short, even as an ever greater number of investors and policy makers wonder whether they will ever be repaid the money they lent to the U.S., there are reasons to expect the recovery in the U.S. to continue simply because these investors and policy makers continue to invest.  The catch, of course, is that as the U.S. balance sheet deteriorates (some estimates say U.S. government debt will reach 100% of GDP by 2011), and as U.S. creditors actively plan for a non U.S. centric world, investment in the U.S. has its limits.

Conclusions

There is a popular theory that while the last 100-years have been U.S. dominated, the next 100-years will come to be known as the ‘Asian’ century.  In this respect the events of 2009 are potentially important in that the foundations for change have been laid. Such is why the actions of Bernanke are potentially very dangerous - he has sacrificed the longer-term imperative of a secure monetary unit in an attempt to satisfy short-term objectives.

When the next financial crisis arrives the Fed stands ready to cut interest rates (assuming there is a rate to be cut), bailout failed or systemically important institutions, and directly intervene in the financial markets (assuming there is any non-Fed controlled markets left). There is no abracadabra when it comes to central bank wizardry.


And yes, curiously absent from our discussion on potential long-term threats to the U.S. dollar is the Chinese Renminbi (Yuan). That China continues to take baby steps towards making the Yuan an international currency is notable. More notable still is the fact that as China blatantly manipulates its currency it fails to stoke international ire.  Specifically, that the U.S. fails to officially brandish the word ‘manipulate’ is a testament to China’s growing economic clout.  We cover the Yuan with these basic thoughts because the timetable for change appears to be set by China alone…
 

2010 Prophesies

“This economy is in hock.  It has come off 20 years of extreme leveraging. It's going to take time to work through these things. And it won't be pleasant.” Paul Kasriel

While the above sentiment could just as easily have applied to 2008 as 2009, the always astute Paul Kasriel actually delivered them in 2002. What Mr. Kasriel could not have known at the time was that a mammoth U.S. housing bubble would delay the day of reckoning, and that the extension of the credit bubble would help keep investors in Pleasantville for another 5-years.  With the latest financial crisis kicking off a period of de-leveraging and the U.S. government signaling its intent to dig itself into deeper ‘hock’, it certainly does appear likely that ‘it’s going to take time to work through these things’. 

While we remain exceptionally negative on the U.S. economy and financial markets longer-term, we are not oblivious to the possibility of the current ‘recovery’ sustaining itself for a period of time. So long as the U.S. can continue to borrow and spend at acceptable rates of interest, they will - and forecasts of doomsday will have to wait…

We highlighted 9 prophecies in this space last year, 7 of which came true.  Of course our speculations about the future this year are not guaranteed.

*1.  The audit the Fed portion of the House bill on financial reform will mysteriously get removed or severely diluted in the Senate.  Ron Paul fans hold a candlelight vigil.

2. U.S. dollar hegemony lives another year! Not only is there still no viable alternative to the U.S. dollar, but other potential reserve currencies like the Euro are losing their charms.  With the greatest immediate threat of sovereign default seen overseas, the U.S. dollar, from time-to-time, catches the safe haven crowd. 
Caveat: No one can really predict when the dollar crisis will arrive. 

3. The Fed jabbers on about raising interest rates and ends up scaring the hell out of everyone.  The Federal funds rate does not move higher by more than 50bps in 2010. 

4. Protectionist spirits continue to come back to life. By the end of 2010 the verbal hostilities between the U.S. and China will become so heated, and volatility in the currency markets so wild, that a mob of people will be forecasting an imminent dollar crisis.

5. Gold ends the year above $1,000 an ounce but fails to make a big move to $2,000. Try as we might, our crystal ball failed to produce anything more substantial. Buy gold on weakness…

6. Commodities will put in a volatile year but continue to catch investor attention as a hedge against U.S. dollar fears. Uranium puts in a historic bottom in 2010.

7. Despite the rhetoric, policy makers prove that they are not serious about attacking menacing asset bubbles. When the dollar isn’t catching safe haven bids a slumping dollar is fueling dollar carry trades. 

8. The official U.S. unemployment rate ends 2010 at 8.7%. Don’t ask how we pulled this number - remember it’s a crystal ball. 

9. Much like the gold Dinar, the Gulfo fails to gain traction.  U.S. dollar hegemony lives for another day!
 
10. Talk of China shifting its methodical policy of Yuan appreciation remains exactly that, as does speculation of China gorging upon gold with abandonment. U.S. dollar hegemony lives for another day!







BWillett@fallstreet.com