On our Subscribers' Pages, The Privateer maintains a weekly update of the performance of several classes of investments thus far in the year. The "classes" include the US Dollar against various currencies, the Euro against various currencies, Gold and Silver against various currencies, global stock markets, global stock markets denominated in US Dollars, and (Australian) Gold stocks. We also maintain a log of what the three best out of all those we cover are in the week just ended.
At the beginning of April, Silver swept the boards of course, being up 40% plus against every major currency in the world. Then Silver fell headlong out of bed and most other "commodities" - with one glaring exception, more on that later - followed it down. the Asian stock markets took over. Then Asian, and all other, stock markets started heading south, a process which accelerated over the week just ended.
For the week ending on Friday, May 14, the three top positions in our coverage (we don't cover oil) have ALL included the US Dollar. The three best percentage rises of all the alternatives we cover over the year to date have been US Dollar increases against the Australian and Canadian Dollar and the Indonesian Rupiah.
As of May 14, 2004, the US Dollar is the investment "star" of 2004 - so far. Want to see how bent out of shape investment markets have become this year? Want to see how far the "investor disorientation" analysed by The Privateer in recent issues has progressed? No more telling indicator could be imagined.
The currency of the government of the United States of America ...
... is the best performing "investment" so far this year
Does this fly in the face of sanity, let alone any approach to rational economic analysis? Yes - and no. The answer is most certainly yes when looking at the "reasons" given on Wall Street for the ever-strengthening Dollar. Wall Street (and the Fed and Treasury, though they are less outspoken to date) would have us interpret this Dollar strength as an antipication of higher US rates, and the higher US Dollar income flows from Dollar denominated assets which are anticipated from same.
The "minor" problem with this "analysis" is that the capital value of every single existing piece of Treasury debt paper (and all other already issued at fixed yield debt paper) is declining as inexorably as rates borne by the new issuances of said paper are rising. The existing pile of such paper is monumental. The derivative structure built on the "foundation" of this paper is mind numbing.
If I have a piece of debt paper whose capital value is, say $1000, and which yields an interest rate of, say 4.00%, how strong will the demand be for that paper, should I wish to sell it on the secondary market in the face of identical paper with an identical capital value ($1000) which yields an interest rate of 6%? My paper is churning out an "income" of $40 per year. The new paper is churning out an "income" of $60 per year. Clearly, any buyer of my paper is going to demand a discount on the capital value (the $1000) to compensate him or herself for the fact that the income stream is substantially less than what could be gained from buying a newly-issued debt instrument of the same risk status and face value. This is not rocket science, it is "bonds 101".
All over the world, bond prices are falling, for the reason just outlined. All over the world, stock prices are falling, as fears of higher US interest rates mount. All over the world, commodity prices have come off with a rush, partially as a result of the Chinese "growth scare", partly as a result of the anticipation of higher interest rates cooling the demand for consumer goods and therefore for both producer goods and raw materials. Oil is in a special war-affected category here.
All over the world, investment alternatives are being squeezed as investment performance declines. Bond prices are deeply in the red. There are very few stock markets left anywhere which show a gain for 2004. Real Estate is being hit by strengthening headwinds in most major global markets. Yes, oil is still going strong, but how big is oil in the investment plans of the average individual or fund manager? And, of course, precious metals have taken hefty hits since the beginning of April.
So, in what respect is the "no" answer to the question posed above relevant? Why is it NOT surprising that the US Dollar is rising in the face of abysmal investment performance all over the world, not least in the US markets themselves? The simple answer is "deleveraging".
Remember, for most of the past three years, the US has sported a regime of negative REAL interest rates even by official measures. With increasing ferocity over 2004, the gulf between the REAL level of price increases inside the US and the official Fed rate of 1.00% has blown out to unprecedented proportions. This has spawned a huge "carry trade" as investors borrow US Dollars at absurdly low rates in order to invest in foreign (and US) debt paper offering yields at high multiples of the cost of the borrowing. On top of that, there have been many US investors who have simply transferred assets to higher yielding investments abroad (and agency or "junk" paper at home) because the yield on their US investments was not keeping up with the increase in their cost of living.
With the growing apprehension, which has now become certainty, that the Fed is on the verge of raising official US rates, and with the resultant LEAP in rates on Treasury debt (especially Treasury debt of one year plus maturity), a huge hole has appeared in the value of US bond and stock portfolios. This has led to capital repatriation. But a far more potent aspect of the anticipation of higher US rates has been the movement out of high-yielding foreign and domestic investments back into US Dollars. It is this movement, this unwinding of the "carry trade", which is pushing the US Dollar up on the forex markets.
In a sane economic world, the lower the interest rate the lower the level of risk indicated. A low rate implies that there are few doubts about the credit worthiness of the borrower and no doubts about the viability of the currency in which the debt is denominated. A sane economic world, however, does not include within it a Central Bank which can and does manipulate the short end of the yield curve at will.
The economic world of today is anything but sane. Remember the old adage - the higher the potential reward, the higher the actual risk? The Fed has turned that on its head with its regime of negative real rates. Now, the actual state of affairs is the lower the potential reward, the higher the actual risk. This is always the case in a regime of negative real rates and it is almost never seen until it is too late. Low rates mask the economic devastation which is being prepared by the credit excesses put in train by the low rates. When the regime of low rates can no longer be maintained, this damage comes into the light of day, usually very quickly, with effects which are devastating in direct proportion to the extent to which they had not been seen while the low rates masked them.
The present Dollar advance is the VERY last echo of the US bubble markets, fuelled as it is by the accelerating unravelling of all the other ones. The flight of capital is getting closer and closer to "cash". Many can see it, but most think that it will stop there. A flight OUT OF US Dollars, not in spite of but BECAUSE of higher US interest rates (market and official rates) is not seen to be within the realms of the conceivable. Yet that is PRECISELY what happened to the Dollar in the late 1970s, and it is precisely what happens when the lid is torn off the actual economic situation in any "banana republic."
Of course, there is added "incentive" to maintain as low a Gold "price" as possible at present. If the fact that the Fed is being forced to the wall as they struggle not to have to raise rates was not enough, the fact that it is happening in the middle of an election year and at a time when the incumbent is floundering and is seen to be floundering on all policy fronts adds to the "control Gold" imperative.
The result, in lock step with the bloodbath on the US bond market and the unwinding of the US Dollar "carry trade", has been a correction in the $US Gold price which is now approaching the size of the one which took place in March/April 2003, in the run-up and immediate aftermath of the first phase of the Iraq war.
Every financial crackup, whether it be the various Latin American crises, the LTCM crisis of 1998, or the Asian Crisis of 1997-99, is the result of a sudden and major withdrawal of assets from the company, nation, or region so affected. There is an article of almost religious faith in Wall Street, and in Washington, that it can't happen here. It can, and it will.
If it does not happen sooner, the almost certain trigger will be the Fed's first rate RISE. No sooner does that happen than global markets will start looking for the next. No sooner do they do that than the realisation will begin to dawn that the Fed is doomed to play "catch up". No sooner has that realisation dawned than the fear will dawn that there is no way the Fed CAN "catch up", to raise rates far enough to do so would be utterly politically unacceptable. After that, the problem faced by global investors will be that they CANNOT get a rate of return on US assets sufficient to compensate themselves for the risk of holding US assets.
Since the US Dollar is still the world's reserve currency, this realisation will spread to cover all other paper-based markets. And when THAT happens, the rush will be on to find a place to avoid a potential paper asset meltdown. That's where Gold comes in, of course. With every step in this process, its status as the ONLY financial asset which is not someone else's liability will become more attractive. All real Gold "rushes" are made of this, and there has never been a foundation for a Gold "rush" as big as the one which has been laid by the Fed over the past three years.
This three years is, of course, the length of the Gold bull market from its beginnings in the mid $US 250s in April 2001. We are in the midst of another correction in that bull market, not the biggest, but probably the most startling given the situation on the paper markets and the body blow which has been dealt to Americans' view of their own government given recent revelations about Iraq. Americans have been awakened to a lot of "home truths" lately. Watch out for the biggest awakening of all, the realisation of the truth about the Dollar itself.