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Vol 2/8, 2 May 2011 www.amphora-alpha.com
IN THIS EDITION
IT’S THE END OF THE DOLLAR AS WE KNOW IT (DO WE FEEL FINE?)
With each passing month, the dollar moves closer to becoming what one might call a ‘normal’ currency, in that it is gradually losing the pre-eminent reserve currency status it has enjoyed since the 1920s. In certain months, including that just passed, the end approaches rather more swiftly. While we have always regarded the demise of the fiat dollar as both necessary and inevitable, it is important to understand that, using history as a guide, what lies ahead is highly likely to be some combination of unpredictable, disorderly and even dangerous. But rather than stand as deer in the headlights, investors need to take action to prepare. Most important, they need to diversify away from not only dollar assets, but from fiat currencies and financial assets generally.
The dollar has been in focus of late, primarily due to its substantial decline in value versus other currencies and most major commodities. Indeed, when measured in broad, trade-weighted terms, the dollar’s April decline is one of the largest monthly drops of the past decade and extends what has now become the largest cumulative 1 decline since the US economy exited recession in 2009. When measured versus a broad basket of global commodities, the recent decline has been even more dramatic.
As in 2007 and early 2008, the dollar is weakening sharply
There are various ways to measure relative currency strength. One popular way to measure the strength of the dollar relative to other currencies is the DXY index, which compares the dollar to a basket of other so-called ‘major ’ currencies, including the euro, yen, pound sterling, Swiss franc, Swedish krona and Canadian and Australian dollars. While this was arguably a useful measure when the Group of Seven (G7) economies were the largest in the world, it is of substantially less relevance today, with the rise of the BRICs (Brazil, Russia, India, China) and other more rapidly growing economies. As such, we prefer to use broad rather than narrow measures of dollar strength, including the Federal Reserve’s broad dollar index, shown in the chart here.
in their right mind. There are various ways of measuring US business investment. In the current instance. it implies that headline economic growth and the current level of interest rates are the decisive factors that determine exchange rates in the first place. not only is the USA now highly likely to lose its symbolic (if somewhat outdated) AAA sovereign debt ratings. These developments undermine the dollar’ s pre-eminent reserve currency status. Now while the current level of fixed. is not a normal currency. known as ‘ QE2’. higher government deficits. placing the US on a weaker potential future growth path. If these are accommodated by easier monetary policy.THE AMPHORA REPORT Vol 2/8. to distinguish between fixed investment (in plant. is showing disturbing signs of major structural weaknesses pointing to dramatically weaker growth in future. which naturally must have two sides. for the current cycle at least. Indeed. Other factors equal. But as discussed above. It is important. already approaching junk status in many cases. Given the massive public debt overhang already plaguing US federal. The latter is highly volatile and does not contribute materially to an economy’s sustainable growth rate. whereas the former is a better indicator of how sustainable a given economic expansion is likely to be over longer periods. it is understandable that US municipal borrowing costs remain near their recent. This is bad news on a number of fronts. recall that the US dollar. record highs vs. The Fed has acknowledged as much and has indicated that its current policy of steady balance sheet expansion. it looks at only one side of an exchange rate. nonresidential business investment. At a minimum. by implication. 02 . if it does not increase substantially further from here. by implication. It should thus also be no surprise that the dollar has suffered to the extent that is has of late. So what are these signs of major US structural weaknesses to which we refer? Well. at first glance this might seem rather curious. presumably. 2 May 2011 www. it is unlikely that the economy is going to replace that portion of the capital stock which was wiped out during the downturn. just keep on deteriorating. with ominous implications for borrowing costs in future. the US economy. note that. But if the US should lose that status it will. Sadly. is going to buy debt which is growing rapidly in supply at precisely the same time that weak rates of business investment imply lower tax receipts with which to service such debt in future? In this context. consider that. to be followed. lose a substantial portion of its investor base–central banks and other major global financial institutions–and US government funding costs would most probably soar to levels that could well be catastrophic. it appears that. lower tax receipts and. which excludes highly volatile orders for defence and aircraft. While there are debt problems aplenty elsewhere in the world. Second. this implies that the US potential growth rate is going to be unusually weak during the current business cycle and. but also that state and local government finances. it is so weak that. And while US interest rates may nevertheless begin to rise at some point.com As with many financial market developments. inflation or interest-rate expectations. rates are already rising in nearly all the rest of the world and show no signs of peaking given strong growth and soaring inflation throughout much of the global economy. however. up about 10% y/y.amphora-alpha. Now this is not necessarily indicative of a recession ahead. it should be no surprise to informed observers that. when compared to the depth of the recent trough–the last recession–in fact the rate of investment is unusually weak. has turned down quite substantially in recent months. for an even longer period. this situation also implies a growing ‘stagflation’ risk. by virtue of its pre-eminent reserve status. After all. reducing an economy’s potential growth rate. unless the situation begins to change. looks reasonably healthy in a longer-term comparison. including in the euro-area periphery of course. for those who care to look behind the numbers. The problem with the sort of analysis above is twofold: First of all. the rate of business investment has already peaked. property and equipment) and inventory building. will end as planned next month. Treasuries. Who. there must be business investment. state and local government finances. much headline economic data shows that the US economic recovery has been gaining momentum. a healthier US economy and higher US interest rates should be dollar supportive. for an economy to grow in sustainable fashion. by higher short-term interest rates at some point. rates of business investment must at least keep up with depreciation. Weaker potential growth implies weaker wage and jobs growth. the core rate of capital goods equipment orders. any lower and the capital stock will erode over time. Concern that the dollar might lose this position at some point is a far more important factor in determining exchange rates than incremental changes in relative growth. How can we tell? Well. notwithstanding somewhat stronger headline US economic data of late. merely of a more subdued rate in business investment. by contrast.
THE AMPHORA REPORT Vol 2/8.amphora-alpha.and appears already to have peaked for the current cycle .. 2 May 2011 www.... .com Business investment is weak considering the depth of the recent recession.
the government may try to make life more difficult for so-called ‘speculators’. desperate measures will be on the table. Canadian and Australian dollars and possibly also Swiss francs. So what might such a ‘dollar crisis’ look like. that is. such as private 04 . Perhaps more significant. Bangladesh and Sri Lanka are among those countries that have added to their official stockpiles of gold during the past year. there are some general considerations we can discuss with some reasonable confidence. mind you. a convincing programme to reduce the deficit –what might have been a gentle and orderly if concerning rise abruptly becomes sharp and disorderly. all the current assumptions about US debt serviceability must necessarily be re-evaluated for a higher rate environment. Now imagine if you will that as the dollar slides. what really matters is the impact that this has on US government financing costs. for various possible reasons. let’s define ‘ dollar crisis’ . While this would no doubt lead to (increasingly appropriate) comparisons with banana republics. as foreign investors flee US Treasuries and most probably other US assets. perhaps a cap on yields at 5% or so. you have a crisis. domestic investors are highly likely to attempt to do the same. the US Fed and government would nevertheless continue to try to exude an aura of being in control of the situation as investors dump Treasuries and the Fed’s balance sheet explodes. In doing so. While dollar weakness certainly plays a role. major global buyers of US Treasuries and other dollar securities gradually withdraw from the market in favour of alternative currencies or. political and possibly even military. Sadly. In a self-reinforcing spiral.amphora-alpha. rather merely reduce or cease ongoing purchases. While there is no magic number. in short order. US government officials will most probably draw some sort of arbitrary line between those institutions still allowed to transact in precious metals–the big banks–and those not so allowed. perhaps. so extreme actions of this sort should not be ruled out but rather anticipated. and what impact should we expect this to have on financial markets? While we do not purport to have the specific answers to these questions. as we discuss later. they are diversifying to some extent into euros. chances are that financial markets begin to price in a materially higher risk premium for holding US debt. China. finds itself holding the bulk of US Treasury market debt outstanding. Third. The problem with capping yields. we’re not terribly confident that such contingency planning is going to be particularly helpful in the current instance. When these rise to levels that cannot be serviced without resort to direct debt monetisation by the Fed. then the Fed becomes the ‘ buyer of last resort’ and. There are probably more who have been less forthcoming. most likely the Fed implements some sort of ‘emergency’ programme of Treasury bond buying. there are most probably some quite senior and even quite smart people in the current administration who are currently tasked with ‘wargaming’ a dollar crisis and the possible responses thereto.THE AMPHORA REPORT Vol 2/8. they are buying gold. Not only the US but also most countries facing such dire economic circumstances have resorted to comparably desperate measures in response to past economic crises. unless the US government takes swift and credible action to restore confidence in debt sustainability–that is. So what might such a ‘ dollar crisis’ look like. in order to buy some time. they might restrict investors’ access to precious metals in various ways. 2 May 2011 www. is that if the market clearing yield is 2 Actually. India. gold 2 reserves. how would the US government likely respond. how would the US government likely respond. very seriously about what could happen in the event that the dollar’ s status comes under threat. people trying to protect themselves by reducing their exposure to devaluing dollars and risky Treasury securities. making it essentially impossible and perhaps outright illegal for US investors to purchase foreign assets. this is already happening. higher than the cap. Second. At this point. First of all. For example. yen. This is when the US government probably imposes some form of capital controls. Russia. the US government is going to resist the loss of reserve currency status with everything it has got in the arsenal: economic. Do not for one moment think that the government has not already got to thinking very. in the event that Treasury yields rise back above 5% or so. there are some general considerations we can discuss with some reasonable confidence. Although many central banks continue to accumulate dollar reserves. As US borrowing costs rise. First. however.com Given the potential gravity of the situation. It might even be counterproductive. In much the same way that the Pentagon is constantly ‘wargaming’ various scenarios in order to continuously improve planning for all manner of potential contingencies around the world. and what impact should we expect this to have on financial markets? While we do not purport to have the specific answers to these questions. They needn’ t sell their existing holdings.
amphora-alpha. Unless rescinded in sort order. ultimately. its accumulated debts in sharply devalued dollars. If Mr Obama really wants to tackle speculation. President Nixon removed the anchor to gold entirely. Although obviously a default by any other name. It might not have occurred to Mr Obama or his administration colleagues that. To what extent the dollar devalues versus other currencies is.THE AMPHORA REPORT Vol 2/8. with reasonable confidence. a speculative guessing game. in fact they will just bring the day of reckoning closer. Singapore. suggesting that speculators might be behind the recent rise in oil and gasoline prices. and more in keeping with US and global economic history. Perhaps all currencies devalue in real terms as one country after another resists currency strength. one can find historical precedents for all manner of commodities serving as money in some shape or form: Seeds. As far as investors are concerned. Yes. who oversaw massive expansions in domestic entitlement programmes while also dramatically escalating the war in Vietnam. While we do have our opinions as to which currencies are rather more or less undervalued vis-a-vis each other. which has soared in recent months relative to both oil and gasoline as well as most other commodities. grains. would be sustainable and allow for the US to service. including London. attempted to restrict what it regards as speculation.com investors and households. the very idea of the world’ s pre-eminent reserve currency being subject to capital controls is downright farcical. in theory at least. While such doublestandards are no doubt arbitrary. various livestock. Hong Kong. 05 . (We suggest TOUGH. ‘emergency’ language. Don’t forget that it was Nixon ’s predecessor. in fact. Indeed. And many emerging markets are currently experiencing booms. At any stage of the above process. historically. and at what price various commodities will be traded on US exchanges. 3 There are numerous examples of how the US government has. any objective analysis would conclude that the US has had an unstated policy of dollar devaluation since at least 2004 if not earlier. Europeans and probably also OPEC nations from forming new associations and alliances to offset the loss of investment and trade with a United States rushing headlong into masochistic. liquor. the US may simply do away with such shenanigans and devalue the dollar unilaterally in some fashion and to a level which. While capital controls and curbs on ‘speculators’ might also buy some time for the US government to try and restore some degree of stability in financial markets. In the early 1970s. by executive fiat. are at all-time highs. such actions have ‘legal’ precedent 3 and. claiming that this would 4 not be inflationary. cigarettes. FDR unilaterally devalued the dollar by some 60%. the next step could be for the US to open negotiations with foreign creditors to restructure its debt. as alternative stores of value. 2 May 2011 www. given the historical proclivity of US authorities to employ euphemistic acronyms when implementing unprecedented and counterproductive economic policies). Lyndon Baines Johnson. And the farther one descends down the rungs of the global economic ladder. by implication. something which might well prove politically impossible. Indeed. the price of oil has lagged behind a large number of other globally traded commodities during the past year. nuts. in varying degrees. Indeed. inevitably. broadly measured. the US government will no doubt be able to mandate. counterproductive economic nationalism. the magnitude of which have. far simpler conclusion to reach that. Japan and the UK have debt problems of their own. arguably he belongs to that unfortunate group of presidents who inherited a bad economic situation prior to making it even worse. Certainly the euro-area. Yet other metals are not so far behind. gold and silver have the most prominent historical claims to this role. whereas oil prices are still well short of the peak they reached in mid-2008. but to the extent that the rest of the world thinks the price of something should be higher (or the dollar lower). as measured in US dollars. Alternatively. such stores of value may seem uncivilised to some. no doubt the US will call it something else. peppercorns. as that was around the time that the US started to attack China’ s exchange rate policy and. that of any other country which chose to maintain stable rather than appreciating exchange rates vis-a-vis the weakening dollar. and highly likely to occur in our opinion. commodity prices. merely reducing exposure to dollars and dollar financial assets may not be enough. the further along the above process we move. although we doubt that such rhetoric will prevent the Chinese. Yes. as such. the bulk of exchange activity emigrates to friendlier jurisdictions abroad. We will not go into these here. the more likely it is that commodities rise relative to currencies in general as the former begin to function. Russians. In 1934. it is a far. As one desperate time-buying measure after another approaches its effective expiry date. More recently. may well come into force at this stage. unconstitutional and simply unfair. most probably to locations historically keen to acquire such business from the US. Indians. except to provide a brief comment on recent remarks made by President Obama. Switzerland. expect any discussion of capital controls to be couched in ‘temporary’ . what. the associated transactions will take place elsewhere until. Moscow and Dubai. from time to time. the US might simply impose a settlement forcing foreign and possibly also domestic creditors take a huge ‘ haircut’ on their holdings of Treasury debt. even with the best of intentions. President Carter was the most prominent victim of that decision. his decision to sever the dollar’s link to gold played a key role in the soaring inflation of subsequent years. or ‘ Treasury Obligations Under General Haircut’ . the US has done exactly this before. As for the broader impact of curbs on ‘speculation’ in precious metals and possibly also other commodities. ended in busts. capital controls will lead to the US not only losing reserve currency status but probably becoming something of a global economic pariah. As such. but please tell us: What is civilised about a systemic transfer of wealth from the many to the few via currency debasement? If this is 4 While we do not claim to be fans of former President Nixon’s economic policies. Brazilians. such policies will quickly drive global commodity trading offshore. And while inflation did not increase dramatically during Nixon ’s time in office. we suggest he focus on the price of coffee instead. Shanghai. who.
DISCLAIMER: The information. Meanwhile. as indeed the frontier Romans did from around the 4th century onward. These terms are governed by the laws of England and W ales and you agree that the English courts shall have exclusive jurisdiction in any dispute. As the saying goes: What men learn from history is that men do not learn from history. notwithstanding the travails of economic fortune through the ages. Prior to joining DB in 2007. including of course the bulk of what is known today as Great Britain. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. Amphora is a registered trading name of Atom Capital which is authorised and regulated by the Financial Services Authority. rather than succumb.amphora-alpha. the Eastern Roman Empire at Byzantium would last another thousand years.THE AMPHORA REPORT Vol 2/8. empires both large and small have a curious yet consistent inability to long outlive the purchasing power of their currencies. perhaps the most compelling is that. many of which seem reasonable. for the next millennium or so. In time. and under no circumstances shall we be liable for any direct or indirect losses. as the implied tax. where he and his team were voted #1 in the Institutional Investor research survey. northern masters. province by province. including the Normans. north and south. having worked for European and US investment banks in London. well then we’ll take our chances with the Barbarians. All express or implied warranties or representations are excluded to the fullest extent permissible by law. Why? Historians have their various reasons. 2 May 2011 www.butler@amphora-alpha. © Atom Capital. New York and Germany.com John Butler has 18 years’ experience in the global financial industry. to the temptation of currency debasement and inflation. Exeunt. the Byzantines stuck with a tried and tested ‘ hard money’ policy. AMPHORA: A lateral-handled. Historically. Perhaps it should be no surprise that. the bulk of Western European economic progress occurred not in Italy but rather in the more dynamic trading societies of the north. investment products or other financial instruments. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. JOHN BUTLER john. resulting in the complete dissolution of the Western Roman Empire. quantitative strategies. as did their western counterparts centuries earlier.and inflation-relief outweighed the uncertainty of governance under their new. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. even those Romans living closer to home came to regard the Barbaric side of this Hobson’s choice as rather more preferable. where he was responsible for the development and marketing of proprietary.com what qualifies today as ‘ civilisation’. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. who would manage to conquer a large part of the more prosperous lands around the European periphery. In our view. when they finally lost patience with the rapacious regime in Rome and invited the Barbarians in. Nothing in this report shall be deemed to constitute financial or other professional advice in any way. And with that. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. 06 .
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