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By Brian Rogers - Fator Securities Welcome To The Currency Wars “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” --Milton Friedman, The Counter-Revolution in Monetary Theory (1970) Welcome to the Currency Wars After a long and unintentionally extended (thank you Hurricane Irene) vacation in South Carolina, I am back on the desk. I was asked yesterday to comment internally on the recent decisions by both the Swiss National Bank and the Brazilian Central Bank. Both actions, in my view, have potentially exposed everyone in their respective societies to the specter of higher inflation while the benefits of these rate cuts/currency pegs primarily accrue to their export sectors. Is this a big risk? You bet it is. These central bankers are crossing their fingers and praying that inflation remains tame as the US and Europe slow down and likely enter another recession. However, what if inflation doesn‟t cooperate? What if inflation remains persistently high, even as over 50% of the global economy enters a recession? How will the new consuming patterns of the approximately 2.7bn people living in China and India change historical pricing correlations? If the price action of Brent crude is any indicator, these central bankers should be afraid. Very afraid. First off, the Swiss peg. In my opinion, it‟s a sign of a very desperate central bank that is closing its‟ eyes, crossing its‟ fingers and betting everything on red. My bet is that they will lose control of the peg soon, likely before the end of the year. This undermines the entire notion of the Swiss franc as a „safe haven‟ currency and will make gold and silver all that more valuable during the next crisis phase. The Swiss have now made their currency nothing more than a leg in a carry trade. By fixing a peg level, the central bank has placed a huge target on their backs and told fixed income investors to arb away! You can now borrow short-term in CHF, lend long-term in a riskier currency and know that the CHF leg of your trade is safe at 1.20. Remember the Japanese intervention back in March as the JPY rallied after the earthquake? The government got involved in the FX markets at 79 and promptly caused a sell off that went all the way to 85.5. However, with enough time the market simply overwhelms the efforts of even the most ardent money printers. The USD/JPY is now 77.42, or approximately 2% stronger from the original point of intervention. In Brazil, the BCB cut their short-term SELIC rate from 12.5% to 12% using the excuse that this move was needed as growth is slowing. For sure there is some truth to the idea that growth in Brazil is and will continue to slow. The recent
So the trend is clearly downward and much of this attenuation is due to the much stronger BRL which at 1.51. Europe.27% just going back March 2010. Switzerland. And then we devalue again. it does not appear like a weak oil price will be there to help us as before. fertilizers and other inputs will remain high. they have in one surprise announcement thrown inflation fighting out the window in favor of a weaker currency. Despite this. Rinse. metals. However. In the current economic environment where the US is the dumping ground for the rest of the world‟s excess supply. Brent continues to trade firmly above $100bbl.34. They have spent the last few decades diligently working to build a reputation as a hawkish. however. This causes the exporters in the stronger currency to lose earnings and growth. this means we‟re trying to increase our own exports at exactly the same time every country is trying to do the same thing. These are all very different activities with different costs and benefits but the one thing that they all accomplish is an increase in fiat currencies.74/bbl.5% with the upper band at 6. they cut rates 50bps. Brazil and China (via their peg to the USD) are all actively suppressing or cutting their interest rates.3%. currently sitting at $115.1%. grains. Brent is the global oil standard. As one bank prints or otherwise weakens their own currency. But our debt threshold as a people. buying their own sovereign debt or actively intervening in their currency markets. Which causes them to try to weaken their currency and by definition. . just like the Swiss. repeat. inflation fighting institution.GDP numbers came in slightly below expectations of 3. offsetting this data which points to economic weakness has been some rather uncooperative inflation data. by definition they strengthen someone else‟s. It‟s important to understand that the Brazilians and the BCB have their own nasty history with inflation in the 80s.65 is fully 34% stronger than it was in December 2008 at 2. And yet in the face of such data. Japan.04/bbl. Unfortunately.23%. And with central banks globally poised to print to infinity to promote weaker currencies. over 73bps higher than the upper end of the band. Despite the recent spate of bad economic data and warnings of impending recessions. And then they devalue to make their exports cheaper. And then they devalue. Just recently the IPCA Inflation number on a YoY basis recently came in hotter than expected at 7. If we do go into recession. Which means we are now forced to devalue our own currency to maintain our mountain of debt. So we devalue to make our exports cheaper. this is down from an annualized number of 9. breached actually. Let‟s look at Brent crude briefly. wash. this only works so long as we are increasing our own debt levels. economy and government has been reached. even here in the US and it is only down 9% from its April high of $126. Anyone focused on WTI is missing the mark. strengthen someone else‟s. you can bet that the price of oil.5%. by definition strengthening the rest of the world‟s currencies. The problem is that all of the recent data have been coming in above the central band.2% at 3. The BCB‟s target inflation rate is 4. Also moving up slightly is the unemployment rate which has moved up to 6% after recently bottoming at 5. Could the Arab Spring morph into a Western Winter? The central banks of the US. It is fully 239% above its‟ 2008 low of $34.
Welcome to the currency wars. The currency union will fail not because the current political leadership wants it to. And this was when the economy was strong. the Swiss and Brazilian moves signaled the true beginning of the global currency wars. it will fail because the people of Germany are Germans and don‟t want to be equal members of a broader European concept called United Europe. not total exposure. All of the recent local and regional elections in Germany. They will lose billions more on this one until they eventually capitulate. something like a United States of Europe. French. In my opinion. Bernanke. Print More Euros? Nein! So the other option is massive printing. Same thing for the Dutch. even this imperfect solution will never fly. even if it means the breakup of the decade or so experiment called the Euro. The only solution for Europe is a consolidation of fiscal authority at the national level. Wither the Euro Which brings us to Europe and the highly imperfect Euro. having a particular history with money printing to solve debt problems. The depreciation race to the bottom has begun. This will allow for the issuance of a Eurobond and allow the proverbial debt can to be kicked down the road a bit further. However. tariffs and the limiting of certain imports. As investors exit the EUR. Europeans are voting for less integration rather than more so this is a non-starter in my opinion. quite the opposite. some will buy CHF and test the SNB. The Germans will not repeat the mistakes of the Weimar Republic. integration seems unthinkable. Belgians and others. This will ultimately kill the hope some hold out for the Eurobond concept. This is just getting started. Trade wars will be next. aka the preferred option of one Ben S. governments suffering from falling exports will attempt to protect local champions via protective taxes. They have hedged some of their PIIGS risk in the CDS market but in . No fiscal union. In the current economic situation. The Germans. The major European are all underreporting their exposure to the PIIGS because they are reporting net. Which means more EUR weakness and eventually an unwind of the currency union.In my opinion. Once FX interventions fail. Affected governments and industries will retaliate for their own loss of exports and so on and so forth. however. will be loath to support much more printing and the polls in Germany so little support for this “solution.” Trichet will continue to print as the banking crisis worsens but at some point he will simply have to pull the plug and allow the chips to fall where they may. jobs plentiful and the cost of integration viewed to be relatively light. This means a banking crisis is coming. They lost billions earlier in the year on market interventions. There were times in the mid-2000s where the powers that be in Europe tried to pass a unifying constitution and they were soundly rejected. Finland and elsewhere seem to verify this viewpoint as voters continue to elect politicians who will not support more bailouts or further losses of national sovereignty. the ECB is really a proxy for the Bundesbank.
then buy they will. Redemptions will hit the hedge funds. A hedge only has value if your counterparty is financially able to deliver on the contract. As the Swiss and Brazilians just showed.a modern-day banking crisis. This will affect the US banks as well. funding will dry up and capital levels will be questioned in detail. game over. particularly the large derivative players. all options are on the table. forget it. the big banks in Europe are toast. It will also mean incredibly interesting things for the ultimate reserve currency. In addition to the billions being lost on the GSEs. This will force the US government to enact the bank nationalizing powers of the Dodd-Frank Act to ring fence the good assets (assuming there are some) of the major US banks that come under fire. And this particular leg of weakness doesn‟t even consider the capital that may need to be raised from the FHFA lawsuits announced last week. Italy is way Too Big To Bailout. If Italy comes under further pressure. If buying more PIIGS debt helps keep the banks alive another day. Bottom line: now is a great time to get out of govt paper and many miles away from the large US and European banks. you ain‟t seen nothin‟ yet! The 30-yr Bond Bull Says Goodnight The end result will be an eventual eroding of faith in the US government‟s credit. fertilizer companies. oil companies and water . In turn. Imagine a pension fund or insurance company with a 5-8% real return hurdle rate. The death of the long-term bull market in govt debt will mean the nail in the coffin for the USD and the US‟s role as sole superpower. over 31 years. the government will be forced to spend billions on the banking sector while teachers lose their jobs to austerity. this will put significant pressure on the US government as the FDIC is forced to make good on billions of dollars of deposits. the value of those hedges will approach zero as counterparty risk will surge once one of the main banks begins its death spiral. This will further roil US politics as both major parties will want to bailout the banking sector but neither will want to move first! You think we had gridlock over the debt ceiling debate. I am a broken record on this but you should own gold and silver miners. This shift out of public assets and in to private assets will represent a change in preferences that has lasted since 1980. Don‟t be too surprised if it happens. Counterparty risk will surge. The vigilantes will eventually stir and move into other asset classes en masse. I wouldn‟t bet against it completely. How can they possibly stay in 10yr Tsys with a negative real yield? They can‟t. forcing them to liquidate and further rendering the value of any protection they wrote worthless. With Greek paper implying at least a 40% haircut. The market will eventually wake up and realize that monetization is the one and only way our government can kick the can down the road without immediately collapsing the economy. Could the US Fed end up purchasing European sovereign debt in an attempt to prevent a collapse of the Euro? Although it doesn‟t seem too likely today. And that‟s only discussing Greece. gold. Which means fixed income investors will lose ad infinitum.
Corporate bonds of companies providing any of the products listed above (gold/silver. oil and water) makes a ton of sense. . fertilizers. I would avoid the large multi-nationals here as I think trade wars are coming and their cash flows from foreign operations are about to come under fire.companies. Some technology stocks could make sense and reasonable exposure to Asia and Latam.
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