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