So the last decade of rising gold prices simply mirrored the US Dollar’s steady decline. Right…?

Well, no actually as I have repeatedly noted…and never less than when clutching a whisky and ginger this past Yuletide…typically to a fast-emptying room.

Gold’s tripling-and-more since Tues 4th Jan. 2000 came against all major currencies, let alone the minor ones. In fact, when judged against a truly globalized basket of the globe’s truly basket-case currencies — those various monies issued by the top 10 economies in terms of Dollar-GDP — gold turned decisively higher in mid-2001…looking back only a handful of times and never for more than a 20% drop.

All about the Dollar? Don’t you believe it.

Yes, volatility and violence rose together as the gold price pushed higher. And yes, the Dollar-price gains outstripped those in the Euro (292% vs. 180%) and commodity-led Canadian Loonie (179%).

But your local fund managers, financial advisors and op-ed pundits would have been hard-put to beat those returns with anything else. And as gold remains (at least in the view of die-hard, gloating and lone-drinking “gold bugs”) the only viable one-world currency, it’s worth glancing at just how it performed against the last decade’s various top 10 monies by economic weight…

* NB: The GGI is rebased for the top 10 currencies by economic output each year. The 13 gold-lagging currencies above all made one appearance (or more) in the last decade’s data. 2009 positions given here, courtesy of the IMF. The US accounts for 32%, the Eurozone 27%.

Of course, no one much cares for the last 10 years of data, however — not outside the relative performance tables of mutual fund sales teams.

But whether you think gold warned of trouble ahead when it first doubled to the start of 2006…or you feel it merely worked-as-prescribed when it almost doubled again during the financial crisis that then followed…it’s clear that the decade of gold just ended was a long way from a “Dollar down” story alone.

And all this without the much-fabled price inflation which newcomer pundits believe is essential for a long-term rise in the gold price. Just imagine what the price might do from here if a true surge in the cost of living now shows up worldwide.

Regards,
Adrian Ash
BullionVault

January 6, 2010

One Golden Decade and 13 Decayed Currencies was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Pound up…

Euro down…

Aussie pulling back…

Canadian giving way…

Yen losing ground…

October is coming to an end, and we haven’t really seen hide nor hair of any terrifying market moves or monstrous returns to the old days of dollar safety, when anything that even had a scent of risk was spurned as foolhardy investing.

But as of now, the dollar has been tanking and anything that is paying a higher interest rate has been soaring, thanks in part to the hawkish comments and actions by the Reserve Bank of Australia, but mostly due to the boneheaded actions of the United States.

Any way you put it, when a man shows up and says, “Hello! I’m from the government and I’m here to help” — RUN. As fast as you can. RUN.

We are following in the footsteps of Japan. Should this continue, we will have to replace our Stars and Strips with a new flag, ”The Land of the Setting Sun.”

No Happy Ending for the Dollar

We’re now at a 9.8% unemployment rate, and we lost a jaw-dropping 263,000 jobs in September. Now it’s true this isn’t the 700,000 we were losing not so long ago. But it still is not awe-inspiring evidence of a recovery.

The euro’s meteoric rise was on the G-7’s agenda this week. But before we start jumping up and down for joy as the powers that be begin pushing the euro back down (and the dollar up), I must confess that I smell a rat.

The folks at the European Central Bank have not been too worried about the strengthening euro up to this point. That could always change. But for now, they seem to be enjoying this appreciation. For them it acts as a nominal rate increase, which will keep inflation in check should it appear. But don’t get me wrong. Central bankers are men just like us (only often with a lot less common sense). They can get blinders on and only see things a certain way. After all, don’t all humans usually see things the way we want to see them? And this can handicap them when it comes to reading the data — the same way it can handicap us. Should they allow the euro to rise too much and too early, it will crush their budding recovery… much to their surprise and chagrin.

That being said, the dollar is in a bad way. Aside from the sheer size of its GDP, and the fact that historically it has managed to pull its fat out of the fire, I’m not sure what we can look at currently to construct any happy outcome for the dollar. That’s it, plain and simple.

The Dollar Will Be Let Down Gently

But nothing, not even the dollar, falls all at once. Hence all this jawboning about the euro (and yen, while were at it) being too expensive. None of these foreign economies can afford to let the dollar fall too much, too quickly. Thus, if they continue to badmouth the strength of their own currencies, it buoys the dollar and gives them opportunities to get out at a better price. But they can’t dump too much on the market all at once. If investors get wind of that, the big boys will have a harder time getting their target price.

So it seems to me that we should be looking for another return to dollar strength. That would play right into the hands of foreign economies that are looking to quietly unload the dollar. It is also the reason I don’t think we should look for the dollar to go into freefall — it is simply too costly for our trading partners. I believe they will do all they can to allow themselves an exit at a decent price.

No matter what may happen to the dollar’s reserve status in the decades to come, it will retain this status for a long, long time. Thus in this great tug of war between the currencies, there will always come periods when the dollar will be viewed as too cheap, and those who need it for continued trading purposes will not be able to resist the drive to buy it.

No Dollar Strength from This “Recovery”

For our last note, let me reassure you, dollar strengthening will not come as a result of the recovery we are supposedly in.

The stimulus has not performed as promised. A quick look at the figures from last November to the present will reveal it was no panacea:

Unemployment
November ’08: 6.6%
October ’09: 9.8%  (up 50%)

GDP
November ’08: $14.3 trillion
2nd quarter ’09: $14.1 trillion (down .25%)

Housing starts
November ’08: 655,000
October ’09: 590,000 (down 10%)

Food stamps participants
November ’08: 31.1 million
July ’09: 35.9 million (up 15%)

Home mortgages underwater
November ’08: 15 million
October ’09: 25 million (up 66%)

Deficit
November ’08: $450 billion
October ’09: $1.5 trillion (up 300%)

Looking for a Dollar Bounce

Let’s sum up. I am looking for a bounce in the dollar (and I have been since mid- September). I thought that perhaps the fall season might be enough to bring it on. That hasn’t happened. That’s not the same as saying it isn’t in the cards. We are now in the midst of the new equities earnings season. J.P. Morgan produced stellar figures that pumped risk appetite into the market strong and hard. Other corporations may not be able to do as well.

It seems to me that this rally is already on thin ice. At any rate, the dollar will bounce. It will likely end up being a bigger move than most anticipate and it will be fueled by fear and short covering. Then, when the big boys have had enough, the course will be reversed, fundamentals will resume their place, and the dollar will begin its drift toward the nether regions once again.

It is a treacherous pathway before us, but it should yield us some really nice profits if we position ourselves accordingly.

Due to the increased interest in currencies, the NASDAQ now offers an easy way for anyone to play up to ten currencies against each other. Click here to for the full fact sheet on the NASDAQ currency options. So you can do your positioning to take advantage of the coming strength in the dollar…and in the dollar’s ultimate decline.

Regards,
Bill Jenkins

October 22, 2009

Dollar Strength Then the Decline Resumes was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

GOLD’S CURRENT price-tag of $1,000 an ounce suggests big doubts over the US Dollar, its domestic economy, and its status as the world’s No.1 reserve currency.

Or so we guess after 10 years of watching it quadruple from two-decade lows. But gold investors (old, new and everywhere) should note that this decade’s bull market in bullion is about much more than the greenback.

Here are three ways of judging what you might call the “real price of gold” instead.

#1. The Global Gold Index

Gold has risen against all world currencies since the start of 2001, very nearly tripling on average and hitting record highs against everything bar the Japanese Yen. (Tokyo gold buyers are still waiting for a near-double to the peak of Jan. 1980…)

Introduced in July 2008, Bullion Vault’s Global Gold Index is a stab at mapping this trend. It monitors “real gold” by plotting the daily price in terms of the world’s ten most important currencies, averaging their moves by size of the issuing economy.

Thus the Global Gold Index currently starts with the US Dollar gold price, and then takes in the gold price for Eurozone buyers, Japan, China, the UK, Russia, Brazil, Canada, Mexico and Australia – as per the latest World Bank and IMF data. (It’s rebased each year to accommodate changes in that league table of gross domestic product; India, the world’s hungriest physical gold market until the start of this year, flips in and out.)

Not quite the price of gold for everyone worldwide, this “real” value does at least cover 2.5 billion people who account for over two-thirds of world economic activity. It starts at 100 on New Year’s Day 2000, hitting a record peak for this decade in May 2006, and then all-time record peaks in March 2008 and then Feb. 2009.

Currently, the Global Gold Index is trading some 5% off that top, rising strongly into Sept. ’09 so far.

#2. Gold vs. the Cost of Living

What about inflation; has the ultimate “inflation hedge” (as most commentators and analysts still mistake it) out-done the cost of living?

Given how suspect inflation data can be (wherever you live), let’s roll our third “real” gold price into this picture too, comparing gold against the cost of raw, productive materials as bought and paid for in the market-place…

This chart shows the Dollar gold-price adjusted for official inflation in US consumer prices (the gold line). Jan. 2000 marks the start of our indexation. You’re looking at gold priced in Y2K dollars, left-hand scale.

The chart also maps the “real” price of gold in terms of raw materials prices (dark red, right scale), indexing it against the CRB’s Continuous Commodity Index of the most-heavily traded 19 natural resources – crude oil, corn, soy beans and the rest. (Again, Jan. 2000 is our starting point for the maths, indexing the real price of gold in commodities at 100.)

But is gold cheap or dear right now? Three observations:

• Gold built a strong base against commodities during the 1980s and ’90s, holding onto far more of its 1970s’ gains than did natural resources;
• Gold has never been more expensive in terms of the raw materials it could buy than in Feb. ’09, almost doubling in purchasing power from crude oil’s record peak of summer last year;
• Real gold prices stand at only 50% of their 1980 inflation-adjusted peak, but they’ve trebled so far this decade;
• Consumer-price inflation has thus been stronger since Y2K than you might guess…adding 27% to the cost of living and lopping a whole multiple off gold’s nominal gains since the start of this decade.

Still, the Noughties come fifth out of the last eleven decades both for “price stability” and “low inflation”. And gold’s performance in the face of rising consumer prices is varied to say the least…

Most significant perhaps for the fate of Dollars, gold and inflation, is the fact that real commodity prices have in fact halved over the last fifty years. Adjusted for US inflation, they were never cheaper than at the start of this decade.

The decline in real commodity prices between June 2008 and Feb. ’09 was comparable only with their doubling in 1972-73. Dropping 40% inside eight months, real commodities fell faster than any time on the CRB’s five-decade record.

If this decade’s bull market in gold were only about inflation and commodity-price fears –whether priced in US Dollars or anything else – gold would not be trading four times higher above $1,000 today.

Regards,
Adrian Ash
BullionVault

September 22, 2009

The Real Price of Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

We have commented on their plans and purposes on numerous occasions. Now that the meeting has come and gone, let’s take a serious and sober look at what these countries are about, and why they are doing what they’re doing. Assuming that they are even doing anything at all…

First let’s look at the growth of these four dynamic economies. In the GDP growth department, last year India came in at 6.7%, Russia at 8.1%, Brazil at 5.08% and China a staggering 9%. Compare that to the United States’ -6.3%, and you start to get an idea about why they consider themselves superior to America and her economy.

No matter how much you may think those numbers are manipulated, the bottom line is that they are all ahead of the West by light years. They are in regions that were once shackled by the constraints of socialism and outright communism, and are just now breaking free into the light. (Meanwhile the United States is steadily advancing its war on capitalism by increasing debilitating taxation and regulation by the day!)

To put this even more into perspective, the United States has a GDP of about $14 trillion annually. Comparatively, Brazil is at $1.9 trillion, Russia at $2 trillion, India at $1.2 trillion, and China at $4.3 trillion. That means that the combined output of these four nations barely equals two-thirds of the United States.

The GDP per capita, where it is estimated what each person produces each year, also shows some marked disparity.

For the United States, GDP per capita is just under $47,000. Brazil is $8,200, Russia is $14,600, India is $1,000 and China is $3,200. Once again, in terms of output, the United States is far and away the leader, nearly doubling the output of the other four nations combined.

Additionally, the percentage of people in these countries that are below poverty level is shocking. The World Bank estimates that 42% of India’s population is below the poverty level; In China, 10%; Russia, 16%; Brazil, 22%. As that sinks in, also keep in mind that the World Bank defines poverty on an international scale as living on less than $1.08 per day

And not only are these people poor, there is no infrastructure in place to facilitate the increase of wealth among a large portion of their citizens.

Please note, I am not talking about wealth redistribution by government mandate. That will ALWAYS make the poor even poorer. As a matter of fact, it will make the rich poorer, also.

But as a rising tide does lift all boats, severe divergences in wealth from various parts of the population is indicative of markets that are not functioning “normally.” We see this in the United States as well, as government regulation interferes with properly functioning markets and facilitates the destruction of the middle class, leaving only the rich and the poor — not to mention a widening chasm between the two.

How do these relatively “poorer” countries get to call the shots? Why are they influencing policy discussions around the globe? Why do markets tremble when they speak? What is going on here?

You may remember the axiom of Baron Acton, “Power tends to corrupts, and absolute power corrupts absolutely.” Let us be careful here. Absolute power does not corrupt absolutely. God, of course, is exempt, however, in the world of men, it is indeed seemingly axiomatic that the more powerful a man becomes, the greater the temptation to corruption.

No place is this more true than in politics (except maybe religion!). And frankly, it doesn’t matter whence a man hails, what color his skin may be or even what language he speaks, the intoxicating effects of power are universal.

The four BRIC nations have been drinking deeply from this well. They want more power. They want more influence. They want more wealth. In short, they want more. They want what the United States has flaunted. They want the American dream. But they want it wrapped in a turban, served with fine vodka and no more white rice.

They’ve also learned the meaning of another English proverb: “Strike while the iron is hot…”

There is no doubt that that the international media often depicts the United States as an absurd mix between the playground bully and the dunce in the corner. When was the last time you heard an international story praising the U.S. position on anything? From economics to foreign policy, bureaucratic regulation to welfare statism, the United States has become the international piñata.

The fact is, many nations — especially BRIC nations — would like to increase their own amount of “loot” by beating it out of the United States.

The question is, can they do it? Can they decrease the usability of the U.S. dollar while increasing their own. The United States seems fairly determined to bring the first portion to pass by its own volition. The BRICs may not need much help in that arena. But does that automatically guarantee them a seat at the table? Does a U.S. decline mean, ipso facto, that any one, or all four, of these countries gets moved to the head of the class?

I’m not sure that question has been thought through. Frankly, I believe they just see an opportunity and figure they will jump on it. But only lightly. Because there are repercussions, and some of them are not so favorable.

As they’ve sent up a hue and cry for a supranational currency, I have to wonder if they have really learned any lessons at all. Their complaints have centered around a single manipulated currency at whose mercy they find themselves. They seem to intuitively know that a fiat currency system is flawed. It is flawed because men are easily corrupted.

After all, what good is the guilt of corruption, and who would want to bear that burden, unless they could effectively salve their conscience by the increase of wealth? In short, power is rarely of any use to men unless it results in more money. That’s what the United States is being accused of (and rightly so). We have taken our position of unquestioned strength and used it to create the illusion of wealth at home, at the expense of our neighbors. And now the neighbors don’t like it.

But what is their solution? More of the same. Another fiat currency. Actually, a currency made up of a basket of currencies. This should really strike us as hilariously funny, if it weren’t so sad. And by sad, I mean stupid.

It’s like draining bad oil out of a motor and replacing it with equally bad oil. Or like removing a tire that has a nail in it, only to replace it with one that is dry rotted. Or like trading a job you hate for one that will eventually kill you. Or like… well, I hope you get the picture. Essentially, the solution they have put forward is no different from the problem they’re attempting to repair.

And that’s not the only problem…

Here’s what I mean. Both India and Russia still receive foreign aid from the United States. They’re rather like a rebellious teenager who takes potshots at their parents while holding out their hands for cash and car keys.

Beyond that, consider that the BRIC nations hold over 30% of the U.S. Treasury market. That’s a lot of eggs in one basket. So when they start grumbling about policy, they can really strike a fire. On the other hand, upsetting the basket breaks a lot of their own eggs.

The problem is that they must measure their blows carefully. If memory serves correctly, it was China who fired the first shots across the bow of the U.S. economic state. But then, like a playground dog pile, Russia jumped on top as well. Then, lo and behold, the statements are retracted (or at least ameliorated!).

This has gone back and forth, and I imagine it will for some time, since they can ill-afford to knock the United States completely off its horse. To that end, the BRICs have discussed intermarket trading with each other while bypassing the U.S. dollar and talking about a new currency reserve.

Now this is some pretty braggadocio poppycock from upstart powers that “wannabe.” It was just a decade ago that Russia scored big on the international monetary scene by defaulting on a $40 billion dollar debt. (That was back in the day when a billion dollars actually meant something!)

If that were you or I, we’d still have that default on our credit report! And no one would let us forget it, no matter how well we had rearranged our household finances.

So then… have these four countries turned the corner financially? Have any of them got the economic muscle to merge the other three into a formidable monetary force against the United States? Let’s take a look.

Last year during the first leg of the global economic collapse, commodities took a real whack. So did the economies associated with their production and distribution. That means oil — and that means Russia and Brazil.

Even though the Russian stock market climbed more than 6,000% in the previous 10 years, it fell 80% in the eight months of crisis. 80%! While it was the worst of the BRIC alliance, Brazil fared little better. Its equities were down 60%!

And how about the other two BRICs in the wall? Indian stocks were down almost 65%, and Chinese companies… a whopping 73%!

We also now know that while Russia’s equities were tanking, so was their currency, the ruble. After losing nearly 60% of its value, the bleeding was only stopped when Russian authorities jumped in and sold nearly $200 BILLION worth of dollars to support their currency in crisis. That was nearly one-third of their currency reserves — up in smoke to defend an already overvalued currency.

Now, after all that, they start talking about the concept of buying one another’s bonds, and lessening their investment exposure in the United States.

Now let me ask you a simple question: If you had to buy the bonds of either the United States or Russia, which would make you feel safer? One that defaulted on their debt not so long ago and was just hemorrhaging the value of their currency in the last six months? I’m not saying that America is rock solid as an investment, but if you have to pick the lesser of two evils, who you gonna choose?

At this point the U.S. dollar index is hovering around 80 against the weighted basket of currencies by which its value is measured. Last June it was around 72.50 at its lows. That puts it up about 10% on the year.

Conversely, the rupee, real, and ruble, even after some recovery, are still down 35%, 25% and 35% respectively.

Also, consider that from top to bottom of the crisis moves, the ruble was down nearly 60%, the real nearly 70% and the rupee down 30%.

China, of course, has continued to peg its currency, the yuan / renminbi, to the dollar, so such fluctuations, “don’t exist.” Because when a nation, like China, pegs its currency to another nation’s currency, such as the United States, the foreign authorities continually buy and sell their own currency to keep it in a trading range against the other. That way it never suffers from severe fluctuation shock.

But when all is said and done, this betrays the fragility of each of their economies, and how connected they are to dollar based difficulties. So as they chop away at the tree, they had better be careful lest it fall on them.

It is hard to say what the future may bring in terms of changes, but even now, although the BRIC’s are referred to as an alliance or “federation,” the only two countries that have a trade relation of any substance with one another are Russia and China. India and Brazil see very little trading action with them, and are not even in their top seven in terms of import/export volume.

Just some things to keep in mind as we take a closer look at the news…

BRICs Buying Less Debt

Last week we talked about the Treasury Income Capital (TIC) figures, which shows foreign net purchases of long-term U.S. securities. Essentially, it’s a measure of how foreigners are funding U.S. debt.

The headline April TIC number fell to $11.2 billion from the $55.4 billion recorded in March.

Additionally, we’ve learned that the current account deficit for Q1 was a negative $101 billion. The TIC data for January through March showed foreigners funding only $40 billion of that deficit. That means effectively we were a negative $61 billion in the hole as a country for Q1. We are still paying our bills — so where did the money pay them come from?

In line with our theme for the week, China’s purchases of U.S. Treasuries decreased to $10.3 billion from $14.8 Billion. Russia and Brazil showed small outflows in April, which was similar to the past few months. But the biggest change came from Japan, which showed an outflow of -$1.2 billion, way down from the previous $23.2 Billion inflow.

While one series of number releases does not make a trend, one can’t help but wonder where this will lead. As we covered last week, there are only two destinations that I know. If foreign entities are unwilling to fund our deficits with the higher Treasury yields (up from 2.1% to 3.75%), one of two things will happen:

1. Yields have to go up more, raising rates across the spectrum from mortgages to loans to credit cards, thus inducing a second wave of “Credit Crunch”

2. Or foreigners will NOT fund our U.S. deficits. That means the Fed will purchase more U.S. Treasuries, and it means they will print more cash to do so.

Neither of these choices bodes well for the United States or the U.S. Dollar. Only time will tell us if April data was a fluke month or if it was a sign portending things yet to be.

But not all is dreary in the world. Our friend Chuck Butler over at EverBank had this to say:

“It seems that Australia’s government has decided to put government backing on state-issued bonds like the QTC’s (Queensland Treasury).

“This is HUGE for these bond issues, especially since Australian states were seeing downgrades in ratings! The country of Australia has a higher rating, so these bonds will also inherit that rating, since the government is backing them!

“However, this will tighten up the yield on these bonds, probably by about 10-15 basis points.

“Why is this important? If the QTC bonds now have a higher rating, more institutions will be able to buy them. That means more investments flowing into Australia, and more cash flows into Aussie dollars!”

The thing here is that in the long run, this is good for the Aussie dollar!

Thanks, Chuck! Notice he said, “in the long run.” Since that news broke last week, the Aussie dollar has been on a fall. But as soon as it firms up a bit, we’ll be jumping back on board!

And here’s a little good news from Stateside (especially for the Fed). Consumer inflation dropped 1.3% over the last 12 months, the biggest decline since 1950. What? No inflation in the United States? Hey, Ben! Keep those presses rollin’! We can continue to “stimulate.” Good Lord, deliver us!

Also, some other good news — continuing claims for unemployment finally dropped last week, ending their heartbreaking streak. Hard to say what this week will hold, so we’ll wait and see.

We will also be looking at the Treasury auction this week. The U.S. government will be issuing a record $104 billion of 2-year, 5-year and 7-year Treasury notes between Tuesday and Thursday. Traders are watching these auctions because of their sheer enormity and also because it will shed some light on whether bond buyers are willing to fund the growing U.S. budget deficit. If demand comes up short, the dollar could get whacked. But, as always, it is not that simple.

You can’t just sell the dollar if the auction appears weak. Because weak demand may drive up yield rates, which will be good for the dollar, as long as there are buyers. And as I’ve covered above, there are likely to be more dollar buyers than there are those who buy everything else.

Thus as we come to the end of our musings and examinations today, we are looking at consolidations taking place.

The euro has been locked in a down drifting channel but remains in a larger uptrend. And now it is hanging around a crossroad. Yogi Berra said once said, “When you come to a fork in the road, take it.” We are currently waiting to see which road the euro will take. Yesterday’s move up was unusually strong and uncharacteristic. We will watch to see if it was just short covering or a real rally beginning.

The pound can’t quite seem to make up its mind either. It has out-appreciated its European counterpart and moved higher. But we may see some weakness to come, as it is having difficulty pressing up at this level. If it breaks through, however, we could be in for another extended run.

The Aussie has drifted further down, but has not violated its 30-day lows. Just about time to take a new position here. But we need to wait for a bit more confirmation.

Today the Fed will announce interest rates. No one expects that they will be changed. But we do expect to hear something on the Fed’s view of the economy. In his last appearance before Congress, he stated in no uncertain terms that the deficits could not continue. Now deficits are not really his department. That is the domain of Congress. But if he hints at the fact that the existing Treasury buy-up is going to be stopped at $300 billion, this could be massive for the dollar. There are only two paths ahead of us.

Bernanke knows as well as any, that inflating the currency further will lead to dollar destruction. It is my feeling that as the dollar has seen a sell-off, that this month they are going to stand on the other end of the see-saw and talk up some dollar strength.

Regards,
Bill Jenkins

June 25, 2009

BRIC Nations Getting Bolder was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.