Main menu

Currency update








The dollar has been in the limelight of late, benefiting from the euro's Greek travails, but as the last chart shows, the dollar in general is still pretty weak compared to where it's been in the past. And since gold is rising against all currencies, it makes more sense to say that the euro is weaker on the margin than the dollar, than to say the dollar is strong. The dollar is rising on the margin relative to a lot of currencies because the news here is somewhat better than the market had feared (i.e., less bad than expected), while the news overseas is either not continuing to improve or is underperforming optimistic expectations, particularly in Europe with the looming restructuring of Greek debt and the ECB apparently willing to monetize some debt to provide relief to struggling debtors.

The euro is still somewhat strong relative to its purchasing power parity vis a vis the dollar, but clearly weakening. The market is pricing in the increased likelihood that the political pressures for a Greek bailout will compromise the ECB's ability to run a tight monetary policy. The bearish euro trade likely has some room to room, because it would have to fall a lot more before it became cheap.

The currencies that are fundamentally strong these days, on a purchasing power basis (according to my calculations of PPP as shown on the charts), are the emerging market and commodity currencies. The Australian and Canadian dollars are about as strong relative to the dollar (on a purchasing power basis) as they've ever been, and ditto for the Brazilian real. But they do seem to be pushing their limits. When a currency is stretched relative to its PPP, the news has to continue to be awfully good (or awfully bad, as the case may be), in order to sustain those valuation extremes. So that means AUD and CAD are very vulnerable to any signs of a) weaker growth, b) tighter monetary policy in the developed world, or c) weaker commodity prices. Being long these currencies at these levels requires courageous conviction.

The yen is also fundamentally strong, but primarily because the Bank of Japan continues to pursue a very tight monetary policy—note that the steep upward slope of the PPP line reflects over three decades during which inflation in Japan has been significantly lower than in the U.S. The yen has a lot of tight money momentum going for it, but most of that is being counteracted by a persistently weak economy. Plus, at these levels it is clearly overvalued relative to its PPP and thus vulnerable to any bad news or just news that isn't completely supportive.

I've been moderately bullish on the dollar since last December (check my forecasts near year-end),  but I am losing my enthusiasm as the dollar climbs. The Fed continues to insist it will remain super-easy for the foreseeable future, and that is a clear negative. At the same time I think the world is overdoing its concerns about the demise of the euro. The euro currency area is a bit larger than the U.S. economy; you don't just walk away from the euro because one relatively small country is having problems. Imagine telling the 300 million people in the U.S. that you're going to change from the dollar to the Can-dol-peso; the logistics alone, not to mention the political fury that would be unleashed, are mind-boggling. Europe has made its currency bed and it is going to have to sleep in it. At some point the majority of Europe is just going to have to ignore the Greek protests. And the Greeks are just going to have to trim their bloated government, and that won't be an unbearable task. For heaven's sake, all this government spending is a huge problem, so getting rid of it should be a huge relief.

Reading the monetary tea leaves


M2 growth over the past 6-9 months has been extremely low. Lower than at almost any time in the past 50 years. Economy bears point to this as evidence that the economy is on thin ice, because the Fed hasn't done enough to counteract the deflationary pressures that are being created by all the "slack" in the economy. Economy bulls like me see things very differently. I note that M2 growth surged in late 2008, mainly because the public's demand for money (M2 being a better measure of money demand than of money supply, in my view) surged. That was when everyone wanted to hoard money, and as a consequence spending ground to a halt all over the world. That money is now being released, and it is showing up as increased spending (see the retail sales post earlier today). Money demand here in the U.S. is declining, and M2 velocity is rising, and that goes hand in hand with the return of confidence and the improving fundamentals of the U.S. economy.  So as I see it, the slowdown in M2 growth is a very good sign that the economy is coming back to life.


In Europe, however, it's a different story. The list of pundits and economists predicting the demise of the Euro is long and growing daily. I note that yesterday even Paul Volcker jumped on the "euro is dead" bandwagon. There is great fear and trembling in Europe over the possibility of Greek contagion spreading, bringing down the banks and ultimately the euro. I don't think that's likely, but in the meantime this fear is showing up as a much stronger dollar and a surge in dollar currency outstanding, as this second chart shows. Since January, when Greek default risk first started to rise, the euro has dropped about 15% against the dollar, and the growth of dollar currency outstanding (most of which is held overseas) has risen from zero to a 3-month annualized growth rate of 8%. A similar panic-driven demand for dollars occurred in late 2008, only then it was much more intense. (Interesting footnote: if it weren't for the recent surge in foreign demand for U.S. currency, M2 growth would be at an all-time low, currency being about 10% of M2.)


This latest Greek panic attack has spilled over to equity markets worldwide. As this third chart shows,the Vix index, a good proxy for the market's level of primal fear, has surged and equity prices have fallen. We saw a similar situation in January. So far it doesn't look like a big deal.

How are things likely to play out from here? I think the fundamentals in the U.S. are fairly strong at this point. So many things are improving in the U.S. economy and in Asia that the momentum to the upside is powerful. The U.S. economy is unlikely to be derailed by the problems in Greece, just as the problems in California are unlikely to make a huge difference to the rest of the economy—California has been struggling for quite some time now, and Greek has been unproductive for years, but both might get revitalized if fiscal policies can get back on track. The U.S. is growing despite numerous headwinds, and Greece is but a whisper in a gale. Furthermore, Europe is not going to collapse even if Greece restructures its debt. The world has survived big debt restructurings before (recall the Latin America debt defaults of the early 1980s) with growth hardly skipping a beat. I take the optimist's view that the world's intense focus on Greece's problems, which all stem from bloated government and strong unions, is very likely to drive meaningful political change (i.e., calls for smaller government) going forward; and that is a very good thing. In fact we're already seeing this here in the U.S., with Utah Senator Bennett's stunning defeat in the Republican primary.

Meanwhile, Europe is legitimately concerned about the problems in Greece, because a) citizens of the Eurozone are being forced by their governments to effectively bail out the lazy Greeks with new loans (think of all the money we wasted on TARP), and b) the ECB may bow to political pressure and monetize Greek debt, thus adding an inflation burden to the citizens of the Eurozone. Investors are exiting the euro in advance of its possible debasement, creating a self-fulfilling prophecy. None of this is a good portent for European growth, but then again, nobody ever expected Europe to grow like gangbusters.

In short, while the problems in Europe are real, I think this crisis will not have much impact on the U.S. economy, and that consequently the latest bout of the heebie-jeebies in the U.S. equity market will pass. Turning back to the monetary tea leaves, you might say that the M2 velocity story is much bigger and stronger than the dollar currency story.

Retail sales are growing nicely


Retail sales in April rose by more than expected (0.4% vs. 0.2%), and they are up at a 10.7% annualized pace in the past six months. They only have to rise by another 4%, so at the current pace we could see sales regain their previous record high by the end of this year. Sales appear to be leading the way in this recovery, and that's not surprising since the recession was largely provoked by a financial panic which drove people to suddenly hoard cash. Money was stuffed under mattresses as the world's consumers prepared for a prolonged depression. When that failed to materialize, consumers gradually began unhoarding their cash. The turnover of money has risen appreciably since last summer, confirming that the recovery has in large part been driven by spending that is making up for what was postponed in late 2008. This should continue to be the case, since this process is a virtuous cycle: the more that spending and production and employment rise (as it is now), the more consumers will be confident that the world is getting back to normal and the more cash they will pull out from under their mattresses.

Consider also that with sales almost back to their prior highs, but with total employment still very near its recent lows, businesses are seeing a tremendous pickup in productivity and profitability—sales per employee have shot skyward. Profits are the mother's milk of future growth, and this process is not yet over by any stretch. Businesses that have survived will soon have the resources and the desire to expand employment and grow. Again, a virtuous cycle that should last for a long time.

Industrial production chugging along globally


U.S. industrial production in April rose 0.7%, and is up at a 7% annualized rate in the past six months. Although industrial production in some parts of the world has experienced a fairly dramatic V-shaped recovery this past year (Japanese production is up almost 30% in the 12 months ending March, and Eurozone production is up at a 13% annualized rate in the past six months), a full recovery to previous high levels of activity is still a long ways off. Call it slow progress, but it is sure a lot better than the doom and gloom forecasts of depression that were bandied about a year ago. 

Finance Book of the Year


Panic: The Betrayal of Capitalism by Wall Street and Washington  by Andrew Redleaf and Richard Vigilante, is a giant of a book, but its title is very misleading. The book is not at all about how Wall Street and Washington "betrayed" capitalism. It's about how the vast majority of investors, politicians, and bureaucrats fail to understand how markets really work. Most of what we learned about modern portfolio theory has blinded us to some key insights which the authors share. I've been immersed in markets for over 30 years, and I can't remember the last time I read a book or article that made me rethink so many of my deeply-held beliefs.

Are you one of the many that believe in the Efficient Market Hypothesis? In the Capital Asset Pricing Model? Do you agree that, in general, the more risk you assume the greater your reward should be? Do you believe that portfolio diversification is key to managing risk? Do you think that highly liquid markets are by nature efficient? Well, think again. Read the book and discover what you have been missing.

Here are some choice sound bites from the book: "Risk is not the foundation of profit but its most dreaded enemy." "Profit is the payment earned by the exercise of judgment to reduce the risk of an enterprise in an economical way." "Investors are paid for being right, not for the possibility of being wrong." "Diversification is always and everywhere a confession of ignorance." "The preference for public financial markets over all other markets creates a preference for weak ownership over strong." "Both the mortgage crisis and the crash are best understood as the result of government policies that pushed trillions of dollars in assets out of the hands of relatively strong owners and into the hands of weak owners." "The dream of market efficiency and the dream of socialist efficiency are the same dream ... both yearn for capitalism without capitalists." "Free economic markets are especially good at rewarding the creative and productive use of capital ... yet no matter how free the market, it is the men not the market who do the creating."

In addition to offering numerous and seemingly paradoxical insights into markets and investing, the book does a great job of explaining how the financial crisis of 2008 came about and how, with the help of hugely misguided government intervention, it eventually led to a global recession. In my professional career I have spent hundreds of hours trying to explain derivatives to colleagues, professionals, and executives, so I was amazed to see what a good job the book does of making extremely complex securities understandable to just about anyone.

The authors' prescriptions for making things better include: less government regulation, not more; less reliance on securitization, structured finance, and portfolio diversification; more respect for entrepreneurs and savers; a rejection of "too big to fail;" and the elimination of "agencies" such as Freddie and Fannie. I hasten to note that the authors are bipartisan critics, heaping plenty of scorn on the "crony capitalists" that inhabit both Republican and Democratic administrations.

All investors can benefit tremendously from this book, but it should be required reading for all politicians and bureaucrats. That's because the more the government tries to shield us from risk and uncertainty, the worse things become. Rarely have I seen anyone do such a good job of explaining why that is so.

HT: Ashby Foote, who not only recommended, but kindly sent me a copy of the book

Shipping update: continued improvement




These measures of ocean shipping rates continue to point to healthy demand for shipping in both the Pacific and Atlantic. That in turn translates into continued good news for global growth. The best reason to think that the Greek debt situation will not prove contagious or harmful to the rest of Europe is the fact that the global economy is strengthening. Growth is a great remedy for debt.

The federal budget is still bleeding trillions


For the 12 months ending April '10, the federal budget deficit rose $60 billion to $1.42 trillion, or about 9.7% of GDP. The deficit has been running at a $1.4-1.5 trillion annual rate since last June. As a percent of GDP, the deficit has shrunk from a high of just over 11% last September, primarily due to a modest reduction in outlays and an upturn in the economy (nominal GDP rose 2.5% from September through March).

There are tentative signs that revenues may have stopped declining, and this would make sense given the economic recovery that began last summer. Although spending has declined from its peak, under current law it is unlikely to decline much further as new spending and entitlement programs kick in. Consequently, we are unlikely to see any meaningful improvement in the U.S. fiscal situation before the November elections. A very large budget gap., record levels of spending relative to GDP, and intense pressure to raise tax rates are almost sure to be the major issues of the campaign. Every survey I've seen suggests Democrats will suffer significant losses in November, enough surely to make legislative gridlock likely, and maybe even enough to allow Republicans to veto the spending needed to launch Obamacare, thus putting a lid on future spending. It is not impossible either to foresee enough pressure developing to block next year's scheduled increase in income taxes.

The situation today is not pretty by any stretch of the imagination, but there is reason to be optimistic for the future.

A V-shaped recovery in trade



Here are two ways of looking at U.S. imports and exports, and to my eye both show that trade has experienced a V-shaped recovery. We still have not recovered fully, of course, but as of last March, exports were only 10% below their 2008 high. At the rate they're growing (exports up at a 20% annualized pace over the past six months), we'll reach new high ground by October. The trade sector of the economy will not have grown for roughly two years; that is the price we will pay for the housing and financial debacle that ensued. Progress will have been sidelined, living standards will not have risen as much as they otherwise could have. But life will go on and the economy will keep growing. And with any luck, we'll elect some people in November who will make it their business to shrink our bloated government, which was ultimately the cause of the slump.

On that latter point, I can't help but give a plug to Scott Walker, a young, rising star in the Republican firmament. His "Brown Bag" pitch is sure to catch on.

Easy Fed, easy ECB, strong gold



Today gold bugs are celebrating as the price of gold rises by $30 dollars and €31 euros. Gold has now reached a new all-time against both currencies. In yen, however, gold is still almost 30% below its 1980 high (1980 figures in this chart are month-end, not daily, so the actual gold high was somewhat more than what is reflected in the chart). Thus we see how dramatically the yen has appreciated against the dollar and the euro in the past 30 years. Not surprisingly (since inflation and the value of a currency are intimately related), Japanese inflation has been much lower over this same period than inflation in the U.S. and the Eurozone: since early 1980, Japanese inflation has totaled a mere 35%, while U.S. inflation has been 150% and German inflation 90%.

Supply-siders like me believe that gold is a good common denominator against which to measure currencies over long periods. Currencies that hold their value better against gold invariably have lower inflation than currencies that don't. A corollary to this is that when all currencies decline meaningfully against gold, as they have been doing in the past 4-5 years, then global inflation is quite likely to rise. Given the substantial degree to which currencies have fallen relative to gold since 2005 (a few years after most central banks adopted accommodative monetary policies), we should therefore expect a substantial pickup in inflation around the world in coming years, and the cause will be easy money. Since the end of 2005, gold is up 80% vs. the yen, 120% vs. the euro, and 140% vs. the dollar.

Unfortunately, I am unaware of any formula that relates changes in gold prices to changes in future inflation. The linkage is loose, the lags are long, and there are other things which get into the mix—such as geopolitical risks—that muddy the waters. But if this theory of gold and currencies holds any water at all, we should see rising inflation in the future, and that should be quite a surprise to most global bond markets, since they are currently priced to inflation remaining very low and stable.

By way of illustrating how this process works, I offer the following simple rule of thumb for any central bank desiring to keep its currency stable against gold (and thus replicating a gold standard): add or subtract whatever liquidity is necessary to keep the price of gold within a relatively narrow band. In practice, that means trying to find the short-term interest rate that makes the public indifferent between owning a short-term deposit or owning gold.

If interest rates are too low, gold becomes more attractive and rises; people prefer to hold less money and more gold, and the unwanted money tends also to get spent on things, pushing up their prices in the process (this is similar to the velocity story I have been highlighting in recent months). If interest rates are too high, the public prefers to own bonds rather than gold, and gold prices fall. When gold prices are stable, a currency is "as good as gold;" demand for the currency exactly matches the supply of the currency, and inflation is negligible. The history of gold standards tells us that when implemented correctly, a gold standard is virtually guaranteed to deliver very low inflation.

Is the rise in gold prices a signal to buy gold? Not necessarily. Indeed, I would argue that gold prices at today's levels already reflect a substantial amount of monetary inflation. Inflation almost has to go up to validate current gold prices, and central banks almost have to continue making the mistake of keeping interest rates too low. Gold has had a substantial run, and it can't keep rising at this rate forever. If the past is any guide, gold might rise about 1-2% a year on average over the next several decades. Buying gold today for the long haul is almost certain to be a poor investment, although gold could certainly rise further over the next several months. Gold is going to be the asset most vulnerable to the first indications of central bank tightening, whenever that happens to occur.

Remember when gold used to be worth about $35/oz. back in the1930s, 40s, 50s, 60s, and 70s? Taking early 1940 for purposes of comparison (inflation was about zero that year, after having been negative for most of the 1930s), the U.S. CPI today has increased by a factor of 15.6, while gold has increased by a factor of just over 35 (a strange coincidence). That sounds impressive from gold's perspective, but on an annualized basis, gold has appreciated only 1.2% more than the rate of inflation over the past 70 years, and that's not very impressive. You can't expect that buying and holding gold for the long haul will do better than most alternative investments.

Finally, as these next charts show, the price of gold in constant dollars tends to oscillate around some value (e.g., the real price of gold is mean-reverting) over time. By any historical standard, the price of gold is quite high in real terms relative to its long-term average. (Note that the first chart uses year-end values, while the second chart uses month-end values.)


Mortgage update: still no sign of any threat to housing



It's been six weeks since the Fed stopped buying MBS, and still there is no sign that Fed purchases kept mortgage rates artificially low, or that the end of the purchase program has caused mortgage rates to rise by any meaningful amount. 10-yr Treasury yields are in fact lower today by about 30 bps than they were at the end of March, and MBS spreads to the 10-yr are only about 9 bps wider. Jumbo fixed rate mortgages can be had today for the lowest rate in history, and conforming rates are only marginally higher than their all-time lows of early last year.

A few months ago it was widely believed that the Fed's massive expansion of its balance sheet (achieved largely by buying $1.25 trillion worth of MBS) was keeping long-term interest rates artificially low in order to stimulate the economy. I've always been skeptical of the Fed's ability to control long-term rates. I think the market is the main driver of long-term rates, and the market drives rates based on its growth and inflation expectations. I've argued quite a few times in the past few years that the low level of Treasury bond yields is primarily a reflection of the market's deep pessimism. I think the market is priced to the expectation that economic growth will be 3% at best (i.e., the "new normal" that is in vogue), and inflation will be 2-3% for as far as the eye can see. These are the assumptions that keep bond yields so low. The next chart is my graphical interpretation of this: today's 3.53% 10-yr T-bond yield is the market's way of expressing a very pessmistic view of the economy's long-term growth prospects.


This all circles back to my long-held assertion that the capital markets have a negative valuation bias (i.e., there is little if any evidence of optimism in the prices of bonds and stocks). Market participants are content to buy Treasuries at yields of 3-4% because investors don't expect nominal GDP (which is a good proxy for the growth in corporate profits over the long run) to be more than about 5% (2.5% real growth and 2.5% inflation). Although this is only slightly lower than the 5.7% average nominal GDP growth rate from 1984-2007, it assumes that the economy will never recover all that it lost in the last recession; that the economy will never return to trend growth, and it will therefore suffer with a permanently higher level of unemployment. 

The Greek bailout: spreading the losses around




This collection of charts covers the range of the market's response to the emergence of the Greek crisis and its apparent resolution that came today in the form of a nearly $1 trillion bailout of Greece. Equity markets worldwide today rallied sharply, while the implied volatility of equity options fell significantly; the world breathed a huge sigh of relief as fear of another banking crisis subsided. Greek government bond yields fell hugely as the threat of a default faded, while German yields rose marginally as its value as a safe-haven was marginally diminished; Greece may be much less likely to default, but Germany has now taken on a significant new contingent liability by backstopping the Greek government. Greek CDS fell by 355 bps, but remain at levels that equate the risk of its bonds to that of junk bonds; investors are feeling much better, but they are far from being completely reassured that we've seen the end of the Greek problem. U.S. credit spreads fell, and are now only slightly wider year to date; Greece is unlikely to pose a significant problem to the U.S. economy. Currencies, curiously, were largely unchanged today; this may reflect the fact that the market had effectively discounted the likelihood that the ECB will eventually be forced to monetize some portion of Europe's added debt burden.


The way I see it, the bailout is equivalent to spreading the prospective losses to Greek creditors among a handful or so of major developed countries and the IMF (the U.S. is sharing in this because it supplies about 40% of the funding of the IMF's share of the bailout). Creditors with excellent reputations have tarnished that reputation somewhat because they are now on the hook for a portion of potential Greek losses, should they occur. Presumably, countries like Germany were persuaded to do this to themselves to avoid the potential fallout—in the form of bank failures—from a Greek default.

Whatever the case, the world's investors last week were feeling very uncomfortable holding Greek debt, and now the bailer-outers of Greece have effectively said they are willing to shoulder a significant portion of the default risk of Greek debt. The world is somewhat relieved because a festering source of systemic risk has been effectively socialized. It's similar to what we did in the U.S. with the housing market crash: e.g., the gargantuan losses of Freddie and Fannie became losses that will be born by U.S. taxpayers. This sounds a lot like "spreading the wealth losses around," to borrow a turn of phrase from Obama.

The bailout of Greece doesn't eliminate the risk that Greece will fail to put its fiscal house in order, but it does place much greater political pressure on Greece to do so. Meanwhile it shifts the burden of the risk to other major players and buys everyone some time; if world economies continue to recover, there's a decent chance that growth will reduce government deficits.

So while this is not an optimal state of affairs, it is most likely better than what we had before.