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Thursday, September 17, 2009

Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog

I first wrote this blog post in My original blog on June 17, 2009. Here is the original post (Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog -- If you are a CAPS user, please rec the original blog post. It is another important and comprehensive post and needs as much exposure as possible --). I have decided to update the post right now for a few reasons:

1) *Everybody* is bearish on the US Dollar right now. The latest investor sentiment poll has something like 2-3% Dollar bulls right now. These are the same bearish conditions that were present in the stock market on March 9, and nearly the same bullish conditions that are present in the stock market right now. In short, we are at an extreme sentiment condition, which means things are ripe for a turnaround.

Now, there will be a lot of noise in the coming months when the dollar starts rallying and the stock market starts falling the dollar had put in a "major" bottom and proof that deflation will be the long term outcome. I don't think that is the case (by a long shot) and I think the qualifier "major" regarding the bottom for the dollar is up for interpretation. We will get a bottom that lasts 4-6 months, but I think the dollar will be headed down again.

... But wait? The dollar will be headed down and the market will be headed down. Isn't the weak dollar helping to fuel the stock market rally? Don't they need to move in opposite directions?

2) **NO**. Please look at the following charts and read the following paragraphs

Short term is all noise. And the current dollar weakness is fueling the equity rally. Long term, equities will go down (due to poor fundamentals) and the dollar will go down (due to confidence crisis) together (such as 2007-2008 and numerous other occasions)

By and large, there is **far more** positive correlation between the Dollar and Equities than there is inverse correlation. They both go up and down together as evidenced in the chart above.

However, many others including myself, have observed that the "weak dollar" is currently fueling the the equity rally right now. So why the discrepancy?

Because you need to realize that we are still in the aftermath of the Greatest Deleveraging Event in History (2008)!

During the meltdown of 2008, everything was sold / redeemed for the relative "safety" (used exceptionally loosely) of Treasuries: shares in hedge funds, commodities, stocks, etc. As such there was a massive dollar repatriation. The dollar didn't gain value because it was strong! It did because it was "in the way" (you have to buy dollars in order to buy treasuries, it is sort of a necessity that way).

In the ensuing months we have seen the Fed ream bondholders through ever more massive QE salvos, intentionally destroying the "value" of US Treasury debt and the US Dollar. Since that time, money has been moving back out of Treasuries (putting downward pressure on the dollar) and into more speculative endeavors (the stock market). You can see here that there is not a "if the Dollar goes down then Equities must go up" relationship here. Money was leaving treasuries and equities were oversold so they were bought. That's it. Another force at work is the fact that the weak dollar and the oversold nature of equities a few months ago made stocks attractive to relatively stronger foreign currency holders, who could "get more bang for their Euro" so to speak.

You can see that the current inverse relationship between the Dollar and Equities is a product of a very particular setup and is not a given. In fact, the relative valuation of all of these asset classes (Treasuries, Dollar, Foreign Currencies, and US Equities) has shifted a lot the last few months. Anybody expecting this "status-quo" relationship to persist much farther into the future is going to be rudely surprised.

So what about the future? Are the deflationists right? Does all the world's money rush back into Treasuries and the US Dollar during the next crisis? Any claim of a "strong dollar" is bunk. The Fed has made it abundantly clear that QE is not going anywhere and they are getting more aggressive with Treasury purchases, not less. So anybody who thinks that US Treasury debt will still maintain the iron-clad safe-haven status in the future.... well, I have a Bridge in Brooklyn that I think you would be very interested in!!!

3) Regarding the short term bottom in the Dollar that should last for a couple of months: It is *extremely* important to understand the long term trends of the US Dollar (down) and the fact that all fiat currencies eventually trend toward their intrinsic value (zero). Look at the history of all fiat currencies. We even have dead United States currencies, since the US has been in existence! Anybody who thinks the Fed will not try to inflate their way out of this mess, or thinks there will not be political pressure to inflate the money supply or increase the debt ceiling on the US National Debt, really does not understand history or the willingness of politicians to dismiss sound economic policies in order to "look like they are doing something".

However, simply because the Fed will try to inflate / reflate / devalue does NOT mean that they will be "successful" (i.e. cause a general increase in the price of all assets, as if this were a good thing to begin with)

I have been hammering on the topic because it is the critical issue to understand how all of the advanced economies government's action will not only fail to produce the desired effects, but will more importantly make matters worse. The main issue is  Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. It is critical to understand that an increasing debt load has decreasing marginal utility and there comes a point due to servicing requirements that all new debt has a negative economic impact. This is why we were NEVER going to be able to borrow and spend our way out of a crisis that was caused by too much debt to begin with.

This sets up an extreme deflationary environment (this debt load is unsustainable) within which the Federal Reserve will monetize unprecedented amounts of debt at unprecedented rates. Which will result in a simultaneous deflationary and inflationary outcome: stagflation. There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes.

I do think that most inflationists discount the amount of debt that is collapsing (even though most deflationists use measures like M2 and M3, which have a lot of non-monetary components to prove their point) while at the same time most deflationists discount the amount of monetary inflation the Fed can generate (they argue that the Fed creating base money is like pushing on a string because the banks don't have to lend, even though I am many others have pointed out that the Fed has gone around the banking system and has started monetizing private sector debt directly, which is a trend that is likely to increase not decrease). Most people on either side of the debate is not considering strong evidence that both forces are significant.

So this post is a repost/update to the original post. It has all updated charts with new annotations and revised counts (where necessary). Also I was playing around with a few numbering/coloring schemes when I wrote the original post, and all the charts in this new post are compliant with my EWP Numbering Scheme


The analysis of the US Dollar is one that I wanted to tackle in my mammoth gold blog: Market Thoughts and Analysis: The Gold Blog. Gold...... / Original Post --- The Gold Blog. Gold/Silver/GSMs (and a little Oil for good measure) --- UPDATED POST, Sep 11, 09. However, the last post was really big and this topic is big enough to warrant its own post.

But First, A Discussion with the Deflationists that I Debate With

Hey guys :). Let me say that out of the whole inflation / deflation debate, the only thing I know is that I am not 100% right. I guarantee it. There is no way I am calling the trends and the timing completely accurately. Moreover, I do realize that there are both inflationary and deflationary pressures acting in the economy all the time. I have read Mauldin, Prechter, Mish, Roubini, and Krugman. I am not going into this inflationary stance blindly. I can see the very salient points that are being from the deflation camp.

It is just that when I read all of the evidence, on both sides, I think the inflationary argument makes the most sense for the long term. (IMO).

That does not mean that I am discounting the deflation argument!. Like I said, some of the points being made are very valid. However, I think many deflationists (Mauldin and Prechter definitely do not, but Krugman does ... a lot) combine monetary deflation and price deflation and lump it into one single category (a huge no-no if you are trying to understand the true cause and effects). But even the ones that do not confuse monetary policy and price supply/demand effects, some are improperly accounting for monetary assets, what is and is not one, and using improper monetary supply indicators to look at the problem.

Now those were some bold words. But like I said. This is just my opinion. And opinions are like a**holes, everybody has one :). So I again acknowledge that I am not getting this 100% right, and look forward to good and civil debates about this issue. This issues has been debated a lot in the past on Caps (and I have been taking part in those for over a year), and will continue to do so in the future.

It is that important.

On to the Analysis

There are so many issues to consider that are all interrelated when talking about the economy / inflation-deflation / the US Dollar / US Treasury / Federal Reserve. And there is no way I will be able to do it justice in one post. But here is a list of some of the issues.

- Money and Monetary Assets
- Money Supply
- Monetary Inflation / Deflation
- Price Inflation / Deflation (NOT the same thing!)
- Velocity of Money
- The US Treasury
- The Federal Reserve
- Policy Decisions and speeches made by Chairman Bernanke
- US Treasury Bonds
- Treasury and Market Rates (Bond Yields)
- Quantitative Easing
- Debt Held by Foreign Governments
- Foreign Currencies
- Intentional Currency Devaluation and Currency Devaluation Wars
- .... !! (lots more)

Wow, that is a jam-packed list of some heaving-hitting topics. There is no way I will be able to cover all of these in one blog post. Here is a recommend reading list (highly recommended), and I will try to hit a few highlights and engage in a bit of discussion before I put up some charts at the end.

- Steve Saville: Market Value, Money and Credit - Good layman's description of TMS and its importance
- Quantitative Easing Explained  - Just a good funny article on QE
- Steve Saville: Why We are Gold Bulls - A good inflationary summary
- Steve Saville: Money Confusion and Inflation/Deflation - Good discussion as to what constitutes money and why some monetary discussions are invalid
- Zeal: Big Inflation Coming 2 - Good discussion of inflation and deflation.
- Mises: TMS - Good Definition of True Money Supply (TMS).
- Saville: Inflations New Upward Trend - Misuse of the Velocity of Money concept
- John Mauldin: The Endgame - Very good deflation arguments.

Okay, I will will trying to hit the highlight and put my argument in the smallest nutshell I can manage.

Why I Think We Currently have Monetary Inflation and will get Price Inflation both Long Term and in the Relative Short Term..

An argument that I hear from a lot of deflationists is the "Pushing on the String" argument, which boils down to the fact that the Fed can print 700 septillion dollars if it wants to, but it can't make us borrow them. Another way to think about this would be: What if Bernanke literally printed all that money and put it all in one big pile stacked up next to his desk in his office and didn't hand it out to anybody, would that be inflationary.

The answer to both situations is: no, it would not be inflationary .... ahhh, but if it were only that simple.

I going to let you in on secret that will make this whole argument clearer and put things into perspective. Ready?.

The US Government is broke.

To be clear, the term is technically insolvent. We are running massively enormous annual budget deficits, on top of which we have more that 10 trillion in Federal Debt, and if you add in unfunded entitlements the problem is even worse.

On top of that the economy is in the toilet, Tax revenues are down and government is growing, not shrinking.

So what is the plan: Quantitative Easing.

And the way this will work out is a lot more insidious (and I might even venture sinister) that most of us think about this issue on first pass. From my last blog post:

"...What all of these posts talk about and discuss is what I believe (again, this is all simply my opinion, nobody has a crystal ball on this one) to be the biggest threat to our “money”, and that is inflation.

I believe that every signal that the Fed has given, both in rhetoric and action, is that it will try to spur the economy / avoid economic collapse by monetizing the debt of the Federal Government and all the Financials that made bad mortgage bets. The newest euphemism for this activity is Quantitative Easing. And this will be an unprecedented transfer of private debt to public debt (largest in the history of mankind). Bond rates are already beginning to signal the inflationary hazard of this policy DESPITE the fact the one of the main goals of QE was to put a floor under bond prices (put a cap on bond rates)..."

So here is the QE plan, Part A: The government needs to service the debt (pay the interest owed) on Treasury bond, otherwise it will lose its credit rating (.... uhhhh.... yeah) and then truly be bankrupt. In order to do this, the Fed is buying more Treasury bonds from, yep, the Treasury so that it can a) service the debt on the outstanding treasuries and b) allow the government to continue to run budget deficits. Basically the Fed is issuing new money (out of thin air) to buy new debt to service old debt and to allow the government to run further into debt. And no, you did not read that incorrectly.

QE plan, Part B: Monetary Inflation. Remember in Part A I talked about creating money out of thin air?.

".Now I said the US Dollar is backed only by debt. Remember above that the US Dollar (or more specifically the US money supply) derives it value from the fact that it is a claim on the future tax of US citizens. This is a finite amount (the maximum of course being 100% tax on all citizens). But the point to realize that this is conceptually finite. On the other hand, the Federal Reserve has no limit as to the amount of fiat dollars it can produce.

Increasing divisions (more fiat dollars created out of thin-air) of a finite resource (the future taxes the US money supply is claiming against) make each division, both old and new, by definition less valuable.

This is the definition of monetary inflation.

Who does monetary inflation benefit the most? Debt issuing nations. The old debt is denominated in the same amount of dollars. The size of the debt that needs to be serviced does not grow simply because the money supply grows. So the Treasury can service the old debt with newly devalued (or inflated) dollars, which we new have a lot more of.

QE plan, Part C (they nasty one with lots of unintended consequences): . This aspect of the plan is to buy back toxic assets off of Bank/Financial balance sheets. Like I said in part A, the plan is to keep long term bond rates low, to keep general market interest rates low, so that (hopefully) consumers can refinance (borrow) their way out of their current troubles and spur consumer spending .... Ta-da! ... (uh, okay). The what this ends up being is the largest transfer of private to public debt in the history of mankind, all in the name of more borrowing! *Moral hazard alert*

But lets not even talk about the moral hazards, (because I can't do anything about it), lets follow the money and see if we can guess some outcomes.

So, like I said at the beginning of this thing, a common deflation argument is "the Fed can't push on a string". And for consumer spending this is true, The Fed can buy up every single bank asset and monetize every public and private debts, and that does not mean that consumers will borrow.

But here's the kicker, they no longer need to.

The Fed clearing the balance sheets of Financials AND growing the money supply (which banks access) to *unprecedented* (quite literally) levels, has created a new avenue for this monetary potential energy to leak out of the reactor core of the financial system.

Banks and Financials are not stupid. They may be unscrupulous, they may bend the rules, some may even be crooked, but one thing they are not is stupid.

They see the writing on the wall. The Fed is monetizing debt left and right, and bonds are FAILING! We are in a bond bubble. If you don't think so .... well, there is very little point to this whole conversation then. I believe it is self evident that we have a long term Treasury bubble that has been building for more than 50 years (to clarify, the rising value of Treasuries was not bad when we had legitimate GDP to back it up, but the rise the last 15 years has simply been because the US Dollar is a reserve currency, and NOT due to fundamental economic growth). Rates are rising from a panic low (panic high in bond prices) and now they have only one way to go: up.

To anybody who watches these things, the message is clear: risk is rising.

Monetary Inflation is already baked in based on the borrowing spree of the Treasury. That train is nearly unstoppable now, the new debt - service old debt - run budget deficit triangle is fully self-perpetuating now. Only with a huge slash in the size of government and tightening of all spending will stop that cycle now. But raise your hand if you think that is happening.

To outperform the debilitating effects of monetary inflation, based on the signals from the bond market, financials will find ways to outperform for themselves, their shareholders and bondholders. And that means taking risk, that means speculation, and I believe that ultimately means real assets. I think this newly freed up credit will find its way into hedge funds and will ultimately find its way into the main beneficiary of monetary inflation. Real assets, because they cannot be inflated. I think commodities will be by far the biggest beneficiaries.

Everything that the Fed is doing guarantees, promotes even, the taking of risk. And all of this risk taking and speculation into real assets leads to, yep, price inflation.

As always this is my take, my opinion, and my $0.02.    

What this means for the US Dollar

Honestly? I think the US Dollar is going to tank.

I think Treasury bond rates are going to rise, and they are going to rise substantially. As rates rise because the Fed is unable to keep a floor under bond prices (because I QE is going to fail big time at "providing confidence and stability to the bond market"), Foreign debt holders are going to dump bonds. Foreign governments are not stupid too. The see a rising Treasury Rate on the Worlds Reserve Currency as a sign of increased risk, and they too will put their money into real assets. So when the Foreign governments dump bonds, the Fed has to buy EVEN MORE to try to put a floor under bond prices. This is a positive feedback loop. Both the Input is positive and the Gain is positive, and the on/off switch is stuck in the ON position.

Here is another thought that I stand behind:

"An argument that I have heard going around is that the US will be in a relatively stronger position as the currency devaluation wars goes down. The US is not the only economy in trouble. Far from it in fact. Nearly all Central Banks will be engage in a currency devaluation war. The main purpose of which is to make the debt servicing burden easier for all of the interest paid on Treasuries held by foreign governments. Whether the US comes out on “top” in this “strongest among the weak” battle (which I remain skeptical of, considering the size of the US debt the size of the ongoing QE programs) is irrelevant from my point of view.

Because having a currency that is “stronger” than your competitors while you are devaluing your own, still puts your currency in a weaker position relative to a currency that is not being devalued.

And what currency would that be? Gold.

This is the ultimate reason why I believe that gold is one of the few legitimate bull markets. Because I believe the US and most other Central Banks will try to inflate their way out of this mess. The US Dollar will undergo a huge devaluation in both real and nominal terms. And gold utility and true value comes during times of economic crisis (which I believe we will have a lot more of) and during times of weak currency confidence."

I think all of this risk and speculation not only hurts the Dollar, but is a huge confidence blow to the strength of the worlds reserve currency. I think the US Dollar Index or most USD Forex pairs will trend down over the next several years and gold (especially gold) and commodities will trend up.


Sorry, I am running out of steam again. Here are charts on the True Money Supply (TMS). Notice not only is it at is highest level ever, but recently the growth is accelerating!! Also here are my counts and trendline, S/R charts for the US Dollar (and UUP for a recent intraday proxy)

The trend is down. I don't like it. I HATE IT in fact. But I do recognize that things are they way they are, and not what I want them to be.

So with all of this, I am sharing my thoughts. I am not trying to convince or to lecture. This is a post for the sake of discussion. I have been doing some serious thinking on this issue for a very long time, and I think I have a (hopefully) valuable perspective on it.

Of course, as always, all of this is just my $0.02 .... :)

Assuming You Believe Any of My Analysis Above, What Makes Sense as a Long Term Investment?

Note my specific terminology "long term investment". Not trades, not something to be held for 3 months or 6 months, but what makes sense for the long term (5-15 years). For myself (I am not recommending anything to anyone else, just sharing my own thoughts on how I see the situation), the answer is primarily gold with commodities as a close second. Real Assets makes the most sense. Given the economics weakness, and the inflationary Quantitative Easing policies designed to combat / offset the weakness, real assets make the best protection. Not cash, and absolutely not Treasuries.

Will gold or oil go down in the short term? Maybe, perhaps even likely. How much? Don't know. How long might they correct? Don't know. And moreover, I do not care.

I have no interest in holding large amounts of "fake money" (US Dollars) to try to time the best purchase of "real money" (Gold). Others may play that game or even advocate it. I will not. I believe a currency crisis in the US Dollar is highly probable, if not inevitable. And maybe there will be warning signs, or maybe there won't be. This is a Black Swan event in the making, which makes the timing by definition unpredictable.

So in my investment account: I am in gold now, and I add on pullbacks.

Instead of me talking about gold here, I have a whole post very specifically focused on it, and I would highly suggest that you read it: The Gold Blog. Gold/Silver/GSMs (and a little Oil for good measure) Sept 11, 09


Please feel free to comment, disagree, discuss. And even if you don’t agree with my conclusions, please rec if you appreciate the effort or the explanation of my thoughts, even if you use them draw different conclusions than mine.

The binv standard disclaimer: This in no way constitutes investing advice. All of these opinions are my own and I am simply sharing them. I am not trying to convince anybody to do anything with their money. I am simply offering up ideas for the sake of discussion. As always, everybody is expected to do their own due diligence and to ultimately be comfortable with their own investing decisions.
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