I found a provactive post on the Barrons Online site this week. It was authored by Randall Forsyth, one of Barrons' editors. The idea proposed is that commodities will decline as a result of a backlash or reaction against recent trade deficits in the USA. I accept this argument over the intermediate term. I still think Commodities are in a long term bull market, but it won't surprise me if they take a couple years off while the world economy adjusts to their higher prices.
A strong argument can be made that American trade deficits will continue shrinking due both to a weakening global economy, already under way, and a domestic political reaction reinforced by election pledges of the two Presidential candidates. Specifically, protectionist actions as pledged by Obama, an increase in taxes on the wealthy and corporate windfall taxes against several multi-national companies will all accelerate a shrinking of the American trade deficit. At the same time, to counter inflation imported from America, foreign treasuries will dump their dollars and tighten their own lending standards to reduce liquidity. The net effect is to create a dollar deflation, rather than inflation. It will also raise our own Treasury interest rates as there will be less foreign demand for dollars. This reduces economic stimulus domestically.
As trade deficits decline and move toward a surplus, the dollar naturally strengthens. A stronger dollar is inherently bad for commodities priced in dollars. But what would be bad for commodities would ultimately be good for domestic financial based industries like Banking and Technology. We may be at a crossroads, so consider this possibility while planning your investment strategy for the next six to 24 months.
THURSDAY, AUGUST 21, 2008
UP AND DOWN WALL STREET DAILY
Is the Global Liquidity Tide Turning?
By RANDALL W. FORSYTH
MY INVITATION TO HOB-NOB with the world's monetary muckety-mucks in Jackson Hole this weekend got lost in the mail, yet again. Amidst the Grand Tetons of Wyoming, the Federal Reserve hosts its end-of-summer junket for the movers and shakers and hangers-on to discuss the key monetary matters of the day.
Too bad they are little more than corks tossed on violent seas of global forces totally beyond their control.
The inflationary surge now hitting the U.S. is being felt in spades overseas. Countries that have linked their currencies to the dollar, either explicitly or de facto, are feeling the price effects of the greenback's slide in the past seven years. But as the credit crisis pushes the U.S. economy into recession, the process that pushed prices up abroad could go into rewind.
In a world that's become so interconnected, it seems almost superfluous that what happens in America doesn't stay in America. But it goes beyond the old saw that when the U.S. sneezes, the rest of the world catches cold. The U.S. economy, while the largest in the world, no longer is as dominant. So, the process takes some explanation, so bear with me.
To varying extents, countries in Asia and elsewhere in the world for the past decade or so have tried to keep their currencies' exchange rates relatively stable with the dollar. The U.S., after all, was their best export customer and they all wanted to keep it that way. The key example has been China, which had held the renminbi's exchange rate versus the dollar in a tight band.
With China's burgeoning trade surplus with the U.S., Chinese exporters would accumulate a surfeit of greenbacks. Under freely floating exchange rates, the dollar would decline and the renminbi would rise.
To prevent that, China's central bank would buy up the surplus dollars to keep its currency within a tight band. In the process, the central bank sells renminbi, thereby increasing their supply. The process is the same as Money and Banking 101 textbooks, where the Fed buys Treasury bills, increasing banks' reserves and thereby the money supply.
Other Asian countries, not wanting to lose export competitiveness to China, similarly buy dollars to keep their currencies capped. In the process, they also expand their domestic money supplies.
Of course, these central banks don't keep greenbacks in their vaults but invest the dollars in interest-bearing assets, such as Treasury securities, agency securities such as those from Fannie Mae and Freddie Mac, and U.S. mortgage-backed securities. Private institutions such as banks and insurance companies got funkier and bought higher-yielding mortgage paper rated triple-A but backed by subprime loans.
Economists dubbed this ad-hoc arrangement as Bretton Woods II after the quasi-fixed exchange-rate system lasting from the end of World War II until the early 1970s. Under Bretton Woods I, currencies would be exchanged for dollars at a fixed rate. The dollar, in turn, would be redeemable in gold at $35 an ounce to foreign monetary authorities (U.S. citizens couldn't turn in their greenbacks for gold.)
When the U.S. external deficit grew and foreign central banks found themselves with more dollars than they wanted, they sought to exchange them for gold. On Aug. 15, 1971, President Nixon ended that pledge to redeem dollars for gold, and a year and a half later, the present system of floating exchange rates came into being.
Under Bretton Woods II, foreigners would hold dollars out of their self interest, not because of any U.S. pledge behind its currency. Be that as it may, for years it has been a wonderful system rivaling perpetual motion. The more Americans spent in excess of their income, the more the rest of the world lent to them. That resulted in the famous "conundrum" described by former Fed Chairman Alan Greenspan—that longer-term interest rates remained relatively low even as the U.S. central bank hiked short-term rates.
To be precise, the U.S. current account provided a river of dollar liquidity to the rest of the world. Some of it was offset—sterilized in monetary parlance—by foreign central banks by raising interest rates, increasing bank reserve requirements or selling bonds. For the most part, however, the process inflated the credit bubble.
Like its predecessor, Bretton Woods II became an engine of inflation. Buying up the excess dollars forced banks to expand their money supplies, sending inflation skyward. Some countries that had tied their currencies to the dollar, such as Kuwait, abandoned that peg to fight inflation and no longer import the effects of America's profligacy.
The debasement of the dollar was most evident in the price of gold, which climbed from around $300 an ounce at the turn of the century to a peak of $1,000 last spring. As with the breakdown of Bretton Woods I, this fall in the dollar is being manifested in a surge in oil and other commodities. Foreign economies, which are more dependent on tradeable goods, are feeling this upsurge in prices most acutely.
But is this engine of inflation, the credit bubble that resulted in the massive U.S. external deficit, about to go into reverse?
At this point, it is speculative to conclude that. But alert investors should consider that possibility.
Indeed, Barron's Roundtable member Marc Faber suggests this could happen in his latest missive to subscribers to his Gloom Boom & Doom Report.
A declining U.S. current account deficit could lead to a tightening of global liquidity as foreign central banks accumulate less dollar reserves, which are recycled into the global capital markets. The U.S. current account gap has shrunk from a peak over 6% of gross domestic product to under 5% as weakening consumer demand has cut imports while exports remain relatively robust as growth continues in emerging economies and the dollar is cheap.
As the growth of foreign monetary dollar reserves slows, the dollar is boosted and gold and commodities are hurt, Faber points out. Further, he writes:
"I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, globally liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the U.S. current account deficit by half and lead to a very strong U.S. dollar."
Let's recap. The credit crunch that has resulted in the U.S. recession (that's yet to be officially recognized) is being transmitted abroad by the reduction of the U.S. current account deficit and the quasi-fixed exchange-rate currency system.
Indeed, if Asian currencies begin to come under downward pressure, either in an international flight to quality or as a consequence of a declining trade surpluses, their central banks could use their cache of foreign exchange—mainly dollars—to stabilize their exchange rates. That would turn them into sellers of dollar assets or at least less vigorous buyers.
The inflationary tide in global liquidity could be turning as a result. The sharp break in gold suggests that could be happening, and that's being transmitted through the commodities markets. The dollar has stopped going down, and even has flattened out against the renminbi. The bear market in risk assets, such as stocks and particularly the Chinese market, also is symptomatic of a liquidity squeeze. As for the U.S. housing market, it is at the nexus, resulting in wealth losses for borrowers and a reduction in lenders' ability and willingness to extend credit.
That's something that the crowd in Jackson Hole can scarcely control. So they might as well enjoy themselves on their junket.
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