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Good read - How USD will play out

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  • Good read - How USD will play out

    This is a good article which describes the likely playout of US Dollar and US assetts.


    http://ndknotepad.blogspot.com/2009/...est-rates.html

    Originally posted by NDK Blog
    Vendor Financing, Real Interest Rates, and the USD

    The Fall of the Dollar


    Over the last decade, a number of countries have forced their currencies to be abnormally weak against the dollar. This resulted in two major effects.

    First, there was rapid growth in exports across Asia with a concurrent rise in their trade surplus. These goods and services were artificially cheap to US consumers. This export surge also occurred in major commodity producing countries as they revved up to support the export-driven industrial boom occurring. Some commodity producers directly pegged themselves to the dollar, like the Middle East, resulting in further recycling flows.


    The second effect, caused by the first, was a tremendous accumulation of dollar reserves by pegging countries. These dollars were invested by those countries into risk-free assets, driving down real interest rates on longer Treasuries and leading to Greenspan's famous conundrum. Private investors moved to spread assets and bid them far beyond rational prices, compressing spreads and interest rates across the risk spectrum.


    These recycling flows were vendor financing on a massive scale. Without the pegs, US real interest rates would have soared, halting the process. Instead, a tremendous drop in real interest rates caused by this vendor financing enabled US consumers and corporations to take out stunning amounts of debt via HELOC's, asset bubbles, cov-lite loans, and so forth.


    Through this financial intermediation, more and more money was available to the US to purchase commodities and finished goods from the rest of the world. The rest of the world bought more Treasuries and other safe debt, causing asset values to soar and interest rates to drop. This was all a positive feedback loop.


    A lot of people saw the massive deficits being run by the US and thought the USD must inevitably crash. The consensus was that the USD would crash should China cease its massive reinvestment of its surplus. Indeed, the USD weakened gradually for many years in a row.


    Compiling this, I posit a completely different explanation. The weak USD was a result of the vendor financing. As real interest rates were abnormally compressed by return-insensitive central banks, private capital fled the US to other destinations in search of higher real returns. Because USD was unable to weaken against CNY, it weakened against other currencies instead, making the real returns available even worse.


    The strength of EUR and GBP was partially an export valve for some of the pressure on USD/CNY. As EUR and GBP strengthened against the USD, the asset bubble spread, and they picked up the consumer of last resort role from America's weary citizens.


    The Rise of the Dollar


    I first became concerned in February that the Earth's magnetic pole had flipped, making this powerful engine turn in reverse.



    The weakness of the USD did begin to turn around in March, as the financial crisis began to affect trade in finished goods. It finally truly reversed upwards with the final bursting of the commodity bubble, and it's strengthened ever since.


    Everyone is terrified the USD will continue to fall, mainly as a result of the massive quantitative and qualitative easing schemes underway by the Fed, the persistent current account deficit, the U.S. NIIP position, and so forth. I'm scared too, and I want to remain that way. But I can't justify my fear, and haven't been able to for awhile.


    The USD cannot weaken against the CNY or JPY, and I'm very skeptical that there is any positive traction whatsoever from the fiscal and monetary programs underway. While there is a great deal of disagreement about what determines exchange rates, it's probable that relative real interest rates matter far more than money supply. And those are only moving in the USD's favor right now.


    Indeed, government deficits raise real interest rates, rather than suppressing them. This is intuitively obvious and empirically demonstrable, but theoretically indeterminate, which confuses economists everywhere. Whether that is true in a liquidity trap environment, or whether we're in a liquidity trap now, remains up for debate. But I don't see any reason to believe, outside a stylized AD/AS curve and baseless Keynesian multipliers, that the rules should not still hold.

    The effects of an insolvent Fed's debt load are the same as that for Treasury debt, which means that all these stimulus and rescue programs, including direct monetization, should only lead to higher real interest rates. Since the dollar can't lose value right now by imposition of the pegging countries, and nominal interest rates have hit the zero bound, I conclude that fiscal stimulus and debt monetization will strengthen the dollar and worsen deflation. Until the pegs are broken or serious inflation erupts in the rest of the world, this is the only possible outcome.


    We have seen a further collapse in trade since September which is only worsening, lessening the odds of these pegs breaking, and reducing further the vendor financing that can be recycled. I expect to see further increases in US real interest rates.



    The USD should continue to strengthen until serious inflation occurs in China, Japan, and other countries, or the pegs break. Until such a time, due to the increase in real interest rates and the damage inflicted by deflation, most assets, and particularly longer-dated ones, will decline in value.


    If the pegs never break, and inflation never erupts overseas, then we can expect a massive wave of defaults in the US, possibly including Treasury. So, in perhaps the most likely outcome, USD assets could crash while the USD pulls through just fine.

  • #2
    Re: Good read - How USD will play out

    the question one has to ask is not if, but when, the pegs break.

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    • #3
      Re: Good read - How USD will play out

      Interesting concept - but I'd like to see some data behind this assertion that the UK and EU will take up the burden of consumer of last resort.

      While the most recent report on the UK's trade deficit shows it has grown from 8.3B pounds from 7.6B pounds (from October 2008 to November 2008), on the other hand the pound itself is off 25%. That alone would increase the gap.

      http://www.telegraph.co.uk/finance/f...s-to-help.html

      Of course the pound fall is fairly recent so it will take some time to fully reveal the ultimate impact.

      For the EU the most recent numbers show a 23.8B euro deficit vs. a year ago 17B euro deficit (November 2008 vs. November 2007)

      http://www.washingtonpost.com/wp-dyn...011601122.html

      In contrast the US trade deficit was $40.4B in 11/08 vs. $56.7B in 10/08.

      Of course there are energy considerations, but the $16.3B fall in the US deficit hardly corresponds with the 6.8B Euro and 0.7B pound deficit increases.

      Comment


      • #4
        Re: Good read - How USD will play out

        Originally posted by sishya View Post
        This is a good article which describes the likely playout of US Dollar and US assetts.


        http://ndknotepad.blogspot.com/2009/...est-rates.html
        What happens if oil reverses to the upside because Saudi-Arabia turns the tap off and because Alberta can't pump at losing prices forever? What happens to oil if oil producers just give-up, close-up, and go on an extended vacation in the South Seas?

        I posit that falling U.S. asset values may be joined (and re-enforced) by a growing trade deficit (to buy oil) and a falling U.S. dollar. This would begin the next stage of the death spiral in the U.S. economy: the banana republic stage complete with dollar decline and inflation. The Obama deficits in the federal budget which could reach beyond half-a-trillion dollars per year would nicely re-enforce this death spiral.

        The real sad ending for the U.S. dollar ( the ultimate leg down ) could be when foreign investors begin to realize that the Obama deficits have more to do with Keynsian economics and domestic politics than with a solution to replacing America's foreign imports of oil with domestic supplies. So the failure of solar energy and the failure of windmills to solve the energy shortage will compound the misery of the recession and accelerate the dollar's decline.
        Last edited by Starving Steve; January 16, 2009, 09:36 PM.

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        • #5
          Re: Good read - How USD will play out

          Speaking of foreign investors, US debt, inflation, and a devaluing dollar, if the US taxpayer pays billions, perhaps a trillion+, for infrastructure improvements and new construction, has there ever been restrictions on infrastructure debt written into the legislation funding that prohibits foreign investors from buying state and/or US infrastructures such as bridges, highways, off-ramps, etc. and turning them into toll generating income? I'd rather have toll booths run by our state and/or federal government generating income for the US treasury than having it sequestered in some off-shore tax free account of a foreign investor. Seems a new infrastructure item might just be an attractive target for substantially devalued dollars by a new foreign investor and/or in lieu of US debt owed to a SMF,foreign country, foreign central bank, etc...wouldn't it?

          Comment


          • #6
            Re: Good read - How USD will play out

            The day of paying bridge tolls or road tolls to some corporation seated in the Isle of Man or the Cayman Islands (or some place similar) is just around the corner, especially for the Americans. Jurisdictions (such as California) now facing bankruptcy may have to sell their roads and bridges.

            Comment


            • #7
              Re: Good read - How USD will play out

              Originally posted by vanvaley1 View Post
              Speaking of foreign investors, US debt, inflation, and a devaluing dollar, if the US taxpayer pays billions, perhaps a trillion+, for infrastructure improvements and new construction, has there ever been restrictions on infrastructure debt written into the legislation funding that prohibits foreign investors from buying state and/or US infrastructures such as bridges, highways, off-ramps, etc. and turning them into toll generating income? I'd rather have toll booths run by our state and/or federal government generating income for the US treasury than having it sequestered in some off-shore tax free account of a foreign investor. Seems a new infrastructure item might just be an attractive target for substantially devalued dollars by a new foreign investor and/or in lieu of US debt owed to a SMF,foreign country, foreign central bank, etc...wouldn't it?
              This will happen. There was a bill on the table in the PA state House last year regarding a Citi-Abertis (Spain) takeover of the Turnpike for $12b, for a forty-year lease. It failed miserably, as it was politically impossible for many newly-elected House members to vote for it, given its unpopularity.

              Opponents of the turnpike lease plan often cited the likelihood of a foreign company operating the 500-mile roadway. "There's no more American institution than Citigroup," Rendell said. "And Abertis already operates and manages several [projects] in the U.S."
              http://www.bizjournals.com/philadelp...9/daily10.html

              At the time of Rendell's quote, the two largest investors in C were Barclays (UK) and Kingdom Holdings (Saudi Prince Al-Waleed).

              Here's two more stories:
              The Cheap Pennsylvania Turnpike
              Pennsylvania Gets Turnpike Bid From Abertis, Citi

              I expect this issue to return in PA, as the state needs the revenue and House Republicans blocked the tolling of Interstate 80, which is a better measure, IMHO.

              Comment


              • #8
                Re: Good read - How USD will play out

                there's no doubt that asian currency pegs pushed dollar weakening to excess v. gbp and eur, witness the distortions in purchasing power parity. i've seen discussions of a radical yuan devaluation if the chinese try to re-pump their export machine. this might likely trigger a protectionist reaction in the u.s. alternatively, schiff's scenario has long been that the asians would suddenly awaken to the fact that if they revalue UP their costs for food and energy would suddenly plummet. interesting times....

                Comment


                • #9
                  Re: Good read - How USD will play out

                  Originally posted by jk View Post
                  there's no doubt that asian currency pegs pushed dollar weakening to excess v. gbp and eur, witness the distortions in purchasing power parity. i've seen discussions of a radical yuan devaluation if the chinese try to re-pump their export machine. this might likely trigger a protectionist reaction in the u.s. alternatively, schiff's scenario has long been that the asians would suddenly awaken to the fact that if they revalue UP their costs for food and energy would suddenly plummet. interesting times....
                  schiff lack a 'ka' in his model... a period when every country wants a weaker currency to battle domestic deflation. he's hung up on the idea that the dollar will collapse... the share price of usa inc. will crash... because usa inc. is run by nincompoops and foreign central banks will panic sell... while the pols in washington pray that they do and that it does... at least a bit

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                  • #10
                    Re: Good read - How USD will play out

                    No hyperschiffs!? :eek:

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