the amazing shrinking dollar

So far this year, the US$ has fallen by about 14% against the €, and around 8% against the ¥ and £.

A substantial portion of this movement is giveback of the sharp dollar appreciation which happened last year after the surprise election of Donald Trump as president.  That was sparked by belief that a non-establishment chief executive would be able to get things done in Washington.  Reform of the income tax system and repair of aging infrastructure were supposed to be high on the agenda, with the resulting fiscal stimulus allowing the Fed to raise interest rates much more aggressively than the consensus had imagined.  Hence, continuing dollar strength on a booming economy and increasing interest rate differentials.

To date, none of that has happened.   So it makes sense that currency traders would begin to reverse their bets on.  However, last year’s move up in the dollar has been more than completely erased and the clear consensus is now on continuing dollar weakness.

 

Dollar weakness has caused stock market investors to shift their portfolios away from domestic-oriented firms toward multinationals and exporters.  This is the standard tactic.  It also makes sense:  a firm with costs in dollars and revenues in euros is in an ideal position at present.

It’s interesting to note, though, that over the weekend China lifted some restrictions imposed last year that limited the ability of its citizens to sell renminbi to buy dollars.

To my mind, this is the first sign that dollar weakness may have gone too far.

It’s too soon, in my view, to react to this possibility.  In particular, the appointment of a new head of the Federal Reserve could play a key role in the currency’s future path, given persistent Republican calls to curtail its independence.  Gary Cohn, the establishment choice, is rumored to have fallen out of favor with Mr. Trump after protesting the latter’s support of neo-Nazis in Charlottesville.

Still, it’s not too early to plot out a potential strategy to benefit from a dollar reversal.

 

 

The financial crisis and the renminbi

As I apparently never tire of writing, the financial crisis that came to a head five years ago has resulted in an extended period of emergency ultra-low interest rates.  The tried-and-true idea behind this is to give economic activity a boost by making loans carrying negative real interest rates readily available.  “Free” money should make anyone with a pulse willing to borrow and spend.

In the past, these low-interest periods engineered by the Fed lasted at most a year.  We’re now into year six of the current episode.

One result of this extremely long emergency period is that fixed income investors are currently lapping up low-coupon Italian, Greek…even Iraqi..sovereign debt.  And crazy (in my view) fixed income products like contingent convertibles, no-covenant junk bonds and pik (payment in kind) junk bonds, where interest is paid in new bonds, not cash, are all finding eager buyers, as well.

Another is that savers living on interest payments (increasingly Baby Boomers), who are in effect subsidizing the financial rescue, are suffering.  In fact, Millennials have just surpassed Boomers as the most important single demographic force in the US economy.

All of this is well-known.

Another development, though, which may turn out to be the most important in the long run, has escaped notice so far.  It’s the increasing acceptance of the Chinese renminbi in world trade and in investment.

Fifteen, or even ten, years ago, China was content with the fact that all of its trade was effectively done in dollars.  Beijing let Treasury bonds pile up in its coffers, to the point where it rivaled–and the surpassed–Japan as the largest creditor of the US.  It had become uneasy about this situation even before the financial crisis.  Stunned by the meltdown of 2008-09, China decided to offer its currency as a substitute for the dollar.

Until the past year or so, the renminbi has drawn pretty close to zero interest.   This is partly because at first it wasn’t easy for either foreigners or Chinese parties to use the renminbi in trade.  Also, foreigners can’t spend “offshore” renminbi in China itself.

Yes, the renminbi is easier to use today.  But I think a big reason the renminbi is suddenly extremely popular now is the very low-interest rate environment we’re in.  Multinationals with Chinese operations can save 3% – 5% by settling Chinese trade transactions in renminbi.  In other circumstances, this might not be worth the hassle.  But if your cash balances are earning effectively zero and if you have to buy a pik bond or Iraqi debt to get a 5%+ yield, then switching from dollar to renminbi trade settlement is a relative bonanza.

This movement seems to be feeding on itself.  It’s causing very rapid growth in renminbi use, admittedly from a low base.  I don’t think this development has any important immediate investment consequences.  But it could end up making a profound (negative) impact on the dollar and the euro if it continues–as I expect it will.  The ultimate result would be to make renminbi earners much more attractive as investments than they currently are.

The big investment question is when the inflection point will come, when the renminbi will begin to be regarded as a viable alternative to the dollar as the world’s reserve currency.  Perception will likely precede reality by a long stretch   …although I don’t think the tipping point will come this year or next.  I view this as something important to keep in mind, however, so we can recognize what’s happening if this trend develops faster than I now think it will.

 

China calls for a “de-Americanized” world

China editorializes

Over the weekend, Xinhua, the official Chinese news agency, wrote an editorial, sparked by Beijing’s worry about possible US debt default, but also addressing its general concerns about the military, political and economic dominance of the US in the world.

Xinhua says:

” instead of honoring its duties as a responsible leading power, a self-serving Washington has abused its superpower status and introduced even more chaos into the world by shifting financial risks overseas, instigating regional tensions amid territorial disputes, and fighting unwarranted wars under the cover of outright lies”

Therefore, fundamental change is needed.  Along with renewed respect for international law and increasing reliance on the UN, 

“What may also be included as a key part of an effective reform is the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.”

my take

These sentiments aren’t exactly new.

Internally, the faction of the Chinese Communist Party that controls the investment of the country’s gigantic accumulated current account surpluses has got to be very worried that it will take the political fall for any loss on China’s Treasury bond holdings if the US defaults.  That’s what political infighting is all about.  And loss could come either through rising interest rates or a decline in the value of the dollar.  Important, then, to get the story out that the real villain is, as usual, the US.

At the same time, the editorial underlines the immense power that the US wields because the dollar is the world’s  de facto reserve currency.  For the US, it’s like owning the bank and being able to write/cash a check to yourself whenever you please.  You also get to defuse internal economic pressures by exporting them to the rest of the world through the currency.  

The US won’t lose this central role in world commerce any time soon.  However, an unintended consequence of the current Washington rhetoric of embracing default as a political tool–and the prospect of more of the same to come–may be a serious China-led effort to decouple from the dollar.  

Potentially very damaging to the US   …but a long time away.  

The imponderable here is the discounting mechanism in the financial markets.  Were large international banks and foreign government managers of their countries’ financial reserves to sense the possibility that a move away from the dollar might actually happen, their defensive measures (selling the dollar) could come very far in advance of the facts.  In other words, a move away from the dollar could snowball.

As investors, I think we have to be concerned that the role of the dollar as world reserve currency may not be as secure as the consensus thinks.  Personally, I’m a long way from acting on this possibility.  But it’s a lot higher up on my list of worries today than it was a month or two ago.

 

defaulting on the government debt: what it would mean

debt ceiling crunch time

According to the Washington Postthe letter Treasury Secretary Jack Lew recently sent to Congress said that in mid-October, the Treasury will reach the legislatively imposed upper bound on borrowing to pay for goods and services that Congress has ordered up.   That’s a problem, because Washington’s spending so far this year has exceeded its income by about $100 billion a month–and that’s even after the sequester kicked in.

D-Day is October 17th.

The Treasury figures it will have $30 billion on hand on that date.  Bills coming due can reach as high as $60 billion in a single day.  The current layoff of large numbers of Federal employees through the Tea Party-created shutdown might “save” $5 billion a month, but that doesn’t move the needle much.

what if Congress doesn’t act?

If Congress doesn’t raise the debt ceiling, two related problems arise:

–someone has to decide who gets paid and who doesn’t.  The biggest chunks of spending are Social Security, Medicare/Medicaid, the military and interest on the Federal debt (which alone averages about $33 billion a month), and

–inevitably there’ll come a day when the till is empty and the Treasury either misses an interest payment or, more likely though a rollover timing issue, a principal repayment on Treasury securities.  That’s a default.

what default would mean

Secretary Lew is saying that a government debt default could/would create an economic crisis bigger than the bank failures of 2008.

Yes, I think the inevitable default that would come from not raising the debt ceiling would be a major shoot-yourself-in-the-foot moment for the country.  Worse than 2008, though?

…unless we’re talking about possible very long-term consequences, I think this is possible but not probable.  On second thought, minimizing the damage would require Congress to realize what an idiotic thing it had done and “cure” (as the technical term goes) the default immediately.  The more reluctance by Washington to do so, the closer to the Lew scenario we get.

Default would have several important negative consequences:

slower economic growth

–by not paying on time, the US would establish itself as an unreliable borrower.  Lenders, both foreign and domestic, would therefore demand a higher interest rate for the use of their money.  How much higher?  That depends a lot on Congress, but basically no one knows.

–given Washington’s dysfunction, the only effective tool of macroeconomic policy the country has is the Fed.  To at least some degree, the Fed would lose its ability to influence rates if investors begin to regard Treasuries as risky securities.  That’s not good.

weaker currency

–the move among emerging countries to replace the dollar as world currency with, say, the renminbi, would kick into higher gear.  This would risk the US losing the perks of being the world’s banker–lower interest rates, ease of borrowing.

–in extreme circumstances, global buyers and sellers might lose enough confidence in the dollar that they’d refuse to accept it in trade.  This might freeze global commerce in the same way that was so devastating to the world in late 2008-early 2009, when firms wouldn’t take bank letters of credit.  That could be really ugly.

 

There is, of course, the issue that adding $1 trillion+ a year to the Federal debt isn’t a sustainable plan for financing the Federal government.  And business-as-usual Washington has no tolerance for addressing the holy trinity of budget-busters–the military, Social Security and Medicare/Medicaid.  Still, puling the house down around everyone’s ears isn’t a great solution, either.

 

 

S&P downgrade of US sovereign debt: investment implications

what S&P said

After the stock market close in New York last Friday, Standard and Poors’ Ratings Direct issued a research report in which it downgraded the long-term credit rating of the United States from AAA to AA+, with a negative outlook.

According to S&P, “negative outlook” means that there’s at least one chance in three that it will downgrade the US further within the next two years.

Short-term paper remains unaffected, with a A-1+ rating.

its reasoning

Two main factors:

–the rising public debt, and

–the fact that “elected officials remain wary of tackling the structural issues” in a way that AAA countries are expected to do (which I read as meaning that S&P regards government in Washington as a bunch of wannabe ballplayers wearing big-league uniforms and demanding big-league perks but who can’t hit the ball out of the infield ).

Apparently, the performance of all parties to the debt ceiling debacle was enough to make S&P revise down the opinion it formed in April.

who doesn’t know this already?

I think it would be hard to find any professional fixed income investor who isn’t aware the US has a debt problem.  In fact, over my thirty+ years watching the stock market, conventional wisdom (and actual experience) has always been that the rating agency opinions are lagging indicators of financial health.  To my mind, one of the crazier aspects of the sub-prime mortgage bubble is that professionals actually claimed they relied on the ratings, rather than doing analysis themselves–kind of like depending on last year’s calendar to tell you the day of the week.

As Casey Stengel would have commented, ” You could Google it.”   In round numbers, Washington has $2.5 trillion in annual income but spends $4 trillion.  Outstanding federal debt is already over $14.3 trillion, or about six years’ worth of gross income.  And that doesn’t count $40+ trillion in the present value of retirement and medical care promises Washington has made but hasn’t set aside the money for.

investment implications

short-term

There may be a day or two–if that–of negative reaction in both stocks and bonds to having the S&P shoe finally drop.  Otherwise, in the short term, I think there are no negative consequences.

Two other ratings agencies, Moodys and Fitch, have already reaffirmed their AAA rating of US sovereign debt.  So it’s unlikely that any large investor has a contract that will force it to sell Treasuries.

Besides, where else is there the same combination of liquidity and relative safety that still exists in Treasuries  …Japan?   …Italy?    I don’t think so.

In addition, as I mentioned above, this is scarcely a surprise.

longer-term

This is much harder to handicap.

On the one hand, the downgrade will doubtless cause China to increase its efforts to create a substitute for the dollar as the global reserve currency.  As Xinhua, the Chinese news agency puts it, “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”  In the same article, Xinhua also calls for international supervision of the issuance of dollar obligations, and the establishment of a substitute world reserve currency.

On the other,  Americans’ opinion of Congress is at an all-time (meaning since the Seventies) low, with 82% rating legislators unfavorably.  The New York Times, a Democratic bastion, just ran an op-ed piece arguing the country would be better off with Richard Nixon as president than Barack Obama.

It’s at least possible that the embarrassment of a national credit downgrade after 70 years of AAA will sharpen political debate and influence the next national election–coming in November 2012.  The groundswell appears to me to be already taking form.  If so, the public outcry may well influence, in a favorable way, the recommendations of the congressional committee being established to make budget-balancing recommendations as part of the debt ceiling deal.

Who knows.

I also think this event brings us closer–both in time and value–to a buying opportunity in world markets.  Today will be an interesting day to watch closely.

downgrade, default and Default: a Washington scorecard

framing the issue

1.  In round terms, the Federal government is taking in $2.5 trillion a year and spending $4 trillion.  It borrows the $1.5 trillion difference by issuing Treasury securities.

The main areas of government outlay are:

–military     25%

–healthcare     23%

–pensions     21%

–welfare payments     13%.

Interest payments on Treasuries amount to around $200 billion.  That’s 5% of total outlays, or 8% of tax receipts.  This isn’t a near-term concern, but imagine what would happen if fates started to rise.

2.  Congress periodically passes laws setting a maximum allowable level of federal government borrowing.  The current limit is $14.3 trillion (including things like government agency debt in addition to Treasuries).  The Treasury Department estimates Washington hit that limit in mid-May.  The Treasury can create wiggle room for a while–like keeping the proceeds of maturing Treasuries in federal government employee retirement funds under the mattress instead of reinvesting them.  Such stalling tactics will probably run out within a couple of weeks.

what can happen

rating agencies

Let’s look at the rating agencies first. 

S&P is saying that it wants to see some evidence that Washington will do something now to address the budget deficit and the accompanying buildup of federal debt rather than pushing action back until after the November 2012 election.  In the latter case, S&P argues, legislation will be passed in 2013 at the earliest and probably won’t take effect for some time after that.

If it doesn’t see action, chances are it will downgrade Treasury debt from AAA.  It has also said that if congress doesn’t act like grownups, it may downgrade for that reason alone.

Downgrade is unlikely to come as a shock to an institutional buyer of Treasuries, domestic or foreign, who will have seen US government finances steadily deteriorate over more than a decade, from surplus in 2000 to the current situation.

In theory, downgrade means that the US will have to offer higher interest rates to induce investors to continue holding Treasuries.   Maybe, maybe not.

To my mind, there are two big practical issues with downgrade:

1.  The more important is whether/how the role of Treasuries in the working of global financial markets will change.  This is a question of the rules that financial players have to follow, either because of legislation in their countries or their contracts with customers.

Will institutional borrowers have to put up more Treasuries to collateralize a given transaction than before?  Will investment companies be forced by their contracts with customers to hold fewer Treasuries than before?  Will they have to sell, or just let their holdings mature and not reinvest?  How will this affect the ability of corporations to get short-term finance?

At the very least there may be a period of adjustment that reduces the speed of financial transactions–and therefore economic growth.

2.  The second is how domestic retail investors will feel about Treasuries after a downgrade.  Will they withdraw money from money market funds that concentrate on government paper?  As I mentioned in an earlier post, money market funds are already bracing for withdrawals by emphasizing the shortest-term securities.  This is having a negative effect on the ability of some EU banks to tap short-term sources of funds.

default

This is a separate issue from downgrade.  It’s much more serious.

Mr. Geithner has been careful to say that if the debt ceiling limit isn’t raised the government will default “on its obligations.”  This is very different from saying that the government will default on its debt–either by failing to make interest payments or by not returning principal on maturity.

Without the ability to borrow, the federal government won’t be able to pay 40% of its bills, or about $130 billion worth a month.  Given that failing to service existing debt would be disastrous–also, given the fact that interest payments on Treasuries are only a drop in the bucket at present–the Treasury Department would certainly have debt service as its number-one priority.  So, as a practical matter, default on government debt is out of the question.

Which bills don’t get paid?  The Treasury Department decides.  One open question is how sophisticated its computers are.  Can they, say, pay every government employee below a certain pay grade and no one above?  Can they sent out checks to Social Security recipients for 60% of their entitlements?  Can they do the same with all defense contractors?

The choices Treasury might have to make would all be intensely political.  …don’t pay Congress, but pay the administration and the courts?

From an investor’s point of view, however, no matter where the cuts come, they would represent an immense fiscal contraction.  Whether cuts happened by accident or design, the damage to the economy would be substantial.

I don’t think that stock prices, either in the US or the rest of the world, contain even the slightest discount for the possibility that this could actually occur.

Why the current weakness in stocks?

I think it’s mostly uncertainty.  Worries about a possible economic contraction are causing companies and state and local governments to put spending plans on hold.  Citizens who rely on Social Security or unemployment benefits are also likely conserving, to the extent they can.

I also think that some investors are looking back to the TARP debate, when it took a plunge in the stock market to persuade congress to vote to prevent the domestic financial system from failing.  So they’re raising funds on the idea that the same pattern will recur.  I suspect, however, that in the convoluted way that Wall Street minds work, other investors are taking the contrary position.  They’re saying to themselves that the obvious pattern is the TARP episode; therefore, that’s the least likely outcome in the present situation.

Who knows what will actually happen?  The only thing I’m confident of is that congress would come under intense pressure to act if the flow of money from Washington were cut dramatically.  A partial government shutdown might also lead to substantial turnover in congress in the 2012 election.  Therefore, I think a possible period of shutdown would be very short.

renminbi as an international currency–more steps forward

About a month ago, I wrote a post summarizing the steps the Chinese government has already taken on its march to join the US dollar as a world reserve currency.  That is to say, Beijing wants the renminbi to be used not only as a reference currency in the worldwide trade in goods and services, but also to be held as a store of value in the coffers of the world’s private and government central banks.  Almost no one believes that’s Beijing’s final destination, however.  The ultimate goal, I think, is to supplant the dollar, rather than supplement it.

For a while now, China has been encouraging companies involved in international trade to construct and settle their transactions in renminbi instead of (mostly) dollars.  To this end, it has been allowing more of its currency to seep out of the mainland and be held legally in foreign banks, notably in Hong Kong.  In addition, it has been supplying currency to foreign central banks who want to provide renminbi to firms that make up their countries’ side of the deals.  One catch, though:  the money can get out of China very easily.  Getting it back in is another matter.

Last week, though, according to the Financial Times, Beijing took another step.  It is now encouraging Chinese companies that are setting up businesses or making acquisitions abroad to do their business in renminbi, as well.   Such deals have to be approved by Beijing, just as any foreign currency purchase would be.  Same catch, though:  easy to get the money out, but once the cash leaves the mainland, there’s no guarantee it can get back in.

Of course, interest rates are low, so the opportunity cost of holding renminbi in short-term deposits isn’t high.  And if you think the Chinese currency is undervalued, you may be willing to bet on having it appreciate.  So you might say it’s kind of like gold, only without the physical storage difficulties.

There are two conclusions that I think we can draw from this development:

–the targets are unlikely to be publicly traded companies in the US or Europe.  I can’t imagine pension funds or index funds voting in favor of deals that would land them with hundreds of millions of dollars worth of renminbi that they would have to dispose of.  I don’t this is that big a change in strategy, since Washington and the EU have made it pretty clear they’ll throw up all sorts of (mostly bogus) political obstacles to almost any deal where the buyer is Chinese.

–If this initiative is successful, China is going to be piling up lots more dollars.  China was involved in a tenth of the global merger and acquisition activity last year.  The Economist predicts, I think, that this is just the tip of the iceberg.  My take on this thrust, plus the foreign aid to Latin America and Africa, and the offers to buy the government bonds of ailing European countries like Greece, is that a good part of China’s motivation has been to try to divest itself of as much of its gigantic hoard of US Treasury bonds before the profligate ways of Washington cause them to lose value.  In fact, the cover of the Economist issue (November 13, 2010) that I linked to above has the Chinese buyer offering a wad of American cash.

Suddenly, however, the emphasis has changed from shrinking the central bank’s pile of greenbacks to draining the domestic economy in China of part of its supply of “redbacks,” as some have begun to call the renminbi.

Why?  My guess is that Beijing has worked out that it can’t reduce the risk of holding tons of dollars by just spending them as fast as it can. More just keeps on coming in.  And it may well lose as much on bad acquisitions as it would on depreciation of the dollar.  The only real solution to its currency risk is to push harder to get more renminbi circulating outside the mainland and see what happens.

Step one will be to see if there are any sellers willing to take Chinese currency.

Investment implications?  This is more something to keep an eye on than to worry actively about.  An increased willingness of China to hold onto dollars would arguably be good for the US currency, at least for a while, and would imply that interest rates might stay a bit lower than they would otherwise.  But let’s see how big the offshore renminbi market gets before doing anything else.