what might cause a dollar swoon

government saving/spending–in theory

In theory, governments spend more than they take in to ease the pain and speed recovery during bad economic times. They spend less than they take in during booms to moderate growth and repay borrowings made during recession.

what really happens

In practice, this occurs less than one might hope. Even so, the Trump administration is one for the books. Despite coming into office after seven growth years in a row, Trump endorsed an immediate new dose of government stimulus–a bill that cut personal income tax for his ultra-wealthy backers and reduced the corporate tax rate from nosebleed levels to around the world average. While the latter was necessary to prevent US companies from reincorporating elsewhere, elimination of pork barrel tax breaks for favored industries that would have balanced the books was conspicuously absent.

The country suddenly sprouted a $1 trillion budget deficit at a time when that’s the last thing we needed.

Then came the coronavirus, Trump’s deer-in-the-headlights response and his continual exhortations to his followers to ignore healthcare protocols belatedly put in place have produced a worst-in-the-world outcome for the US. Huge economic damage and tens of thousands of unnecessary deaths. Vintage Trump. National income (and tax revenue to federal and state governments) is way down. And Washington has spent $2 trillion+ on fiscal stimulus, with doubtless more to come.

To make up a number, let’s say we end 2020 with $27 trillion in government debt (we cracked above $26 billion yesterday). That would be about 125% of GDP, up where a dubious credit like Italy has typically been. It would take 7.7 years worth of government cash flow to repay our federal debt completely. These are ugly numbers, especially in the 11th year of economic expansion.

At some point, potential buyers of government bonds will begin to question whether/when/how they’ll get their money, or their clients’ money, back. In academic theory, foreigners work this out faster than locals. In my experience with US financial markets, Wall Street is the first to head for the door. The result of buyers’ worry would be that the Treasury would need to offer higher interest rates to issue all the debt it will want. To the degree that the government has been borrowing short-term (to minimize its interest outlay) the deficit problem quickly becomes worse. Three solutions: raise taxes, cut services, find some way of not repaying borrowings.

not repaying

Historically, the path of least resistance for governments is to attempt the last of these. The standard route is to create inflation by running an excessively loose monetary policy. Gold bugs like to call this “debasing the currency.” The idea is that if prices are rising by, say, 5% annually and the stock of outstanding debt has been borrowed at 2%, holders will experience a 3% annual loss in the purchasing power of their bond principal.

The beauty of this solution in politicians’ eyes is the ability it gives them to blame someone else for what they are doing.

The downside is that international banks and professional investors will recognize this ploy and sell their holdings, creating a potentially large local currency decline.

The issue with the devaluation solution in today’s world is that sovereign debtors have been trying for at least the past decade to create local inflation–without success.

This would leave either tax increases or default as options. The slightest inkling of either would trigger large-scale flight from the country/currency, I think. Again, Wall Street would likely be the first. Holders of local currency would assume third-world-style capital controls would soon be put in place to stop this movement, adding to their flight impulse.

The most likely signal for capital flight to shift into high gear, in my view, would be Trump’s reelection.

where to from here?

signs of excess

The US is now awash in money being pumped into it by the federal government, both through Federal Reserve buying bonds and offering overnight money to banks basically for free and Congress sending out trillions of dollars in stimulus money. Why? …to combat the enormous and unnecessary damage done to the economy by the pandemic (not by the virus itself but by Trump’s bizarre implosion under pressure–calling the pandemic a hoax, urging citizens to ignore medical advice, fomenting race conflict to cover up his failure).

For the stock market, most of this is in the near-term rear view mirror. There are clear signs that there’s no shortage of cash in circulation. Barstool Sports’ shift from sports betting to day trading stocks is one. The increasing popularity of Robinhood–and the response of traditional discounters in offering trading in fractional shares is another. The weird resurrection of the stocks of bankrupt companies like Hertz (I can’t think of an instance where common shareholders have ever come out of a Chapter 11 proceeding with anything at all).

it’s all about the money (supply)

Yes, these are serious warning. But healing at least some of the damage Trump has done during his time in office takes priority for now, as I see it. And until there’s a change in government policy to “take away the punch bowl,” stocks will likely continue to hold up relatively well. This was certainly the case during the gigantic bull market in Japan during the 1980s as well as in the runup in the US stock market during the Y2K/Internet bubble of 1999.

my biggest question marks today

–is the market rotation toward domestic economy-centric stocks that began in late March over? My guess is not yet.

The winning strategy for Wall Street since the positive effect of the 2017 corporate income tax cut began to wear off in early 2018 has been to hold the US-traded stocks that have the least to do with the domestic economy. From late March to late April, these laggards, as measured by the Russell 2000, began to keep pace with the broader market. For the past 6 weeks or so, thanks (I think) to Washington stimulus, they have been outperforming. A counter-trend rally, which is what I think this is, typically lasts about two months. I regard the start as the end of April, not the end of March. So even though price movement can be read as the R2000 rally being over, my guess is that it still has some weeks to run.

–will Trump be reelected? Former Wall Street economist, Stephen Roach, now teaching at Yale, is the first public figure to be talking about my Mexico-1980s analogy as a possible future for the US. He does so in a Bloomberg article that reads in part:

“Look no further than the Trump administration. Protectionist trade policies, withdrawal from the architectural pillars of globalization such as the Paris Agreement on Climate, Trans-Pacific Partnership, World Health Organization and traditional Atlantic alliances, gross mismanagement of Covid-19 response, together with wrenching social turmoil not seen since the late 1960s, are all painfully visible manifestations of America‚Äôs sharply diminished global leadership.”

He thinks a fall in the dollar of about a third is possible.

Although Roach doesn’t put it this way, a very big question to be answered in November is whether the US doubles down on the Trump anti-growth, anti-science, white supremacist agenda or tries to start to repair the damage done to date.

A final point: Mexico in the 1980s was a horrible place economically, where the currency lost 90+% of its value. But because the government did not permit citizens to move assets abroad the stock market there was the best-performing in the world over that period.

more tomorrow