The US Dollar and the Cone of Uncertainty
By John Mauldin
Dec 22,
2014
Currently
we have an international monetary non-system. Nobody has to follow any rules.
Everybody does what they consider is in their own short-term best interest. The
real difficulty is: What is in their short-term interest – for example,
following ultra-easy monetary policy – could well backfire somewhere. It might
be not in their long-term best interest. And as the easy monetary policy
influences the exchange rates, it influences other countries. Almost every
country in the world is in easing mode, following the Fed, and we have
absolutely no idea how it will end up. We are in absolutely unchartered
territory here.
–
William S. White, former Chief Economist, Bank for International Settlements,
in an interview for Finanz
und Wirtschaft
I
visualize this process [of forecasting the future] as mapping a cone of uncertainty, a
tool I use to delineate possibilities that extend out from a particular moment
or event. The forecaster’s job is to define the cone in a manner that helps the
decision maker exercise strategic judgment. Many factors go into delineating
the cone of uncertainty, but the most important is defining its breadth, which
is a measure of overall uncertainty.
Drawing
a cone too narrowly is worse than drawing it too broadly. A broad cone leaves
you with a lot of uncertainty, but uncertainty is a friend, for its bedfellow
is opportunity – as any good underwriter knows. The cone can be narrowed in
subsequent refinements. Indeed, good forecasting is always an iterative
process. Defining the cone broadly at the start maximizes your capacity to
generate hypotheses about outcomes and eventual responses. A cone that is too
narrow, by contrast, leaves you open to avoidable unpleasant surprises. Worse,
it may cause you to miss the most important opportunities on your horizon.
–
Paul
Saffo, technology forecaster
Saffo
borrows the term “cone of uncertainty” from weather forecasting. While you may
not be familiar with the concept, you see it in use every time there is a
hurricane forecast. The further away you get from where the hurricane actually
is at the moment, the wider the “cone” predicting its possible paths.
For
the past two letters we’ve been looking at the global scene and trying to
figure out which issues will help us outline scenarios for 2015. We finish the
series today by looking at the impact of the dollar bull market on the
probabilities for various 2015 developments.
Let
me say at the outset that I think a global currency war (kicked off by Japan
last year and just now heating up) and a rising bull market in the US dollar
are the big macroeconomic drivers not just for 2015 but for the next four to
five years. I think all future economic outcomes pivot along with these two
major forces – they are the lever and fulcrum, so to speak. As we look at all
possible futures, as we map our own cones of uncertainty, it is certainly true
that that our assessment could change with the emergence of important new
trends at the outer fringes of the cone; but I believe (and have believed for
some time) that we need to organize our forecasts around the currency war and
the dollar bull market.
(Let
me note that even though this letter is much shorter than usual in terms of
actual words, for which readers may be grateful, it will print longer, as there
are an unusually large number of charts.)
Currencies
are not supposed to have large movements in short spans of time and certainly
not violent moves such as we have recently seen with the Russian ruble.
Relatively stable currencies – ones that make moves measured in single digits
over multiple years – are what you want to see for stable trade and world GDP
growth.
Violent moves like the ruble’s signal that something is seriously
wrong, so wrong that it may well precipitate a deep recession. You very seldom
if ever see a similarly rapid upward
move in a currency. (Off the top of my head, I can’t think of one, but surely
somewhere in history… and if I said “never,” I would probably be corrected by
my astute readers.)
Over
the last few centuries, as the world moved away from the gold standard and
gold-backed currencies, the valuations of fiat currencies began fluctuating,
sometimes wildly, over time. Currency wars following the onset of the Great
Depression certainly contributed to the length of the downturn. After World War
II, the financial leaders of the nations of the world came together and created
a monetary system called Bretton Woods, named after the mountain resort in New
Hampshire where it was created. Basically it was an anchored dollar system,
where the dollar was convertible into gold and the rest of the world used the
dollar for their reserves and generally pegged their currencies to it. The
linchpin of the deal was the understanding that the US dollar would remain a
stable currency.
We
didn’t live up to that deal, printing too much money during the Vietnam War;
and the nations of the world, led by France, began to ask to convert their
dollars into gold. Since that would have drained the gold out of the United
States, Nixon closed the “gold window.” We won’t get into the argument about
the propriety of his move here.
The
chart below shows the US Dollar Index (the DXY, which is heavily weighted to a
comparison with the euro) since 1967. Prior to 1967 the dollar was generally
stable.
As the value of the dollar began to slide in 1970 – a troubling
development if you were holding dollars in Europe – the world began to wonder
if perhaps the United States was taking advantage of its position. Note that
after the closing of the gold window in ’73 the dollar continued to fall but
with greater volatility. This was mostly due to the Federal Reserve’s allowing
inflation and printing money.
Then
Paul Volcker came along and began to raise interest rates, and a major dollar
rally ensued. The dollar doubled in value in less than five years. As interest
rates came down from nosebleed highs in the late ’80s, the US dollar fell back
to its original level and more or less drifted sideways for the next 10 years
before once again climbing to 120. Then, in the early’00s, low rates and easy
money took their toll, and the dollar fell to an all-time low in the middle of
the credit crisis and has traded around the “80 handle” for the last six years.
This is in spite of the Fed’s undertaking massive quantitative easing and
flooding the world with dollars, which you would think would put downward
pressure on the dollar. That is generally what happens when a central bank
floods the world with its currency. Certainly, it is what is happening in
Japan, and it is what we expect to happen in the Eurozone.
Something
is different about the dollar, then. That difference can be explained mostly by
the fact that the US dollar is the world’s reserve currency and the demand for
dollars for global trade, which is growing at a rate the world has never seen,
is stronger than ever. If the Federal Reserve had not entered into a policy of
massive quantitative easing, it is entirely possible that we would have seen
the dollar rise significantly over the last five years rather than languishing
as it has.
Now
that quantitative easing is finally done and the Federal Reserve is thinking
about raising interest rates at a slow drip back to something that
looks normal (possibly, maybe, perhaps, conceivably – we aren’t in any hurry and you may need
to be patient for a considerable period of time and anyway everything is
data-dependent), the coiled spring that is the dollar may be set
free.
And
since we are in background mode, we need to understand that there are many ways
to measure the strength of the dollar. As I mentioned, in the standard US
Dollar Index (the DXY), significant weight is given to the euro. To more
accurately reflect the strength of the dollar relative to other world
currencies, the Federal Reserve created the trade-weighted US dollar index (for
more about it see here
and here),
which includes a bigger collection of currencies than the US Dollar Index.
The
composition of the US Dollar Index (DXY) is
-
Euro (EUR), 57.6%
-
Japanese yen (JPY), 13.6%
-
Pound sterling (GBP), 11.9%
-
Canadian dollar (CAD), 9.1%
-
Swedish krona (SEK), 4.2%
-
Swiss franc (CHF), 3.6%
Thus
a fall in the euro, as we’ve seen recently, changes the valuation of the index
more than it might another index like the Bloomberg Dollar Index (BBDXY), which
is composed of a broader basket, including emerging-market currencies, with
less emphasis on EUR/USD:
-
Euro (EUR), 31.4%
-
Japanese yen (JPY), 19.1%
-
Mexican peso (MXN), 9.6%
-
Pound sterling (GBP), 9.5%
-
Australian dollar (AUD), 6.2%
-
Canadian dollar (CAD), 11.5%
-
Swiss franc (CHF), 4.2%
-
Brazilian real (BRL), 2.2%
-
Korean won (KRW), 3.3%
-
Offshore Chinese yuan (CNH), 3.0%
Note
in the chart below that at times one index is stronger than the other. This is
primarily a reflection of the strength or weakness of the euro and the fact
that the Bloomberg Dollar Index contains a much higher proportion of
emerging-market currencies.
So
the takeaway here is that, when we say “the dollar is strong,” we are really
talking about its strength relative to particular groupings of currencies. It’s
a generalization. If an index included the Russian ruble or the Argentine peso,
then the dollar would even be “stronger” as measured by that index.
In
general, nature keeps a balance in a given ecosystem. There is a continual
adjustment between the number of predators and the number of prey, but over
time the system tends toward balance.
Just
as nature has a way of forcing balance in the order of things, basic accounting
(math is its own force of nature) has a way of forcing balance in currency
flows and valuations. Quantitative
easing and the developing currency war have created a great imbalance in the
global economic order. The process of rebalancing the world
monetary system is somewhat chaotic and crisis-prone in the best of times. Now, the massive amount of debt, both
public and private, that has been created in the past decade is making that
process even more chaotic.
It
is usual in a crisis like the Great Recession that there is a resolution in the
amount of outstanding debt, through a process called deleveraging. The process
can take many forms, but in the past it has almost always meant that at the
culmination of the process there is less debt. However, in recent months I’ve
highlighted papers demonstrating that this time around there has been no
deleveraging. Central banks and governments simply did not allow it to happen.
That means we have pushed the inevitable process of deleveraging into the
future. Debt cannot grow to the sky – at some point it has to be dealt with.
Four
years ago in Endgame
and in speeches since, I’ve been proclaiming that the dollar is
going to get stronger than anyone can possibly imagine. I was saying this even
as the yen and the euro were strengthening at times against the dollar. Those
who have been proclaiming the destruction of the dollar are just seeing one
small part of the equation: quantitative easing. There is a far larger and more
complicated process going on in the world, and the rebalancing that is underway
is going to mean that the dollar will increase in value against most
currencies, and against some currencies by a great deal.
The
beginning of a bull market in the dollar has multiple consequences, many of
them not benign. Let’s start with the BIG one, the USD breakout and unwind of the
USD-funded carry trade.
The
yen and euro are dropping fast as the USD strengthens. As of today, the EUR/USD
is below 1.23, while the USD/JPY has climbed to nearly 120. This is a function
of central bank policy divergence… which in turn is a function of economic
divergence among the major developed economies… which in turn is a function of
debt divergence in those various economies. Total debt-to-GDP is approximately
334% in US, 460% in the Eurozone, and 655% in Japan, according to Lacy Hunt’s
latest note.
With
such divergence comes the major macro risk that the US Dollar Index (DXY) is
breaking out in a big way. To anyone who believes in technical analysis (and
skeptics should keep in mind that a lot of macro and currency traders DO), it
looks like the USD is ready to break out of a 29-year downtrend that began with
the Plaza Accord way back September 1985. The reversal of a trend that has been
in place for that long is going to catch a number of people offsides.
Unfortunately in investment and economics, you get more than a five-yard
penalty for being offsides on a trend this big.
We
are now going to look at a number of charts in rapid-fire fashion. As noted
above, the dollar bull trend is exacerbated by debt. Global debt-to-GDP has
been rising over the past several years.
The
pool of developed-world financial assets is still growing, after a minor
decrease in 2008. Again, there has been no deleveraging.
Even
though debt and financial assets have been growing in the developed world, the
real explosion in debt and financial assets has occurred in emerging markets,
where the unwarranted flow of easy money has fueled a borrowing bonanza on the
back of a massive USD-funded carry trade.
These
QE-induced capital flows have kept EM sovereign borrowing costs low and enabled
years of elevated emerging-market sovereign debt issuance, even as many of
those markets displayed profound signs of structural weakness. I’m seeing
estimates for the USD-funded carry trade around the world ranging from $3
TRILLION to $9 TRILLION. Raoul Pal believes it is roughly $5T, with nearly $3T
of that going directly into China. (Other estimates for China suggest a
somewhat lower number, but whatever it is, it is massive.)
Earlier
this year, Bridgewater argued that total portfolio flows into emerging markets
had doubled between 2008 and early 2014, from $5T to $10T.
Their
study gave us some very specific data on flows into the larger EMs.
The
following slide from Hyun Song Shin, head of research for the Bank for
International Settlements, estimates that
total USD-denominated credit to non-banks outside the United States is more
than $9T.
What
I’m getting at here is that a reversal in flows from a forceful unwind in USD
capital flows could have disastrous effects on emerging markets... and there
are a number of ways the unwind could blow back on the USA and other developed
markets in coming quarters. The crazy thing is that EM currencies as a group
have already given back more than 10 years of gains… and their losses can get a
LOT worse.
Companies
and governments in emerging markets have borrowed in dollars because of the
ultralow interest rates available, but they earn the money to pay those loans
back in local currencies. If the local currency is dropping significantly
faster than the dollar, then no matter how profitable a business is, it is
sinking deeper into debt with every tick up in the dollar. That’s what happened
in 1998, and it’s happening again today.
The Fourth Arrow
Moving
on in our survey of the world, we see the Japanese yen continuing to fall as
the Bank of Japan engages in the most massive experiment in quantitative easing
the world has ever seen. And they are doing it at the time when Japan’s current
account and trade balance are both deeply negative.
These
three realities combined mean that the yen is going to fall much further. The
fourth, unstated, poison-tipped arrow of Abenomics is the launching of a major
currency war, the consequences of which are now starting to be felt, as we can
see in the next chart.
The
potential for policy mistakes or monetary crises on the part of other Asian
nations is very real and very troubling. We could see a country lose control of
its currency as it tries to respond to Japan, and it is not altogether unlikely
that at some point Japan itself will lose control, which would bring about a whole
different set of problems and crises. Meanwhile, the US dollar’s rise will go
on creating further problems for dollar-denominated debt in emerging markets,
including China, which may decide that it needs to respond by devaluing the
renminbi.
China’s
investment boom is cooling; its competitiveness is eroding; and markets may
already be pricing in a renminbi devaluation. China’s boom was largely a result
of foreign direct investment and a massive increase in debt in a short period
of time.
Even though bank lending has grown substantially, the real growth in
debt in recent years came through an explosion in non-bank loan funding. China
has created a shadow banking system that is staggering in size.
There
have been a number of studies on the relationship between the rapidity of
growth of debt and subsequent financial crises. Even if we look to a broad
sample of 48 instances over the last 50 years where total social finance
expanded by as little as 30% over five years (less than half the magnitude of
China’s credit explosion), history suggests there is still a 50% chance of a
banking crisis or an abrupt fall in growth during the post-boom period. My
point is that there is a
clear relationship between the intensity of a credit boom and the subsequent
adjustment (downward) in GDP growth rate. There are no cases in modern history
where an economy has managed to avoid a banking crisis or outright bust after
experiencing rapid lending growth anything like China’s ongoing credit boom.
The
world is simply not prepared for a major China slowdown, let alone a hard
landing. And gods forbid that the Chinese have a problem at the same time that
Europe slides back into crisis.
The
big question is, what happens next in China? Personally, I think it will be
very difficult to avoid a real fall in the Chinese growth rate in the next 3-5
years. The reforms required to rebalance China to a more sustainable growth
model will be very
painful, and there is a real chance they could bring on a banking panic in the
short term; but without those reforms, China literally has no chance. The
Chinese Dragon is attempting a very intricate and delicate dance. The world
needs China to succeed, but we must recognize that a Chinese hard landing is
very much within our cone of uncertainty.
I
want to close this letter with a quote from William White, who recently did an interview
with Finanz und Wirtschaft,
perhaps the leading business and economics newspaper in Switzerland. White is
the highly regarded former chief economist of the Bank for International
Settlements. Longtime readers may recall that I have quoted him at length over
the years, as his writing is some of the most thought-provoking in the
economics world.
The
interview focused on the decision by the Swiss National Bank to go to negative
interest rates on January 22, 2015. Not coincidentally, the European Central
Bank will be meeting that day to decide whether or not to implement its own
quantitative easing program. The Swiss are quite concerned about the massive
capital inflows that are pushing their currency to very uncomfortable levels.
In a highly unusual move, they are going to start charging banks for the
privilege of holding Swiss currency accounts.
For
the Swiss to enact such a move means that they must be convinced that the ECB
is actually going to do something on January 22. Technically, it is against the
rules for the ECB to buy sovereign debt, and the Germans are adamantly opposed.
But my highly connected friend Kiron Sarkar asks:
What
if the ECB does introduce a QE programme, involving the purchase of EZ
government debt, though only on the basis that the relevant countries meet
pre-agreed targets? You have provided a massive incentive to introduce
structural reforms, dealt with the German's/Bundesbank objections, and those
countries that play ball will benefit from lower interest rates and a weaker
euro. On the other hand, if EZ countries do not cooperate, yields on their
bonds will blow out massively – just the right stick to wield. It's the classic
carrot and stick approach. Too fanciful? Well, maybe, but...
I
guarantee you just such a solution is being talked about. We will see what
actually gets implemented. Now let’s turn to the conclusion of White’s
interview:
The SNB has to follow the ECB in its monetary policy. Is
it not dangerous when the monetary policy of one country affects another?
Currently
we have an international monetary non-system. Nobody has to follow any rules.
Everybody does what they consider is in their own short-term best interest. The
real difficulty is: What is in their short-term interest – for example,
following ultra-easy monetary policy – could well backfire somewhere [else]. It
might be not in their long-term best interest. And as the easy monetary policy influences the
exchange rates, it influences other countries. Almost every
country in the world is in easing mode, following the Fed, and we have
absolutely no idea how it will end up. We are in absolutely unchartered
territory here. This worries me the most. The Swiss National Bank has been
doing well in what it was forced to do by this international monetary
non-system. The Swiss have to do the best they can, because that is what
everybody else is doing.
What are the risks of this non-system?
There
is no automatic adjustment of current account deficits and surpluses, they can
get totally out of hand. There are effects from big countries to little ones,
like Switzerland. The system is dangerously unanchored. It is every man for
himself. And we do not know what the long-term consequences of this will be.
And if countries get in serious trouble, think of the Russians at the moment,
there is nobody at the center of the system who has the responsibility of
providing liquidity to people who desperately need it. If we have a number of
small countries or one big country which run into trouble, the resources of the
International Monetary Fund to deal with this are very limited. The idea that
all countries act in their own individual interest, that you just let the
exchange rate float and the whole system will be fine: This all is a dangerous illusion.
My
associate Worth Wray will join us next week, presenting his forecast for 2015,
which will concentrate on the emerging markets and China. I will return after
the first of the year with my own 2015 forecast – there is much to ponder over
the next couple of weeks.
I am
home for the rest of the month, but the calendar for next year is beginning to
fill up. I see Cincinnati, Grand Cayman, Zurich, and Florida on my schedule. It
has been awhile since I was in the Cayman Islands, and this time I’ll take a
short hop over to Little Cayman to visit my friend Raoul Pal for a few days. A
brilliant macroeconomist and trader, Raoul has now based himself in Little
Cayman, although he frequently flies to visit clients. He is also a partner
with Grant Williams in Real
Vision Television, a fascinating new take on internet investment TV. I’ll
be writing more about it in the future.
And
speaking of Grant, I wish him well as he embarks upon a new endeavor, that of
turning his passionate avocation of writing his brilliant newsletter Things That Make You Go Hmmm…
into a business. It has been an honor and privilege to publish Grant for these
last years and to help bring his wicked (not to say warped) humor and dazzling
writing style to a larger audience. But the far greater reward has been getting
to know Grant personally. I appreciate the kind words he wrote about me in his
letter last week, and the feeling is mutual. Grant is just one of the most
genuinely nice people I have ever met.
It
is time to hit the send button. Let me take this opportunity to wish you and
all your families and friends the merriest of Christmases and the happiest of
New Years. This is one of those times when our tribe expands to encompass the
globe, to become part of a greater celebration, one in which the other “team”
does not have to lose in order for us all to be happy.
Have
a great week. I forecast that the final episode of The Hobbit will be coming to a theater very
near me very soon. And that forecast has a very narrow cone of uncertainty.
Your
gathering my own small tribe together this week analyst,
John Mauldin
0 comments:
Publicar un comentario