The Illogical Trade — Buy the US Dollar As Economy Flounders
Wednesday, 24 Sep 2014 08:04 AM
By Ashish Advani
The U.S. dollar has seen an impressive strengthening in the past three months. That is a fact that has many analysts, including me, scratching their heads.
Very early in my trading days, I was taught the golden rule: The market is always right and can stay illogical longer than your deep pockets can.
We have seen the U.S. dollar strengthen across the board against nearly all currencies of the world. The worst of the currencies in the last month has been the Japanese yen. Just a few weeks ago I wrote to you about the insanity that Prime Minister Shinzo Abe has unleashed upon Japan and how it will lead to no good.
The United States is following in Japan's footsteps and yet we see the U.S. dollar soar.
One of the pillars of the growth in the U.S. economy is consumer spending. The most popular measure of consumer spending is the Personal Consumer Expenditure (PCE). In 2013, we saw this indicator rise or stay flat every single month. In the first half of 2014, we have seen the PCE rise in three of the six months and fall in the other three. So we have no clear indication and actually deterioration compared with 2013.
The next tenet of U.S. growth is the housing market. Here again we have seen tepid to inconsistent signals of growth. The data indicate that while we have growth in the housing markets compared with last year, we are at about 50 percent of what is a normal growth pattern. Each month in the last several years has had contradicting signs of the growth. So there are pockets of growth, but no consistent growth.
Jobs are another anomaly in our data. The unemployment rate came down, but more so due to people who have stopped looking for jobs. The politicians claim we have recovered all the jobs lost during the recession but forget to mention that we traded high-paying jobs for minimum-wage jobs. Sustainable economies cannot be built on minimum wage jobs. Don't forget the data massaging we see in the unemployment numbers that cast a dark shadow on that metric anyway.
Yet the U.S. dollar has been soaring. This dollar strength will actually hurt the tepid recovery that we may be experiencing in the United States. The United States may be a service economy, but we still manufacture quite a bit in the United States. With a strong dollar our exports will suffer. The strong dollar will already reduce GDP by approximately 0.3 percent to 0.5 percent this year alone.
The dollar strength sentiment has been helped by the Federal Reserve stopping quantitative easing. This is no indicator whatsoever of an increase in interest rates, just a reduction of stimulus. The euro losses are all self-inflicted for the most part. That has also boosted up the dollar. The collapse of the yen is another failed attempt by a politician and that has pushed up the dollar.
Manipulation in gold prices along with weak demand for commodities has crushed the Canadian dollar. The temporary weakness in China's growth has pushed the Australian dollar down.
With all the inherent and obvious weakness in the U.S. economy, we should be selling the dollar, not buying it. Yet today I suggest we buy the U.S. dollar and sell the euro and yen, as we will continue to see weakness in other currencies and strengthening of the dollar.
As my mentor used to say, "Never cloud your trading with economic facts (in the short term) when sentiment rules the markets."
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The Bear's Lair: Get on with it!
It took the Fed until early 2006 to achieve positive real interest rates, since 12-month consumer price inflation was running around 4% at that time. It is not 20-20 hindsight to criticize the dilatory nature of the Fed's interest rate rises in 2004-06; this column did so on several occasions at the time.
The housing finance market peaked in 2005 with mortgage origination volume of $2.76 trillion, according to New York Fed statistics. By the first part of 2006, with real interest rates positive, it was already beginning to slow—volume for 2006 down somewhat at $2.52 trillion. Thus, as you would expect, the rise in interest rates began to kill off the housing market once real interest rates turned positive, with the Case-Shiller 20-city index of house prices peaking in July 2006.
Now consider if the Fed had doubled the speed at which it raised interest rates, with half-percent increments at each meeting instead of quarter. By the end of 2004, the federal funds rate would already have stood at 3.5%, following five such interest-rate increases.
With inflation in early 2005 running at around 3%, real interest rates would already have been positive. By the time the Fed stopped its rate increase program at 5% in late April 2005 or at 5.5% in June 2005, the housing finance market would have been in full retreat and house prices would have peaked. The housing bubble would have been popped a full year earlier than in real life.
Roughly, 2005's housing finance market would have resembled 2006's, and 2006's housing finance market would have resembled 2007's, with prices in full retreat. Since roughly $2.5 trillion of housing finance paper would never have come into existence, and house prices would have had less far to fall (the Case-Shiller 20-city index rose by 7.2% in the year to July 2006, and its 15.1% rise in the year to July 2005 would also have been slowed with rates rising rapidly) the bottom would have been reached somewhat more than a year earlier, perhaps around June 2007 rather than September 2008. The 2008-09 recession would have become a 2007-08 recession, less severe in depth than actually occurred.
The most important change would have been that much of the worst speculative activity, which took place around the top of the market, would never have occurred because such activity would have been choked off a year earlier. Fabrice "Fabulous Fab" Tourre's synthetic CDO activity, for example, which by creating artificial loss-making securities with which to stuff German banks amplified the downturn's losses, occurred almost entirely in 2006-07, with the notorious "Abacus 2007-AC-1" deal taking place in early 2007. By bursting the bubble a year earlier and cutting off the Abacus series of deals, the Fed would have reduced Fabulous Fab to Mediocre Fab, making him miserable in the short run but greatly improving his life prospects long-term.
Cutting off the bubble a year earlier would also have eliminated most of the bankruptcies that made 2008 such a dreadful year. Lehman Brothers, for example, increased its balance sheet total from $410 billion to $691 billion between 2005 and 2007. Without the last phase of the housing finance mania we can assume that this balance sheet bloat would not have happened and that Lehman would have avoided bankruptcy.
Bear Stearns similarly increased its balance sheet total from $293 billion to $395 billion between November 2005 and 2007. Its survival must be less assured than that of Lehman, but without the final increase in leverage must be odds-on. It must be remembered that the disastrous SEC deregulation removing the limits on investment bank leverage occurred only in 2004, so a boom that stopped a year earlier would have markedly reduced those institutions' ability to get in trouble.
As for AIG, the wild expansion of its credit default swap operations began after the ouster of Maurice Greenberg as CEO in January 2005. By September 2008 it had $440 billion of CDS outstanding on mortgage backed securities, mostly subprime. With the housing market peaking in July 2005, much of this activity would have been avoided and no AIG bailout would have been necessary.
That's not to say the recession would have seen no defaults. Angelo Mozilo of Countrywide was already expressing alarm about its company's product range, such as the "80/20 subprime loan" in April 2006, and attempting to rein in the company's operations. The fact that he was forced to sell at a fire sale price as early as January 2008 to Bank of America, which has since incurred some $50 billion of additional costs as a result of its foolish purchase, is sufficient indication that even with the bubble bursting a year earlier Countrywide would have been unlikely to survive through the entire recession.
However, without the Lehman and AIG defaults, there would have been no need for Congress to vote a $700 billion TARP bank bailout in October 2008, no public obloquy of bankers in the following years and no tsunami of regulation with the Dodd-Frank act. Furthermore, with no major financial crisis to trigger it through misapplication of Walter Bagehot's dictum of "lend freely, but at penalty rates," there would, even with Ben Bernanke at the Fed, have been no toxic monetary policy of six years of zero short-term interest rates. It's also most unlikely that the U.S. budget deficit would have reached even half the $1.4 trillion at which it peaked in fiscal 2009.
The economic recovery would have been more normal in shape, without the massive distortions caused by government activity, although since Barack Obama would presumably still have won the presidency in 2008 there would still have been a productivity sluggishness caused by excessive regulation and economic meddling. Markets would not today be in bubble mode, and there would be no further mountain of malinvestment waiting to cause another financial crisis and more years of misery.
The $2.5 trillion figure of 2006 home mortgage lending at which I had initially estimated the cost of the Fed's appalling dilatoriness in raising interest rates in 2004-06 is thus undoubtedly an underestimate. When you add in the costs of the financial crisis and the output lost through the excessive depth and length of the 2008-09 recession, the total cost of that Fed bungle must come to many further trillions. Truly, central banks are the ultimate destructive force of our time.
It also follows that the Fed's current sluggishness in beginning to raise interest rates, together with the very prolonged and reluctant trajectory by which it means to raise them when it begins, is likely to be a huge mistake, possibly even more costly than the error of 2004-06. Now that unemployment is reduced to a tolerable level, the U.S. economy is at least chugging forward and markets are in a state of overvaluation resembling that of 1999 (mainly through the bloating of corporate earnings), the Fed should raise interest rates immediately by a substantial amount, perhaps to 2%, still around zero in real terms, and then institute a moderate program of further rises.
Of course, the stock market and other overextended asset prices would tank, but their bubble would have been burst earlier than it might otherwise have been The Fed would be blamed for the bursting, but as William McChesney Martin said over a half-century ago, to end the party before exhibitions of financial drunkenness cause real damage is the principal function of a soundly managed central bank.
Since Alan Greenspan began to pump up the money supply in 1995, the Fed chairman has been almost universally popular. That is a sign of utter failure in his (or now, her) most important duties.
Wall Street's Best Minds
What's the Next Step for Bond Investors?
A Wells Fargo fixed-income pro lays out moves in advance of a Fed rate hike next year.
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
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