What a Robust Dollar Means for U.S. Business — and the Global Economy

Apr 15, 2015
Strong dollar

Recently, the value of the U.S. dollar has risen from strength to strength against a basket of currencies, notably against the euro and the yen. In fact, the dollar has reveled in the longest streak of gains since 1971.

While the strong U.S. dollar is good news for American consumers who can get more bang for their bucks when buying some imported goods or traveling abroad to certain areas, like Europe or Japan, American multinational companies find themselves in a different boat, say experts from Wharton and elsewhere. For one thing, their overseas earnings are worth a lot less when they translate unhedged profits into U.S. dollars.

This can have a big impact on U.S. firms when, for example, nearly 40% of total sales of S&P companies come from abroad. In the long run, however, the higher dollar is a mixed bag of pros and cons for U.S. global companies.  

Why the U.S. Dollar Shot Up

How exactly the strong American currency will play out is hard to predict. In just the past year, the dollar has climbed an average of 18% and is now higher than it’s been in more than a decade against major currencies. “People are freaking out about the strong U.S. dollar but in fact it’s been much stronger before,” says Jeremy Cook, chief economist at World First, a currency house in London. “In 1985, it was 33% stronger than where it is now so there is a lot more room to rally.”

“The reason the U.S. dollar is strong is not so much what the Americans are doing but rather what the Europeans are doing with quantitative easing,” adds Mauro Guillén, Wharton management professor and director of The Lauder Institute. As the European Central Bank’s bond-buying program takes off in Europe, the dollar should continue to gain in value over the euro. The dollar is already worth over 30% more than last year against the euro, making Parisian vacations a lot more affordable. Trip Advisor reported a 9% drop in European hotel prices in dollar terms. “Industries that have to do with tourism will benefit, including companies that take American tourists abroad,” says Guillén.

Undoubtedly, the news is better for European companies than American ones as the former are now able to price products more competitively against American goods. It is already had a huge impact on growth in the eurozone, notes Joao F. Gomes, Wharton finance professor. U.S. importers of foreign-made goods like French wines and German appliances might “experience a windfall” as their products become cheaper, adds Guillén.

The Japanese yen, meanwhile, has slid by 40% since early 2012 in part due to extreme quantitative easing, part of Abenomics, Prime Minister Shinzo Abe’s monetary and fiscal stimulation efforts to escape decades of slow economic growth and deflation. This has put pressure on China — which is experiencing its slowest growth in 24 years — to defend itself in Asia’s currency wars. “There is speculation that the People’s Bank of China will increase policy stimulus this year in the face of slowing growth,” which in turn will weaken the yuan, says Jane Foley, senior currency strategist at Rabobank International in London.

“China and Japan have been involved in a currency war in a very limited way,” adds Adam Slater, senior economist at Oxford Economics. “If they’re doing anything, they’re nibbling away, but they’re not aggressive at this point.” Nevertheless, adding weight to the view that China will force a devaluation was the recent announcement that March exports had fallen 15% from the same period in 2014.

Falling oil prices, set in dollars, also support U.S. dollar gains. A net oil importer, the United States has been reducing its reliance on foreign oil due to shale gas production. America imported 60% of its oil needs in 2005 but by 2015, it will import just 21% of its petroleum products. So, less spending on overseas oil means a smaller supply of dollars circulating there.

What’s more, when it’s cheaper to run your car, Americans get more money in their pockets to spend on other things — including imports. That’s significant when 68% of the American GDP comes from consumption, says Guillén. So far, though, the savings in gasoline expenditures have filtered down in a limited way and far less than most analysts had predicted.
While it might look like good times for the American consumer, U.S.-based multinationals are juggling a different set of factors. Many U.S. companies, from soda giant Coca-Cola to luxury jeweler Tiffany’s, rely on generating half or more of their profits from overseas.

“Through much of last year, volatility in the forex market was low,” says Foley. “This raises the risk that many firms were lulled into a false sense of security over the outlook for currency movements and there may be been some firms that found themselves inadequately hedged this year.”

Adds Gomes: “Companies were caught out a little bit, but what has been bad for American companies has been good for European companies Twitter . Things have looked phenomenal for German companies and we’ll see more of that this year.”

How U.S. companies are affected by the high dollar drag and what they’re doing about it varies by company and industry.

“The companies that will be hurt the most will be the ones who produce in the U.S. and export outside the U.S.,” says Guillén. Some companies have global operations, thus currency movements won’t affect them that much, notes Bulent Gultekin, Wharton finance professor.

Those firms will use local input for the local markets. If the companies bring the profits back to the U.S., it’s true that their reported earnings will be lower. But corporations should be looking at the long-term growth opportunities and the change in currency will not make a difference in the long run, Gultekin adds.

Guillén notes that for the companies that produce abroad and sell abroad, there might not be an immediate impact because those firms could keep their profits in the foreign currencies and reinvest in foreign operations. Their dollar revenues might look like they’re taking a hit when the companies translate profits into U.S. dollars. However, just because the dollar profits will be smaller doesn’t necessarily mean cash flow will diminish, he points out.

“It will be a mixture of what accounting practices they might use,” adds Slater. He agreed that “some may decide to wait before taking a translational loss and reinvest in foreign markets.” Cook agreed: With other currencies “weakening against the U.S. dollar, American companies have incentives to spend money abroad if they can.”

The weaker euro may also draw more merger and acquisition activity (M&A) as well. “European companies may be more susceptible as takeover targets,” adds Foley. “There is evidence that Chinese investors stepped up interest in Europe in 2010 as the euro fell on the back of the eurozone crisis.” The strong U.S. dollar makes “European companies more attractive to U.S. buy-outs, too.”

Technology companies offer a further case in point, given that up to 60% of their revenues flow from foreign markets. Apple is an interesting example. Even as it set the record for the biggest quarterly earnings — $18 billion — for any company in history back in January, the tech giant “lost” $2 billion in sales via currency fluctuations. Yet, it should not make that much difference for Apple, says Gomes. There may be fewer dollars reported as profits, but the firm should be making investment decisions based upon growth, Gomes adds.

According to TechCrunch, Apple is thought to have $54 billion in profits sitting offshore that have not been subject to higher U.S. taxes. “A number of U.S. corporations have been stashing their money overseas. If they don’t repatriate back to the States, then they don’t get taxed back in the States,” notes Gultekin. However, those firms run the risk of getting into the hedge fund business unintentionally, where they might take a hit from trying to predict currency movements, he adds.

A month after setting the quarterly earnings record, Apple announced its largest investment in Europe yet — $1.85 billion (1.7 billion euros) to build two state-of-the-art data centers, powered completely by renewable energy, in Ireland and Denmark. Though the European investment is one way to reinvest euro profits, Apple also benefits from favorable corporate tax rates in places like Ireland, says Cook.

Another interesting case: The airline industry, particularly the U.S.-based Boeing versus the Europe-wide Airbus operations. “Commercial aircraft are priced in U.S. dollars. The higher U.S. dollar in principle allows Airbus to give more discounts and win some sales,” says Olivier Chatain, strategy and business policy professor at HEC business school in Paris and senior fellow at Wharton’s Mack Institute for Innovation Management. “However, this depends, at least in the short term, on Airbus’ currency hedging strategy. It is likely that they locked in some exchange-rate contingencies before the fall of the euro.” He also points out that Airbus has a backlog of eight years of production, but there is also less pressure to buy new aircraft “that are consuming less fuel” in the short term.

Another sector where foreign companies are leveraging their cheaper goods is the American steel industry. U.S. steel needs grew by 13% in 2014, while China’s demand is slowing for the first time since the early 1980s, according to UBS Group AG in a Bloomberg article. China also produces half of the world’s steel, causing an excess in production that pushes down prices.

To add to the complications, big steel exporters like Russia and Brazil are also seeing their currencies drop drastically. The result is foreign steel companies are able to muscle into U.S. markets with lower prices. Gultekin adds, “Importers into the U.S. will certainly have an advantage, and most emerging markets have an export steel industry.”

What Companies Should Do

“Companies should invest where growth is expected to be higher, like parts of Latin America and Southeast Asia,” says Gultekin. On a dollars basis, it should not affect corporate business decisions, which should be done under the fundamentals of operating results, he adds.

Guillén points out that U.S. export companies will now have to focus on being more productive, more proactive and more efficient in order to compete. Moreover, Cook advises that companies hedge away from currency risks by setting up contractual terms on currency values in the beginning and let businesses focus on their own viable business models.

Another complicating factor is the Federal Reserve, which has been widely expected to raise interest rates by the end of the year, though if recent soft numbers on the economy continue, the timing of any change could easily stretch out. That would raise financing costs for U.S. corporations and the U.S. government.

Good for the Long Term

Overall, the robust American currency will have a positive effect on the global economy, experts say. What we’re seeing is a “redistribution of income from countries with a low propensity to consume to countries with a high level to consume, and the whole world stands to benefit” says Slater. “We believe it will be good for the global economy in the long run.”

While it looks like the eurozone may ease out of the doldrums and China is slowing from its former astronomical trajectory, U.S.-based firms need the rest of the world to flourish in order to buy its products. “We have to bite the bullet for now,” Gomes adds. “It might hit profits in the short term but in the long term, growth in the overall global markets will be good for American companies.”

The Most Dangerous Financial Headline I've Seen Since the 2008 Crisis

By Keith Fitz-Gerald, Chief Investment Strategist

April 16, 2015

In my capacity as Chief Investment Strategist, I read newsfeeds from more than 100 sources every day. That helps me keep tabs on the Unstoppable Trends we follow at Total Wealth, what's going on around the world, and, more importantly, discover opportunities for you that others don't yet understand or even recognize.

Given everything going on – ISIS, Russia, Washington, fabricated economic numbers, earnings… you name it – it takes a lot to surprise me. I'm pretty jaded.

But a headline I recently came across stopped me in my tracks. Cold.

It was, by far, the single most dangerous story I've seen since the 2008 Crisis. Worse, it merited only a passing mention on Bloomberg. Not a single major U.S. network I'm aware of paid it any meaningful attention.

They should have.

What I am about to tell you is proof positive that big banks are not the bastions of stability and financial prowess many believe them to be at this stage of the "recovery."

This Small German Bank Just Put Up a Huge Red Flag

More to the point, big banks may harbor hidden risks and are not, as many analysts believe, the bright spot in this otherwise potentially disappointing earnings season.

Here's that headline… and what it means for four bank stocks you may own.

The scariest headline I've seen since the Financial Crisis:

"Heta Fallout Reaches DuessHyp as Fitch Sees Capital Gap Looming"

Source: Bloomberg
Last month, according to Bloomberg, the Association of German Banks (BdB for short) had to bail out Germany-based Düsseldorfer Hypothekenbank AG (DuessHyp).

Never heard of it? I hadn't either… but here's what you need to know.

Like many banks around the world that have made questionable investments, DuessHyp was facing write-downs on debt it held. In this case, some 348 million euros (approximately $375 million) issued by Austria's Heta Asset Resolution AG, which "blew up" – a banking term meaning "failed" – because of bad loans.

Theoretically, this isn't a big deal. Every bank maintains reserves sufficient to deal with this kind of situation. Or at least they're supposed to.

But, also like many banks, DuessHyp had been trading highly leveraged swaps, and that meant the Heta failure caused a hit to the bank's reserves. Consequently, DuessHyp would have to post additional margin to maintain the highly leveraged trading positions on Eurex, Europe's largest derivatives markets.

Only DuessHyp didn't have it. So DuessHyp was forced to seek a rescue, lest the damage caused by Heta's failure cause the bank to fail and the damage to spread throughout the European banking system.

I realize that all this can be hard to follow, so let me cut right to the chase:

A bank almost nobody's ever heard of before with a total capitalization of under 15 billion euros in assets and just 52 employees is suddenly deemed "too big to fail" and has to be rescued when it's unable to post additional collateral on a mere 348 million euros in bad debt.

The total notional value of derivatives exposure by U.S. banks was $240 trillion according to the Office of the Comptroller of the Currency (OCC) as of Q4/2014.

Contrary to what Wall Street wants you to believe, derivatives are not investments… in anything. Not stocks, not bonds, not currencies.

They are nothing more than legalized gambling, because they are wagers on the expected outcomes of specific events like the failure of Greece to secure sovereign financing and what happens to its national debt when that comes to pass.

It was the same thing for Ireland, Portugal, Italy, and several other countries during the depths of the Financial Crisis – bad debt and a lack of collateral to cover it when it went bad caused regulators and central banks to "rescue the system."

So this begs the question: Why? Big banks make big bucks from trading this schlock.

Meanwhile, everybody pretends like everything is okay.

Here's where it matters to you and your money.

Derivatives Trading Is Not Only Still Happening… It's Growing

Many analysts are expecting the "undervalued" financial sector to post positive profits this earnings season at a time when there will be otherwise disappointing earnings ahead.

Much of that will come from a "surprisingly robust mortgage business that bolsters earnings," notes Paul Vigna of The Wall Street Journal. John Butters of FactSet observes that the financials may report positive earnings results reflecting as much as 8.4% growth.

At the same time, banks are planning billions in stock buybacks and raising dividends as a means of enticing skittish investors.

I think they ought to have their heads examined because the highly leveraged derivatives trading that got them into this mess is still out there… and growing.

Goldman Sachs, JPMorgan Chase, and Morgan Stanley had to alter their dividend payouts to pass the Fed's (questionable) "stress tests." Bank of America passed only provisionally.

Any big bank, no matter how tempting, is truly a case of "buyer beware." Especially now.

Ironically, only one man on Wall Street seems to get this, and it's somebody you'd least expect to raise the flag of caution.
It's none other than JPMorgan's CEO, Jamie Dimon.
In a March 2015 letter to shareholders, he noted that the U.S. Treasury market's freakish behavior last fall – which included a decline of 40 basis points, which is so many standard deviations from the norm that it should happen approximately once every three billion years – was the result of a foreseeable liquidity crunch. "We need to be mindful," he wrote, "of the consequences of the myriad new regulations and current monetary policy on the money markets and liquidity in the marketplace – particularly if we enter a highly stressed environment."

Many people think Dimon is the financial equivalent of Darth Vader. But I believe he may be the ONLY banker on Wall Street who fully understands the big picture. As such, he gives JPMorgan a decisive edge over the other big banks, many of which could be brought to the brink of collapse when the next bubble bursts.

Here are four banks that will learn the hard way – perhaps not tomorrow, or even next quarter, but sooner than most people think.

Banking Stock to Drop, No. 1:

Deutsche Bank AG (USA) (NYSE: DB)

In the 2008-2009 crisis, Deutsche Bank stock lost 64% of its value. It's seen an explosion of toxic derivatives since then, becoming the most overleveraged holder of these "financial weapons of mass destruction" in late 2013. The bank's total derivatives exposure is now greater than 52 trillion euros – or five times greater than the GDP of Europe, according to the company's 2014 annual report, published March 2015.

Despite this massive undertaking of risk and exposure, DB stock ended 2014 without a lot to show for it. The company reported net revenues of 31.94 billion euros in 2014, up just 0.07% from the 31.91 billion euros achieved in 2013.

Banking Stock to Drop, No. 2:

Goldman Sachs Group Inc. (NYSE: GS)

A lot of people feel comfortable investing in Goldman because of the (not unfounded) perception that that the bank has U.S. legislators wrapped around its trading finger. After all, Goldman received $10 billion from taxpayers in the last crisis.

But GS shares still fell by 55% in that time period, despite the cash infusion. You may remember that its slide was arrested by none other than Warren Buffett, who pledged a $5 billion infusion in GS stock in return for a hefty 10% dividend yield on his preferred shares.

Despite that big vote of confidence, it took the stock more than six years (until September 2014) to recover from the crash and reach its old July 2008 price.

Goldman Sachs has been secretive about the exact extent of its derivatives holdings, but the bank was reported to have derivatives exposure of $48 trillion by late 2013, and Bloomberg Businessweek reported that the bank plans to acquire derivatives even more aggressively going forward.

With its enormous derivatives exposure and extremely anemic stock performance in the midst of a historic bull market, Goldman Sachs is a banking stock to avoid.

Banking Stock to Drop, No. 3:

HSBC Holdings Plc. (NYSE: HSBC)

Research shows that HSBC has $4.75 trillion in derivatives exposure as of December 31, 2014, according to the OCC. For a bank with $170 billion in market capitalization, that's a staggering amount.

And the company's leadership doesn't inspire confidence, either. The London-based bank was ordered by French authorities yesterday to pay $1.07 billion in restitution following the investigation of alleged tax evasion in Switzerland.

The bank is appealing the ruling – and shares rallied 1.5% in the wake of the news. That's a short-sighted rally, considering that the bank's stock has shown itself to be especially vulnerable to crises that are becoming inevitable in the wake of the derivatives explosion. HSBC stock lost 65% of its value between Sept. 2008 and March 2009 – and next time could be even more painful.

Banking Stock to Drop, No. 4:

Citigroup Inc. (NYSE: C)

If you thought that the other three banks proved themselves to be vulnerable in the last financial crisis, just look at how the bubble ravaged Citigroup.

From July 2008 to Jan. 2009, Citigroup lost 87% of its value, going from $205.10/share on July 1, 2008, to $25.30/share on Jan. 1, 2009. In the six years since, it's more than doubled from its 2009 nadir, but it's still underperformed the gains of the markets.

This underperformance might be a key reason that Citigroup was ranked dead last in a comprehensive investing report released yesterday. The J.D. Power 2015 U.S. Full Service Investor Satisfaction Study surveyed 5,300 investors who have relied on guidance of advisory firms, ranking their satisfaction levels on a 1,000-point scale. The industry score average was 807; Citigroup came in last at 738.

Besides scoring low in its advisory service department, Citigroup comes up short in returning capital to investors, even compared with its notorious colleagues. Its 0.10% dividend yield is paltry compared to HSBC's (9.90%) and even Goldman Sachs' (1.30%).

One thing the company does have in spades is risk. With just under $2 trillion in assets, Citigroup has approximately $59 trillion in derivatives exposure, according to the OCC report.

In closing, I realize that I am bucking Wall Street here. But I'm okay with that because we've had a terrific run together making calls that they can't fathom.

Remember, the banks, the regulators, our leaders, and the world's central bankers want you to believe the financial sector is in good health because they want you to buy their shares and, by implication, reward their risky behavior. They hope that you will sign off on the fact that you can "safely" have a derivatives portfolio that's hundreds of times bigger than actual total assets.

Fat chance.

China Finally Stops Fighting the Stock Market

By: Peter Schiff

Wednesday, April 15, 2015

Although China's economy has been leading the world in annualized growth since the days that mobile phones had retractable antennas, there have always been some aspects of the country's commercial and financial system that loudly broadcast the underlying illogic of a Communist Party's firm control of burgeoning capitalism. China's stock markets were one such venue where things just didn't add up...literally.

In recent days, the stock market in Hong Kong has rocketed upward, notching the kinds of gains that have inspired many market observers to warn of a dangerous bubble forming. But as we see it, the rise is not the result of an unfounded mania gone wild, but the logical outcome of a deliberate regulatory push from Beijing to allow Chinese markets to function the way markets do in the developed world. In other words, this is not a bubble rally but a move towards normalization.

Until late last year China's stock markets have been regulated with two very different customer bases in mind, creating two very different price structures. Foreign buyers have been allowed to buy shares on the Hong Kong stock exchange but have been prohibited from buying on the Shanghai exchange.

On the other hand, domestic Chinese buyers were prohibited from buying in Hong Kong, but could buy in Shanghai. This meant that the two markets were subject to very different supply and demand dynamics, and very different price trajectories.

Foreign interest was subject to a variety of inputs that did not concern local investors: The strength of overseas markets and economies, the global interest rate environment, opinions about the strength of the Chinese economy, the foreign exchange market, and countless other factors. Chinese buyers were more influenced by the domestic economy, financial regulatory incentives, the local real estate market (which for many years was the investment of choice for the growing middle class), and the movements in gold (another popular investment alternative for rank and file Chinese). This created a tale of two markets, with performance of the Shanghai and Hong Kong markets diverging wildly over the years. The dynamic was most easily observed in the relative valuations of companies that listed themselves in both markets.

These dual-listed companies were often assigned one valuation in Shanghai and a very different valuation in Hong Kong. Normally such gaps would create an "arbitrage" opportunity for investors to close the gap. But the strict financial regulations in China prevented such normalization. That is until recently.

For much of the early years of the last decade, when the Chinese economy was in the midst of a spectacular wave of growth, and many Chinese citizens began to buy stocks for the first time, much of the outsized appreciation occurred in Shanghai. By 2007, dual-listed stocks traded at a premium in Shanghai over Hong Kong. But the market crash of 2008 hit Shanghai shares far harder. Perhaps disillusioned by the losses, or perhaps attracted to opportunities in the property market, Chinese investors pulled out, sending Shanghai into a seven-year bear market. Over that time, Hong Kong largely held steady, and so by 2014 dual-listed companies traded at a significant premium there.

However, even with the relative strength of Hong Kong, Chinese market performance over the last seven years has been dismal in comparison to the West, even though Chinese economic growth continues at a rate that far surpasses the developed world. For example, the United States has seen its stock market double in the years since the depths of 2009, while delivering average annual GDP growth of just under 1.2%.

In many ways the performance of financial markets has seemed to eclipse the health of the underlying economy as the true test of global leadership. With this sore spot in mind, the new regime of Chinese leaders that took position in 2013 and 2014, led by General Secretary Xi Jinping and Premiere Li Keqiang, seemed determined to take energetic action to level the financial playing field between East and West.

The most significant change they have implemented thus far has been the Shanghai-Hong Kong Stock Connect, which takes major steps to open up the barriers that have segregated China's market structure. The provisions will greatly increase the ability for Chinese to buy in Hong Kong and for foreigners to buy in Shanghai. The reforms also change banking regulations and interest rate structures in a way that should incentivize Chinese citizens to take savings out of the bank and invest in shares. It is hoped that these moves will finally give China a stock market that mirrors its economy.

The reforms seemed to have had their intended effect. Beginning late last year, China's investor class finally began embracing shares, pulling the Shanghai market out of its seven-year dive.

The exchange powered up 90% in just six months. Clearly, the action is getting a little frothy. It has been reported that in March alone, Chinese investors opened more than 4.8 million stock trading accounts, a boom of historic proportions. The pace has kept up, with an additional 1.5 million accounts opened in the first week of April (the Chinese government now allows citizens to hold up to 20 separate accounts).

It is assumed that the new interest in shares has been helped by a slowdown in Chinese residential real estate, which had come to be the single greatest focus of the typical Chinese investment portfolio. Having cashed out of property (and to a lesser extent gold), many Chinese turned their attention to the beaten down Shanghai exchange.

At the end of the recent rally, Shanghai shares traded over 16 times earnings, a premium to the Hong Kong Index, which traded at just over 13 times earnings. When the Connect program finally allowed the Chinese into Hong Kong late last month, many Chinese finally jumped in to close this arbitrage, sending Hong Kong up to a seven-year high, finally eclipsing the pre-crash high. (In contrast, the S&P 500 is currently 35% higher than its pre-crash high.) The Hang Seng in Hong Kong rose a blistering 15% in the month between mid-March and mid-April. In this sense, it should be clear that Main Street Chinese investors are finally holding the whip, not the hot foreign money that had been the primary river of Hong Kong performance in years past.

Many have speculated that this current mania is a dangerous flash in the pan that will burn investors who arrive late to what they believe will be a short-lived party. But it's important to realize two things that should give the rally legs. One is regulatory and the other fundamental.

While the Connect laws have greatly liberalized the ability to buy stocks anywhere in China (which by law must now be settled in RMB), a quota system remains in place to keep the lid on purchases.

At present, evidence suggests that the bottleneck has kept the pace below where it would be in an unrestricted market. So far, the maximum quota has been hit every day since the Connect regulations went into effect that allow the Chinese to buy in Hong Kong. This suggests that the demand from Chinese investors has only just begun to be realized. Hong Kong should stay strong as long as it's being pulled upward by a surging Shanghai.

While Western news outlets loudly proclaim the "death rattle" of the Chinese economy (which appears set to slip below 7% - my God how awful!), it is important to realize just how superior that growth rate remains above the moribund West. In China, 7% is described as anemic, whereas in the U.S. 3% is described as booming (although 3% growth in America is looking to be increasingly unlikely). Even if the Chinese markets, which still have plenty of catch-up to do with the West, can capture a portion of this strength, investors could be rewarded for years to come.

The moves also show how the markets in China have been hindered by regulation. The removal of these barriers has revealed hidden strengths. In contrast, U.S. markets have been helped by robust Fed policies designed to keep money flowing into stocks at all costs. Remove these pro-stock monetary incentives, and the possible crash here in the U.S. could become the opposite of the current rally in China.

A Powerful Weapon of Financial Warfare—The US Treasury’s Kiss of Death

by Nick Giambruno, Senior Editor

April 15, 2015

It’s an amazingly powerful weapon that only the US government can wield—kicking anyone it doesn’t like out of the world’s US-dollar-based financial system.

It’s a weapon foreign banks fear. A sound institution can be rendered insolvent at the flip of a switch that the US government controls. It would be akin to an economic kiss of death. When applied to entire countries—such as the case with Iran—it’s like a nuclear attack on the country’s financial system.

That is because, thanks to the petrodollar regime, the US dollar is still the world’s reserve currency, and that indirectly gives the US a chokehold on international trade.

For example, if a company in Italy wants to buy products made in India, the Indian seller probably will want to be paid in US dollars. So the company in Italy first needs to purchase those dollars on the foreign exchange market. But it can’t do so without involving a bank that is permitted to operate in the US. And no such bank will cooperate if it finds that the Italian company is on any of Washington’s bad-boy lists.

The US dollar may be just a facilitator for an international transaction unrelated to any product or service tied to the US, but it’s a facilitator most buyers and sellers in world markets want to use. Thus Uncle Sam’s ability to say “no dollars for you” gives it tremendous leverage to pressure other countries.

The BRICS countries have been trying to move toward a more multipolar international financial system, but it’s an arduous process. Any weakening of the US government’s ability to use the dollar as a stick to compel compliance is likely years away.

When the time comes, no country will care about losing access to the US financial system any more than it would worry today about being shut out of the peso-based Mexican financial system. But for a while yet, losing Uncle Sam’s blessing still can be an economic kiss of death, as the recent experience of Banca Privada d’Andorra shows.

Andorra, a Peculiar Country Without a Central Bank

The Principality of Andorra is a tiny jurisdiction sandwiched between Spain and France in the eastern Pyrenees mountains. It hasn’t joined the EU and thus is not burdened by every edict passed down in Brussels. However, as a matter of practice, the euro is in general use. Interestingly, the country does not have a central bank.

Andorra is a renowned offshore banking jurisdiction. Banking is the country’s second-biggest source of income, after tourism. Its five banks had made names for themselves by being particularly well capitalized, welcoming to nonresidents (even Americans), and willing to work with offshore companies and international trusts.

One Andorran bank that had been recommended prominently by others (but not by International Man) is Banca Privada d’Andorra (BPA).

Recently BPA received the financial kiss of death from FinCEN, the US Treasury Department’s financial crimes bureau. FinCEN accused BPA of laundering money for individuals in Russia, China, and Venezuela—interestingly, all geopolitical rivals of the US.

Never mind that unlike murder, robbery and rape, money laundering is a victimless, make-believe crime invented by US politicians.

But let’s set that argument aside and assume that money laundering is indeed a real crime. While FinCEN seems to enjoy pointing the money-laundering finger here and there, it never mentions that New York and London are among of the busiest money laundering centers in the world, which underscores the political, not criminal, nature of their accusations.

And that’s all it takes, a mere accusation from FinCEN to shatter the reputation of a foreign bank and the confidence of its depositors.

The foreign bank has little recourse. There is no adjudication to determine whether the accusation has any merit nor is there any opportunity for the bank to make a defense to stop the damage to its reputation.

And not even the most solvent foreign banks—such as BPA—are immune.

Shortly after FinCEN made its accusation public, BPA’s global correspondent accounts—which allow it to conduct international transactions—were closed.
No other bank wants to risk Washington’s ire by doing business with a blacklisted institution. BPA was effectively banned from the international financial system.

This predictably led to an evaporation of confidence by BPA’s depositors. To prevent a run on the bank, the Andorran government took BPA under its administration and imposed a €2,500 per week withdrawal limit on depositors.

However, it’s not just BPA that is feeling the results of Washington’s displeasure. FinCEN’s accusation against BPA is sending a shockwave that is shaking Andorra to its core.

The ordeal has led S&P to downgrade Andorra’s credit rating, noting that “The risk profile of Andorra’s financial sector, which is large relative to the size of the domestic economy, has increased beyond our expectations.”

For comparison, BPA’s assets amount to €3 billion, and the Andorran government’s annual budget is only €400 million. There is no way the government could bail out BPA even if it wanted to.

The last time there was a banking crisis in a European country with an oversized financial sector, many depositors were blindsided with a bail-in and lost most, or in some cases, all of their money over €100,000.

While the damage to BPA’s customers appears to be contained for the moment, it remains to be seen whether Andorra turns into the next Cyprus.

BPA is hardly the only example of a US government attack on a foreign bank. In a similar fashion in 2013, the US effectively shut down Bank Wegelin, Switzerland’s oldest bank, which, like BPA, operated without branches in the US.

To appreciate the brazen overreach that has become routine for FinCEN, it helps to examine matters from an alternative perspective.

Imagine that China was the world’s dominant financial power instead of the US and it had the power to enforce its will and trample over the sovereignty of other countries. Imagine bureaucrats in Beijing having the power to effectively shut down any bank in the world. Imagine those same bureaucrats accusing BNY Mellon (Bank of New York is the oldest bank in the US) of breaking some Chinese financial law and cutting it off from the international financial system, causing a crisis of confidence and effectively shuttering it.

In a world of fiat currencies and fractional reserve banking, that is a power—a financial weapon—that the steward of the international financial system wields.

Currently, that steward is the US. It remains to be seen whether or not the BRICS will learn to be just as overbearing once their parallel international financial system is up and running.

In any case, the new system will give the world an alternative, and that will be a good thing.

But regardless of what the international financial system is going to look like, you should take action now to protect yourself from getting caught in the crossfire when financial weapons are going off.

One way to make sure your savings don’t go poof the next time some bureaucrat at FinCEN decides a bank did something that they didn’t like is to put the money into hard assets in safe jurisdictions. Physical gold and silver stored offshore and foreign real estate fit the bill.

Until next time,

Central Banks

Fed Officials Express Increasing Concern Over Weak Economic Data

June interest-rate move looks less likely as policy makers voice wait-and-see view

By Jon Hilsenrath

April 16, 2015 3:15 p.m. ET

    Atlanta Fed President Dennis Lockhart, in a speech Thursday, notably left out the possibility of a June interest-rate increase amid a spate of soft data. Photo: Reuters

A patch of soft economic data has created uncertainty inside the Federal Reserve about when to start raising short-term interest rates, reducing the probability of a move by midyear.

Recent reports showed a slowdown in U.S. hiring in March, tepid growth in consumer spending at retail stores, a big drop in industrial output and softer-than-expected home building, reinforcing a view the economy downshifted in the first quarter and didn’t have great momentum moving into the second.

Fed officials want to see continued improvement in the job market and want to be confident inflation is rising toward 2% before they raise rates from near zero. Most of them see the first-quarter growth slowdown as temporary, but they will need time to make sure a rebound is in store.

“Data available for the first quarter of this year have been notably weak,” Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said Thursday in a speech in Palm Beach, Fla. That “is giving rise to heightened uncertainty about the track the economy is on.”

For Fed officials, the turn of events is somewhat of a recurring nightmare. Growth has continually come in short of their expectations in an expansion nearly six years old. The disappointments, in turn, have consistently forced them to recalibrate their plans.

Many officials entered this year thinking the economy was finally on a stronger growth path after several strong months in 2014 and signs that headwinds related to the financial crisis were receding. As a result, they started looking toward an initial rate increase at midyear.

At the Fed’s March meeting, they opened the door to considering a rate increase in June. But even before the recent spate of weak numbers they were divided on whether action would be warranted by then.

Mr. Lockhart’s comments are notable because he often reflects a middle ground among Fed officials when they are divided on policy questions. In February, Mr. Lockhart said he wanted to keep open the possibility of a rate increase by June. He made no mention of a June move in his comments Thursday and said “affirmative evidence” that the Fed is reaching its goal of 2% inflation isn’t likely in the very near term.

Echoing this hesitation, Boston Fed President Eric Rosengren said in a speech in London, “it remains difficult to separate the temporary and easy-to-explain from the lasting and more concerning—so in my view, incoming data would need to improve to fully satisfy the [Fed’s] two conditions for starting to raise rates.”

Some officials who appeared inclined to move by June are giving themselves wiggle room. Cleveland Fed President Loretta Mester told The Wall Street Journal in February that a midyear move was a “viable option.” In a speech Thursday, she stuck to her optimistic outlook for the economy, but conditioned a decision to act on signs that growth is “regaining momentum.”

The barrage of comments came after New York Fed President William Dudley earlier this month said weak economic data had raised the bar for rate increases by midyear.

Futures markets are already saying as much. Investors are pricing in a very low probability of a rate increase by June and market-implied probabilities for September have declined as well.

The Fed has held its benchmark short-term rate near zero since December 2008 to boost the growth during the recession and weak recovery. Most central-bank officials say they expect to start raising that rate this year, though the timing of their first move is uncertain.

The Fed’s doubts emerge as central bankers and other financial officials gather in Washington for semiannual meetings of the International Monetary Fund. Fed Chairwoman Janet Yellen will spend much of the coming days conferring with colleagues in town from overseas.

Thursday brought more disappointing economic news. The Commerce Department said groundbreakings on new homes rose a modest 2% last month, doing little to reverse February’s sharp 15% slide and a slight drop in January. Since December starts are down 14%.

Earlier in the week, the Fed reported that industrial production fell at a 1% annual rate in the first quarter, the first quarterly drop since the second quarter of 2009, thanks in part to reduced oil drilling.

Analysts at Bank of America Merrill Lynch calculate that the number of disappointing economic reports relative to positive surprises has been greater in recent months than at any point in the expansion, which began in June 2009.

Consumers’ behavior is an important puzzle for Fed officials. Job growth has been relatively strong, aside from the March slowdown. Meantime, falling gas prices are a positive jolt to pocketbooks, stock and home price gains have boosted wealth for some households, and debt burdens have been reduced.

Yet retail sales have been anemic since December. Sales excluding gasoline stations—where they are falling due to price drops—were up 4.4% in March from a year earlier, compared with a 6.7% increase in December.

“Consumer spending in the first quarter was not as strong as expected,” Mr. Lockhart said. “We did not see an expected boost to consumer spending coming from lower gasoline prices at the pump.”

American consumers are especially important to the outlook because other engines of the economy aren’t firing strongly. Most notably, a strong dollar has the potential to dent U.S. exports and oil price declines have led to retrenchment in energy sector investment. Meantime home building has been modest despite low interest rates.

“Not all sectors will contribute equally to growth,” Ms. Mester said. “Whether the drag from the trade sector will be larger or smaller than I’ve assumed is one of the risks to the forecast.”