The dollar can only escape bad US policy for so long

Having the world’s reserve currency has allowed the US to make policy mistakes with near impunity

Jan Dehn


© Reuters


The US government has committed three serious policy mistakes since late 2017. In December that year Congress cut taxes just as the US economy attained full employment. Then, in April 2018, the Federal Reserve turned hawkish as it mistook the temporary sugar high from the tax cut for a higher trend growth. A month later, President Donald Trump abandoned America’s longstanding commitment to free trade by imposing a broad range of tariffs on Chinese imports.

Despite these policy errors, the dollar rose. If any other country had done the same thing, it would have been severely punished in currency markets and probably downgraded by credit rating agencies.

Why can the US act in this manner with apparent impunity in the markets? The answer lies in the dollar’s status as the world’s pre-eminent global reserve currency. Such a status is like insurance — it guarantees access to finance in bad times. The US can access finance even when it causes crises, as in 2008-09. It even determines the size of its own insurance payout by setting the amount of Treasuries it issues. Financial regulations contribute to the dollar’s special status.

US government bonds are assigned a 0 per cent risk rating under Basel III because they are considered risk free. Rating agencies do their bit by assigning higher ratings to the US bonds than to bonds in less indebted, faster growth countries without reserve currency status. The cherry on top: central banks earmark more than 60 per cent of the world’s $11tn of forex reserves exclusively to the dollar.

However, these big advantages do not guarantee that the dollar, a freely floating currency since October 1976, will keep its value. The policy mistakes since late 2017 now weigh on the greenback, which is down this year despite European and Chinese economic weakness.

The dollar may struggle in the medium term as well. Foreign investors accumulated large dollar positions during the era of easy money to participate in the US stock market rally. These positions will now unwind. The US economy has recovered to the point where costs are eating into US company earnings. Higher company costs erode the scope for further capital gains, especially in the context of stagnant productivity, which can be attributed to US companies buying back shares in preference to investing in their own capital stock.

Without prospect for significant capital gains, total return in the US stock market will therefore increasingly derive from dividend yield, which is many times lower than the yield available on, say, bonds in higher yield markets, such as EM. The unwind of dollar longs will eventually subside, but only after US companies have restored a competitive edge; this happens when the dollar is about 20 per cent lower than today.

The dollar faces a mounting time inconsistency problem. The US economy is heavily indebted and unproductive, but Mr Trump shows no inclination towards austerity and meaningful reform. He sees more political upside in restoring American competitiveness by inflating and debasing the dollar. This is why he leans heavily on Fed chairman Jay Powell to lower rates, supports strong pro-cyclical fiscal spending and frequently talks down the currency. Such policies are not consistent with a strong dollar.

Indeed, the last time the US pursued similar policies was in the 1970s, when Fed governors Arthur Burns and William Miller oversaw a 50 per cent decline in the dollar, 10 years of high inflation and negative real interest rates. Mr Trump’s inflationary policies will rob future generations of Americans of their savings and dollar weakness will inflict losses on central banks. It is not pretty, but, politically, inflation and currency weakness are seen as a beautiful way to solve America’s economic problems.

If Mr Trump deliberately “burns” America’s reserve currency status, his timing may be not bad at all. The trick: to avoid a disorderly dollar collapse. As long as Europe struggles with inherent tribalism and China faces deep-seated prejudices neither the euro nor renminbi pose immediate challenges to the dollar’s hegemony. The dollar looks most likely to lose ground against smaller developed market currencies and emerging market currencies. If the US slowdown is gentle, EM currencies will outperform higher beta developed currencies, such as the Canadian and Australian dollars and the Norwegian krone. If the US slowdown becomes more intense, there may be more near-term support for the Swiss franc, Japanese yen, gold and even bitcoin.

At root, the dollar’s reserve currency status depends on American willingness and ability to lead. As America shrinks from global leadership, it is prudent that all investors begin to take currency diversification far more seriously than they have done in recent years.


Jan Dehn is head of research at Ashmore Group


The Ghosts of Versailles

Exactly 100 years after the start of the Paris peace process that formalized the end of World War I, the world is at a historical crossroads again. As in 1919, the temptation to pursue more democracy and deeper international cooperation must be managed carefully, lest tragic unintended consequences follow.

Harold James

paris peace conference


PRINCETON – It has now been just over 100 years since the opening of the Paris Peace Conference, which produced the Treaties of Versailles, Saint-Germain-en-Laye, Neuilly-sur-Seine, Trianon, and Sèvres, bringing an end to World War I. To this day, resentment over the Treaty of Trianon fuels Hungarian nationalism and revisionism, particularly under the current government of Prime Minister Viktor Orbán.

Indeed, the Paris peace process is generally remembered as an example of how well-meaning international cooperation and democracy-promotion can go wrong. Now that we are living through a moment when multilateralism and democracy are again under strain, it is worth asking why efforts to promote the two so often fail.

In 1919, US President Woodrow Wilson’s attempt to forge a lasting peace by destroying the world’s autocracies proved overly high-minded, even as it inaugurated the interventionist consensus that has dominated US foreign-policy thinking ever since. Though US President Donald Trump claims to have abandoned that tradition, he has nonetheless ordered strikes against government military sites in Syria and recognized Venezuela’s opposition leader as the country’s legitimate president.

The Paris process failed because it set expectations too high. The victory of democratic powers did not mean that democratic wishes would be fulfilled, particularly when those wishes would require the losers to pay. Throughout WWI, every side simply assumed that an eventual peace settlement should saddle the vanquished with the material – and even the emotional – costs of the war, all but ensuring an unsatisfactory resolution to the conflict.

Likewise, in 2019, the problems resulting from rapid technological change and globalization might not admit of any widely acceptable solutions. As a result, different countries will produce their own narratives about being cheated by globalization. And, as in 1919, they will invent “villains” to bear the blame. For example, the Trump administration routinely complains about China’s unfair trade practices, Germany’s excessive current-account surplus, aid to developing countries, and so forth. Needless to say, compiling a litany of grievances hardly amounts to a solution.

A second explanation for the failure of the Paris process is that some of those involved – French Prime Minister Georges Clemenceau, British Prime Minister David Lloyd George, and Wilson – were uniquely incompetent or otherwise ill-disposed. Clemenceau was a lifelong nationalist, monomaniacally dedicated to the pursuit of French interests, whereas Lloyd George was the opposite, and thus too pliable and unprincipled for the task at hand. He was prone to attacking others personally, only to forget that he had done so when encountering those people again.

For his part, Wilson’s lofty aspirations far exceeded his acumen for political deal-making, both domestically and internationally. And his mounting health problems certainly didn’t help. Owing to his stratospherically high blood pressure, which went largely untreated, Wilson suffered a major stroke shortly after the Paris proceedings. One obvious lesson from this episode in history is that it is important to monitor the physical and mental health of world leaders, particularly the president of the United States, during periods of consequential decision-making.

When it comes to leaders’ character flaws, 2019 offers just as much fodder as 1919 did. Trump and British Prime Minister Theresa May could not be more different in terms of their personalities, yet both have dispensed with expert advice and done serious damage to their respective countries’ political systems. While French President Emmanuel Macron is often criticized for relative inexperience, German Chancellor Angela Merkel is seen as too experienced at preserving an outdated status quo.

The third reason the Paris process failed is perhaps the most important. The conference’s overly ambitious goals, and the flawed personalities of those pursuing them, were so obvious as to invite a lethal public rebuke. That rebuke came from the British economist John Maynard Keynes, one of the most brilliant minds of the age, in his 1919 book, The Economic Consequences of the Peace.

Keynes’s critique of the Paris process and its participants was devastating, and he knew it. In October and November of 1919, he attended meetings, hosted by the Dutch banker Gerard Vissering, where bankers from the US and various neutral powers developed a sophisticated plan for leveraging private US finance for the reconstruction of Europe. The plan showed great promise, but Keynes could not associate himself with it, because his brilliant polemic had alienated the political leaders who were needed to carry it out. In the end, only a few elements of the plan were adopted, and not until 1924, when it was already too late.

The lesson is that an overwritten critique can be counterproductive. Setting political leaders on the right course of action requires persuasion, not polemics. Hence, when it came time to remake the world in 1944-45, Keynes adopted a very different approach. He elaborated a complex reconstruction plan, but this time he operated behind the scenes. It would not have been difficult to attack British Prime Minister Winston Churchill and US President Franklin D. Roosevelt for their past economic policies, but nor would it have accomplished anything.

True, Churchill and Roosevelt were far better leaders than Lloyd George and Wilson. But even if they had been just as flawed, Keynes had learned the costs of focusing too much on the foibles of bad leaders during bad times. Whether it is 1919 or 2019, obsessing over individual leaders can distract us from working toward the solutions that today’s most pressing problems demand.


Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.


Stock Market Recovery Is A Dead Cat Bounce

by: Katchum

Summary
 
- The stock market has recovered markedly in the beginning of 2019.

- Leading indicators suggest the market is wrong.

- Stock buybacks are causing a dead cat bounce.

 
A few months have passed since the stock market correction in December 2018. Today, the markets have recovered, and it seems nobody is worried anymore (see S&P chart below from Yahoo Finance). However, the numbers are not looking good, so caution is advised if you decide to jump into the stock market.
 
 
 
 
First of all, the leading economic indicator has hit a new low for the year (See FRED chart below).
 
We haven't seen such a bad number since 2010. So I expect that the coincident "soft" indicator will follow soon. Let's go over the deteriorating "hard" indicator numbers.
 
 
 
The latest GDP numbers were abysmal. The Atlanta Fed slashed its GDP forecasts for Q4 in half to 1.5%. So we are really approaching a recessionary period here.
 
 
 
Inflation-adjusted retail sales are now negative year over year (see FRED chart below). Retailers like J.C. Penney (NYSE:JCP), Macy's (NYSE:M) and Nordstrom (NYSE:JWN) have been underperforming.
 
 
U.S. industrial production has now reverted back into a downtrend (see FRED chart below).
 
 
 
The U.S. trade deficit improved in November 2018, but it is still pointing down (see FRED chart below).
 
 
 
Producer prices are crashing down, which suggests that consumer prices will follow the same path (see FRED chart below).
 
 
I
t is probably too early to tell, but initial jobless claims are now starting to move higher, because real GDP growth is weak (See FRED chart below).
 
 
 
The conclusion is that there are multiple signs that the economy is cooling down: GDP growth is weak, inflation is low, and jobless claims moving higher. All the ingredients for a recession are present. With this in mind, I also suspect that the Federal Reserve will end QE this year.
 
You might wonder why the stock market is up for the year then? The answer lies in stock buybacks.

All the money that was being repatriated back into the U.S. and all the money from tax cuts have been flowing into stock buybacks since the start of 2018, and this will continue until the end of 2019. We are now halfway. If you're smart, you'll take this opportunity to reduce your risk.


The Instability of Britain

Brexit is less important than the increasing fragility of Britain and the British Isles.

By George Friedman

 

The Brexit referendum bisected Britain. The vote was designed to demonstrate that Britain did not want to leave the European Union. In fact, had Britain’s political and business elite doubted that the referendum would result in a “remain” verdict, it’s unlikely the vote would ever have been called. But 52 percent of voters wanted to leave the EU; 48 percent wanted to stay. If 2 percent of voters had switched positions, the referendum could just as easily have gone the other way.



 
Britain was deeply divided, and the elites were oblivious to that division. The critical question was: Did they have any interest in the reality facing most Britons?

Well-credentialed, well-spoken opponents of Brexit were certain that those who voted to leave the EU were uneducated and incapable of understanding the consequences of their vote. Brexit opponents attempted to delegitimize the referendum’s outcome by effectively delegitimizing the democratic process: They argued that just over half of the British public was not qualified to have an opinion – effectively saying that 52 percent of Britain’s voters should have left such serious matters to their betters.

The divide that has emerged in the post-Brexit world threatens to reopen centuries-old uncertainties within the British Isles. The European Union itself was not the source of this divide, but its policies helped drive a deeper wedge.
 
The Disparity of Free Trade
Free trade is the main problem underpinning Brexit. EU supporters in the United Kingdom prospered under British membership in the bloc. But free trade did not benefit all Britons, and in denigrating Brexit voters, the EU stalwarts failed to acknowledge this. Brexit’s core supporters were in the industrial areas of the United Kingdom, where people had lost jobs as British companies moved their factories to other countries or as Britain could no longer compete in certain industries.

Free trade posed two vital questions in Britain. First, how long does it take to see the benefits of free trade? In the long run, it might have advantages for all nations. But if you’re 50 years old and have lost your job, you may not live long enough to reap the rewards. As John Maynard Keynes put it, “In the long run we are all dead.”

Second, who reaps the benefits of free trade? Although a country’s gross domestic product may rise, the benefits are not evenly distributed. Significant segments of society don’t share in the prosperity and may even suffer deeply while others profit. This appears to have been the reality behind the Brexit vote: Many gained from free trade, and many lost ground.

The latter lost not only economic ground. They also lost the political ability to change the course of events. EU membership created a rigidity in the political system; many rules imposed from Brussels could not be turned down by  Westminster. Hence, Britain lost a great deal of sovereignty. For those prospering under the EU, this was a small price to pay. For those who saw no benefit, the loss of political power rendered them helpless.
 
Britain’s Divide
This story has been told and told again. The contempt of upper classes for the lower classes was epidemic in Britain until around World War I; thereafter it gave way to a recognition of common citizenship. But the current telling of the story leads to a more important reality. However Brexit shakes out, Britain will remain divided and politically unstable. The bitterness of “remain” voters is striking. To them, this was not merely a policy debate but a question of who ruled Britain. If the withdrawal from the EU hurts their interests, their anger will become a fixed characteristic of the upper classes.

If, on the other hand, Parliament votes to annul the Brexit vote or calls another referendum, a different but substantial part of the British population will become embittered. Either move would signal that the purpose of the first referendum was to affirm the elites’ position on the EU, and that they will keep trying until they win. Pro-EU advocates are certain they would win a second referendum, but nothing can be certain when it comes to matters of public opinion.

Brexit, therefore, is institutionalizing a vast social divide, resurrecting the elites’ contempt for the poor and the poor’s hatred of the rich. Even if another referendum saw one side win by a 70 percent to 30 percent margin, nearly a third of the population would still be profoundly opposed to the outcome. That’s a large slice of the population to leave steeped in anger and alienation.

The British political system is in chaos. The Conservatives historically spoke for one segment of society, Labour for another. It’s no longer clear who is speaking for whom or whether their voices even matter.
 
Beyond Brexit
Brexit, therefore, has redefined Britain’s internal dynamic at a time when the question of the British Isles is reopening. In Scotland, an extraordinary 45 percent of the population voted to leave the United Kingdom in the 2014 independence referendum. That issue, like Brexit, is not closed. More important, the ever-dangerous Irish question has resurfaced. That question had been settled for a century, but Brexit has posed threats to a tenuous peace. Although the border region has not resorted to violence (save for a couple concerning incidents), historically the relationship between Northern Ireland and the Republic of Ireland, and both their relationships to Britain, has been explosive.

So, as Britain passes through its most intense social crisis in generations, the cohesion of the British Isles is once again in question. It is not inconceivable that the Union Jack could become obsolete, and that Britain’s geography could contract to a size not seen for centuries. And if that happens, the dynamics of the Continent will change.

These are extreme and unlikely evolutions, but five years ago the kind of class contempt and hatred that has emerged in post-Brexit Britain would have been unthinkable. Perhaps the most important point is that the EU issue was the trigger. As the reality of a swelling class divide emerged in Britain, the EU made managing the situation much more difficult.

This situation is not unique to Britain. Class tension and political incoherence have become commonplace on the Continent and in the United States, as well as in Russia, where only 33 percent of people say they trust their president. In some ways, I am reminded of the interwar period of the 1920s and 1930s, when class tensions were profound. But even then, political parties in most countries were stable and predictable. The extension of the uncertainty to the political party system makes Britain’s current situation all the more unsettling.


What Blows Up First? Part 6: “Almost Junk” Bonds

by John Rubino


The key insight of the Austrian School of Economics (maybe the key insight of ALL economics) is that the amount you borrow matters, but so does the use to which you put the money.

A case in point is US corporate debt, which has changed structurally lately in very scary ways.

The short version of the story is that after the US cut interest rates to historically low levels to keep the Great Recession from swapping it’s capital R for a capital D, public companies figured out that they could borrow money for less than their stocks’ dividend yield, use the proceeds to buy back their outstanding shares, and generate free cash flow in the process. And – a nice added perk – the increased demand pushed their share price up and landed their CEOs even bigger year-end bonuses.

So that’s what they did, on an epic scale.

corporate share buybacks almost junk bonds

But – recall the Austrian School insight – the result was soaring debt without any new productive assets to offset the cost.

Generally speaking, debt rising faster than operating income equals diminished creditworthiness. So all that borrowing has produced several trillion dollars of debt that’s just one step above junk. Here’s an excerpt from money manager Louis Gave’s take on the subject.
The Size of Corporate Debt One Rung Above Junk Has Never Been Greater, Warns Louis Gave 
Louis Gave at Gavekal Research says the greatest source of potential instability in the years ahead lies with the massive growth of the U.S. corporate debt market, particularly at the BBB-rated (near junk) level. 
Gave recently told FS Insider that it has far outpaced the economy and could be due for a reset during the next downturn, which is increasingly becoming a concern by other strategists. 
When it comes to potential trouble spots brewing in the financial markets or global economy, Gave said “if you ask a French client, they tend to point a finger at Italy. If you ask Italian clients, they point a finger at Deutsche Bank; and if you ask German clients, they point a finger at France. When I talk to my U.S. clients, most of them point a finger at China, which they see as having unsustainable high levels of debt and is an accident waiting to happen.” 

However, Gave sees an even source of potential problems since, as he points out, the “size of corporate debt one rung above junk has never been greater” (see below). 
almost junk bonds
 
The challenge today, Gave said, “is that part of the massive growth we’ve seen in the U.S. corporate bond market has really taken place in the BBB space. And so, if you start seeing an economic downturn (and the usual type of downgrades that occur in a downturn), then all of a sudden you have investment grade that becomes non-investment grade.” 
Gave worries this could send shock waves through the financial markets since U.S. corporate debt is widely held by pension funds, investment banks, and large institutions all around the globe. 
“There are real questions about all the energy debt that’s being issued by a lot of negative cash flow companies in the energy space,” he said, which also leads to questions about industrial, auto and real estate debt. 
Gave asked listeners whether all this growth in debt has “funded the purchase of assets that allow the servicing of the debt and then the reimbursement of the debt or has this growth really funded a massive rise in share buybacks and financial engineering?” Gave said if the answer is the latter it would signify that our balance sheets are far more stretched out than they have been in previous cycles.

To sum up, hundreds of US companies are about to find their bond ratings cut to junk. They’ll then have to pay way up to refinance their debts (or in some cases to make payroll), setting off a death spiral that, if the history of past debt binges is any indication, will end with mass bankruptcies.

And as Gave notes, a ton of these bonds reside in the very same pension funds that are already due to implode in the next recession.