ARE DOLLAR BEARS TOO BULLISH / BARRON´S ( VERY HIGHLY RECOMMENDED READING )

TUESDAY, NOVEMBER 24, 2009

UP AND DOWN WALL STREET

Are Dollar Bears Too Bullish?

By RANDALL W. FORSYTH

It would be so simple to follow the playbook of the inflationary 1970s. Today's deflationary threat is more dangerous, however.

GOLD SET ANOTHER RECORD MONDAY while the Dow Jones Industrial Average gained 1% to a 13-month high, supposedly based on the cheery thought that the U.S. dollar would inevitably collapse to zero.

Investors faced a barrage of bearish articles about America's fiscal plight, from the front page of the New York Times warning about "Wave of Debt Payments Facing U.S. Government" to the Economist's cover story, "Dealing with America's Fiscal Hole" to the Financial Times posing the question, "Is Sovereign Debt the New Subprime?"

No wonder they wanted to flee the dollar. As Dennis Gartman observed in his Monday morning missive: "It is almost as if one can hear capital saying aloud, 'Let me outta here; get me some gold; or get me some euros, at least get me some blue-chip stocks. Get me anything, but get me out.'"

With the U.S. Dollar Index falling another 0.7%, to 75.10, gold continued its seemingly unstoppable advance to another peak. The active December futures contract on the Comex settled up $17.90, at $1,164.70 an ounce after trading at almost $1,175.

And as if to underscore the public's interest in the latest gold rush, the five most-read stories on Marketwatch.com were all about gold. (Marketwatch is owned by News Corp., which also is the publisher of Barrons.com.)

There's no disputing that America's budget mess poses a long-term threat to the dollar, more so than the Federal Reserve's low-interest-rate policies. That was pointed out here just last week ("A Foolish View of America's Debt, Nov. 18.)

So far, however, there seems no shortage of buyers for the U.S. government's debt, including Monday's record auction of $44 billion of two-year notes, which will be followed $42 billion of five-year notes Wednesday and $32 billion of seven-year notes.

That would contradict the notion of an imminent rerun of That ''Seventies Show, featuring soaring interest rates and inflation. That is, after all, what sent gold to its then-record of $850 in January 1980, the final year of that benighted decade. (And by the way, notwithstanding all the recently published assessments of this decade, it doesn't end until Dec. 31, 2010.)

Would that we could have that rerun? We'd all have the playbook on how to deal with those travails. Don't buy any Pintos, avoid polyester and burn disco records. Just buy gold, dump bonds, borrow and borrow and buy the biggest house you can afford. Maybe the last one didn't turn out so well.

Indeed, Albert Edwards, Societe Generale's global strategist, sees the risks running quite the opposite of the consensus, which has a global recovery on track with a steadily falling dollar. Instead, he looks for a double-dip back into recession leading to a surging greenback, with a collapse of "the China economic bubble" resulting in a double whammy for commodity prices.

Writing in his latest Global Strategy Letter, Edwards points to signs of doubts about the U.S. economic recovery, from the labor market remaining "very sick" with the uptick in unemployment rate over 10% plus the Conference Board's consumer finding showing jobs getting still harder to get. Meanwhile, the ECRI Leading Indicator, which trumpeted recovery earlier in the year, has fallen for five straight weeks.

But what's way out of the consensus is the call for China's massive trade surplus to turn to deficit by Societe Generale's Asian economist, Glenn Maguire, who Edwards writes has been "very right on China this year."

"This is a mega-call and will have major implications for the global financial markets," Edwards declares. China no longer will be accumulating currency reserves at nearly the same pace, leaving less to recycle into U.S. Treasuries. The reduced capital inflow would also slow China's domestic monetary growth and real output, which track each other. Meanwhile, capital outflows from Japan, another source of global liquidity, could be hampered were there a sharp rise in its government bond yields.

A synchronized end to the Chinese and U.S. economic recoveries could play out in increased protectionist pressures, including competitive devaluations, Edwards continues. That could lead to a spike in the dollar as speculative carry trades are unwound, as happened to the yen in 2008. A rise in the dollar would pull up the renminbi, which "may be all too much for a beleaguered Chinese economy."

Then, Edwards says, the U.S. goal of delinking of the RMB from the dollar would be accomplished -- with China devaluing rather than revaluing its currency higher.

Edwards adds, "I am reassured that my views are not totally bananas when two of the deepest thinkers are also concerned about a Chinese economic crash."

Those include Edward Chancellor, who has written extensively about bubbles, including "The Devil Take the Hindmost: A History of Financial Speculation," and recently observed the Chinese economy shows symptoms of weakness similar to those after the Greenspan Fed reflated following the bursting of the tech bubble. Meanwhile, Jim Chanos, the famed short seller of Kynikos Associates, thinks he spies manipulated data about China's economy. Chanos, it should be remembered, sniffed out the phony accounting at Enron.

Indeed, there were hints the bubble in China was about to burst, or at least deflated, in the 3.5% plunge in the Shanghai Composite Tuesday. That came after on rumors that China's banks were ordered to raise more capital. Charles Dumas of Lombard Street Research writes in a note to clients this wasn't just a matter of an increased supply of shares, but a move almost certainly on orders of the government for banks to bolster their balance sheets following their lending spree earlier this year. Tightening of monetary policy is likely to follow as the boom produced by massive fiscal stimulus -- equal to 25% of gross domestic product--is generating inflation pressures.

The sort of deflationary crisis, resulting in competitive devaluations, protectionism and contracting world trade, recalls what happened in the 1930s, Edwards concludes. Despite politicians' solemn vows not repeat those blunders, "all I see are more and more protectionist measures being implemented, belying the soothing rhetoric."

The 1930s were indeed very different from the 1970s. In the latter decade, you could just buy gold (though that was more difficult before today's exchange-traded funds) and let your cash earn double-digit yields. The falling dollar battered stocks and especially bonds back then.

Now, cash yields absolute zero but stocks benefit from every drop in the dollar while global investors continue to buy Treasuries, seemingly undeterred by the greenback's steady slide.

But recall a year ago; the dollar soared like the yen with the unwinding of carry trades (which involve the borrowing in those low-yielding currencies) as stocks and other risk assets fell sharply.

Such a rerun seems to be the one potential risk that seems ignored as gold gets bid giddily higher -- a significantly more painful deflationary squeeze than the inflationary surge they see.

At the minimum, China's likely moves to cool its boom could portend outcomes quite different from the what the consensus expects. As Lombard Street's Dumas concludes, "With China's recovery as the leading force in the world recovery, this would mark the end of the stock market, and general risk asset, rebound from last winter's lows."

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