THE DOLLAR: CALM BEFORE THE STORM? / MACLEOD FINANCE

The dollar: Calm before the storm?

Markets expecting falls in interest rates are blind to reality. Lower rates won’t prevent an imploding debt/credit bubble undermining the dollar and its purchasing power.

ALASDAIR MACLEOD

The chart below shows what will blow apart the credit bubble, putting in chain a series of events which could rapidly undermine the dollar, potentially fatally, and all US investment media. 

The carnage is bound collapse the other major G7 currencies and their financial markets as well.

In May 2022, the long bond yield smashed through the 40-year downtrend at 3%. 

The equity bubble continued, with the S&P 500 rising from 4130 to an all-time high of 6550 currently. 

Admittedly, the headlong rush in the long bond’s yield paused at 5.1% in October, since when it has moved sideways. 

But as the pecked lines covering from that period illustrate, this is a consolidation and not an end to the uptrend in yields. 

And very soon, they will start rising again. 

And technical analysis tells us to expect another rapid rise in the yield, covering a similar distance to the preceding move. 

That takes it into national bankruptcy territory.

Already, the valuation relationship with equities is more overstretched than it has been since reliable records began, as the next chart shows:

The long bond’s yield is the same as in the first chart but inverted. 

And as stated above, the S&P 500 Index has continued rising regardless leading to the massive valuation disparity gap indicated by the two-headed arrow. 

There is no clearer proof of an equity bubble, and bubbles always end in a collapse. 

Furthermore, the prospect of such a crisis, which is what the charts tells us, is confirmed by gold’s performance. 

Notice the similar consolidation pattern of the last five months to that of the long bond’s yield. 

Both gold and the long bond yield can be expected to be rising in synchrony subsequent to their respective corrections:

Let’s think through the implications for a moment. 

A rising long bond yield tells us that markets are pricing in greater investment risk for buyers of US treasury debt. 

Investors will require compensation for that risk, which cannot be for risk of outright default because the Fed can always print the government’s way out. 

Therefore, the risk can only be that the dollar will lose purchasing power.

Gold’s rise confirms this conclusion. 

If anything, its recent breakout is front running a break above 5.1% yield for the long bond. 

When that happens, it is bound to collapse the equity bull market.

For a hint of how it may play out and the consequences, we can refer to Germany between 1920 —1923 and the relationship between a credit bubble in its fiat currency (the Reichsmark) and the subsequent consequences for its purchasing power. 

Along with the other European combatants, Germany abandoned its gold standard just before the First World War, financing its war machine by a combination of debt and money printing and minimal taxation.

That the purchasing power of the Reichsmark fell by about 80% between the end of the war in November 1918 and February-1920 need not detain us. 

More important was the credit-driven boom between March 1920 and December 1921. Prices were relatively steady, and business and the stock market were booming. 

The Reichsmark even rose strongly against the dollar, which was still on a gold standard, more than doubling by July 2020 from February that year before ending 70% higher in May 2021. 

It was the best performing currency at that time.

The inflationary excesses of 1918—1920 had died down, to be replaced with a brief period of great prosperity financed by yet more credit and currency expansion but at a more measured pace. 

This prosperity was unevenly distributed, favouring the wealthy and speculators, with the stock market trebling before it peaked in December 1921.

The pause in Germany’s inflation crisis rhymes with the dollar’s current conditions following the post-covid inflation in 2021—2022. 

Since then, there has been a speculative boom, with equities rising to record levels driven by credit expansion. 

As was the case in Germany’s brief boom, Wall Street has created wealth for speculators while Main Street stagnates.

To complete the analogy, all we need to see is the stock market crash. 

It is already wildly overvalued relative to bonds. And for a new round of inflation to commence. 

As Germany was in 1920—1921, we appear to be in the eye of an inflationary storm.

At this point in our analysis, it will be helpful to define inflation properly. 

It refers to an expansion of credit and debt, not to the consequences for prices. 

The confusion arises from a fashionable belief that the general level of prices inflates, and not that the purchasing power of a currency declines. 

It is probably the most misleading error in all economic analysis. 

What happened in Germany over 100 years ago was a collapse in the Reichsmark’s purchasing power, though it has been misleadingly interpreted as a hyperinflation of prices. 

Similarly, the fiat dollar’s purchasing power has been declining and rising prices are the consequence.

Not even expert economists and analysts would think to make the comparison of today’s credit conditions and the consequences with those of Germany in 1920—1923. 

But if Germany’s example is followed, then like the fiat Reichsmark the fiat dollar will collapse entirely. 

The causes might be different, but the essence of the problem is the same. 

So what will be the trigger?

Convention suggests that financial crises are triggered by an event, systemic or otherwise. 

But here is an obvious cause staring us in the face: a growing realisation that the US economy is not just stalling, as recently revised employment figures indicate, but it is descending into recession. 

The need for the US government to fund its deficit will escalate accordingly, and unexpected demand for extra funding can only increase bond yields.

At the same time, the president’s deliberate policy to weaken the dollar with lower interest rates while imposing tariffs on imported goods will make things far worse.

It is remarkable that the US’s creditors haven’t yet appreciated the dangers facing them, but then they are fully committed to the credit bubble. 

Like investors in the German stock market between 1920 and December 1921, they have become drunk on their good fortune and oblivious of the bear about to pounce.

Higher bond yields will end up collapsing the dollar

The consequences for the stock market of bond yields soaring are one thing, but the concerns are far wider. 

As we saw in the US’s 1929—1930 bear market, banks added to the decline by liquidating stocks held as collateral, dumping them onto reluctant markets. 

But the greater damage will be on corporations needing to refinance debt at rates which are commercially unaffordable or go under. 

Furthermore, counterparty risks in derivative markets will increase, threatening the stability of the entire shadow banking system.

To these dangers, there can only be one response and that is to follow Germany of the early 1920s: turn on the credit pump and reflate like mad irrespective of the consequences for the dollar. 

Politics demands it, whatever the Fed thinks. 

Ahead of the forthcoming credit crisis, it is impossible to see how the currency will be stabilised before it has collapsed. 

In Germany between 1922 and November 1923, the pre-war Reichsmark valued at 23 cents US finally settled at one trillion to one, or over four trillion to the gold-backed US dollar.

The economic consequences of a repeat of this performance for today’s fiat currencies hardly bear thinking about. 

The professional classes in Germany lost all their wealth, and along with the labouring classes faced starvation. 

The only beneficiaries were magnates such as Hugo Stinnes, the inflation king and Fritz Thyssen, who made their fortunes by exporting and earning gold-backed dollars.

Gold, which in all European nation’s common law and that of all their former colonies and dominions by adoption is money without counterparty risk. 

It is only just beginning to reflect these existential dangers to dollar denominated credit. 

Unless or until a solution can be magically found to prevent the dollar’s fiat currency value from declining, gold and also silver will be the best refuge from the near-certainty of the ultimate credit chaos.