Wednesday, August 26, 2009

Taipan Daily: The Dollar Conundrum

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Wednesday, August 26, 2009
Taipan Daily: The Dollar Conundrum
by Justice Litle, Editorial Director, Taipan Publishing Group


In November 2008, Taipan Daily ran a piece (by yours truly) called “The Importance of Monetary Velocity.”

The velocity question seems more important than ever nine months on, as the world continues to wrestle with the “inflation versus deflation” question. On the one hand, the prospect of a global recovery is highly inflationary. So is the sheer amount of stimulus being pumped into the system by the United States, China, Europe and others.

On the other hand, the prospect of a fresh banking crisis (and ongoing consumer retreat) is highly deflationary. Those who believe in deflation point out that the world is plagued by excess production capacity... that stimulus (i.e. quantitative easing) has never truly worked in the past... and that the ongoing multitrillion-dollar implosion in the credit and lending universe is enough to outpull any inflation-creating efforts, like a collapsing dwarf star with an irresistible gravitational field.

And thus, the gap between “inflationists” and “deflationists” remains wider than ever. So, too, does the potential for plausible short- to intermediate-term outcomes. Take crude oil, for example. There are good arguments for crude oil at $110 six months from now. There are also good arguments for crude oil at $35 six months from now!

In respect to potential crisis and collapse, another oddity is the behavior of the U.S. dollar. We can see this by noting how the dollar behaved during the darkest periods of 2008.

View U.S. Dollar Index Chart

It’s an ironic thing. Even though the subprime meltdown and the crash of 2008 originated in the United States, the U.S. dollar wound up being one of the main beneficiaries of the crisis!

The greenback flew higher as if shot from a cannon in August 2008 as panic gripped the globe... took a slight breather during the Lehman bankruptcy aftermath... and then went on a true rocket ride for the ages, flying, crashing, and flying higher yet again. Fear was the fuel... the buck finally peaked out, along with max pessimism, right around the time of the March lows.

What does this have to do with the inflation/deflation debate? A fair bit, as you will shortly see.

The world’s knee-jerk reaction is still to embrace the U.S. dollar and U.S. Treasury bonds (and secondarily the Japanese yen) in times of turmoil, because there is no other deep and liquid market quite “ready for prime time” when epic crisis hits. (Gold and silver are tried and true, of course, but viewed as tiny little cubbyholes relative to the tsunami of capital sloshing around the globe.)

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The dollar also benefits in crisis periods due to sudden, sharp reversals in American capital flows. Consider how U.S.-based money managers and well-heeled U.S. investors have enthusiastically put trillions of dollars to work in emerging market countries. The better the global economy looks, the more American dollars that flow to those attractive E.M. opportunities. When fear takes hold, in contrast, those dollars come rushing home at a blistering pace... giving the buck a further boost at the expense of other currencies.

Global currency speculators understand the implications of this dollar correlation full well. That’s a big reason why the euro is far more likely to crash than the dollar in the event of a fresh 2008-style meltdown... even if ground zero for the next panic is again the United States!

First Deflation, Then Inflation?

The disconnect between the dollar’s short-term outlook and long-term future makes it harder to simply pick a winner (inflation or deflation) and be done with it. Instead, if pressed, your humble editor would make a call for “first deflation, then inflation.”

Why deflation first and inflation second? Because the fully felt impact of a new banking crisis could be sharply deflationary, thanks to further sharp contraction in money and credit. (And don’t forget that European banks have serious problems too, potentially more serious than their colleagues in the U.S.)

Along with the impact of rising consumer savings and economic retrenchment, pessimism in general is deflationary as a rule of thumb. As of this writing, of course, we do not have pessimism among investors but rampant optimism. Investors have pulled on their go-go boots in expectation of a V-shaped global recovery. When that balloon of hope meets the sharp pin of realistic expectation, the result could be a loud pop.

So that somewhat sums up the “first deflation” side of things. A fresh fiscal collapse and U.S. dollar spike could bring nominal prices down as fear dominates. But on the “inflation second” side of things, there are the long-run consequences to ponder. It is still true that nobody but nobody can run a printing press like Uncle Sam. The concluding paragraphs from the November 2008 TD still ring true:

It may take a bit longer for Wall Street (and the world) to wake up and smell the bullion. But as to what happens in the medium to longer term, the distribution of outcomes is pretty cut and dry.

If deflation is vanquished and money starts to move again, interest rates will stay low for a good long stretch of time (so as not to cripple a convalescing economy). In this scenario inflation returns, much to the Fed’s relief, and gold resumes its upward climb.

If, instead, the Fed fails utterly, [Fed Chairman] Bernanke will not go gentle into that good night. He will print his way into spectacular oblivion (as all but promised in his 2002 speech)... and Mr. Whitehead’s bad dream will be realized... and gold will respond accordingly.

Warm Regards,

JL

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