Enzio's Clock

Background

1. Super power - or "super paltry" currency?

Readers know that we are red-blooded fans of the depth and sophistication of the American money- and capital markets. In that sense, everyone elses' are but poor and timorous cousins.

But that view does not extend to the dollar. NOT because it is "bad"; its misfortune is that it is a super power currency. We have suggested previously that super power currencies are doomed: the empire runs out of money - usually because of rising costs to defend the Empire. This leads the Central Bank to print more money - so down goes its price.

Britain went through this. Indeed, in Peter Clarke's recent "The Last Thousand Days of the British Empire", one reviewer notes that at the end of this Empire, Britain actually owed its colonies money: India alone was owed Sterling 1.2 billion, and at the end of World War II, America and Canada had to lend England a similar amount to what she owed India, namely US$ 5 billion. America is running down the same path - for not dissimilar reasons.

Thus, it should not shock us to note that since 1971, when most currencies started floating under "Bretton Woods", the dollar has fallen in rounded terms by

• 73% against the Swiss Franc - from SF 3.91/$ to now SF 1.04/$, and
• 67% against the yen - from 1971's yen 314/$ to now yen 104/$.

In addition, since the Euro was introduced in 1999, the dollar has tumbled by 32% - from $1.07/Euro to $1.56/Euro. Indeed, if you do a simple, straight-line formula, that 32% over the past nine years translates into a 132% crash since 1971 - which means that the dollar has declined far more strongly against the Euro than it has against the yen and the Swiss Franc!

2. Government monetary interventions and The Economic Time™

About a month ago we wrote about this, courtesy of one of your particularly shrewd subscriber-colleagues. Let's repeat the key finding. I have created a table so that you can see the tug-of-war between two policies: "save the dollar" versus "save America's banks" more clearly:

So what we have crystallized with/for you is that saving the dollar as well as saving American banks creates a policy dilemma ONLY IN AMERICA (column three above), but NOT OVERSEAS (column five above).

This is where Secr. Paulson's comments are particularly relevant. According to Friday's press, he reckons that the financial crises are more than "half over" in America. Policy implication: particularly in an election year,he will keep supporting banks. Sound cock-eyed? Perhaps. My "take" of this policy-speak is that

• banks remain in a mess: after all, they are only half-way out of the ditch
• Paulson is playing cheer leader, seeking to get punters to believe that the worst is over by blathering something about banks' condition getting better and that he is a "strong dollar" man (has he bothered to see how that "strong" currency has weakened?), and
• Paulson also is cheering us on to believe that the U.S. economy is about to turn. Dream on...
  

Thus, my guess is that he is talking (bad) things up...

Indeed, the actions of the Fed just yesterday, 2nd May, suggest that the current banking crises (yes: plural!) are much more mendacious than cheer leader Paulson wants us to believe. The fact is that any Central Bank efforts to boost liquidity are running into commercial banks' understandable refusal to lend, hence exacerbating America's excess demand for money. Yesterday, the Fed -

• boosted the cash-loan auctions by 50%, to $75 billion every two weeks. Under the Term Adjustment Facility (TAF), commercial banks get access to 28-day loans. These are funded by the TAF, which now can sell $150 billion/month, up by 50% from the previous $100 billion/month. This is the TAF's third increase - which started in December 2007 at $40 billion/month. Up until now, that TAF has multiplied 3.75 times! And markets are telling us there is not a financial meltdown going on backstage?
• boosted its currency swap arrangements with the European Central Bank by two thirds, to $50 billion, and with the Swiss National Bank by 100%,, to $12 billion, and
• widened the scope of collateral that can be used in the Term Securities Lending Facility (TSLF), which makes funds available to non-bank borrowers such as securities firms. The TSLF was announced this March, auctioning up to $200 billion in Treasuries in order to fund such lending to non-bank borrowers...

No changes were made yesterday to allowing investment banks to borrow directly from the Fed, nor, of course, to the $29 billion given to JP Morgan Chase's takeover of Bear Stearns.

So what happens to liquidity? My hunch is that the Fed and Treasury are keener to save banks than to save the dollar, so they create more liquidity at home. Not that this helps much, however: banks just don't want to lend, so any Central Bank creation of an excess supply of money won't alleviate the commercial banks' reticence to lend, in short, their creation of an excess demand for money.

So if, on balance, America continues stumbling under this excess demand for money because commercial banks don't want to lend, that cannot be good for her asset markets. So what you get is the worst of both worlds:

• America's excess demand for money (created by her commercial banks) constrains her asset markets' performance,
• while her excess supply of money (created by her Central Bank) means an ever-weaker dollar, thus fueling imported inflation. In simple talk: Americans have to pay more and more dollars per unit of foreign currency.
• Meanwhile, as in other instances which you all know about (e.g. the Muddle East), the foreigner takes the brunt of American actions. As we illustrated in the table: by having to help support the dollar, and all the more so when the Fed bails-out U.S. banks, domestic liquidity is pumped up. (This is not dissimilar to Mr. Greenspan's legacy of pumping-up America's liquidity, by the way...) The good news is that this helps asset markets, but the terrible news is that this excess supply of money has got to lead to an excess demand for goods once the American economy recovers, and that will fuel demand-pull inflation worldwide. That is what we are alluding to as a "funeral" in today's title.

3. What this implies for inflation and thus interest rates according to The Economic Clock™

The upshot is that America faces (cost-push) stagflation, and the rest of the world will face demand-pull inflation in 2009. The implication is that interest rates have to rise in America as well as overseas in order to contain inflation -

• in America, in order to contain cost-push inflation: the ever-weaker dollar means that Americans have to pay more dollars per unit of foreign currency. Besides, higher commodity prices will have to be passed-on to American consumers, and
  
• overseas, in order to contain cost-push inflation (thanks to higher commodity prices) as well as demand-pull inflation (thanks to an excess supply of domestic liquidity fueling non-Americans' excess demand for goods).

4. How to Make Money Off These Ideas

1. Always consult your financial adviser first.
2. We own some of these instruments by way of our Economic Time Fund and our Theme Fund.
   
3. Currency. PARTICULARLY FOR OUR DOLLAR-BASED subscribers: keep getting out of the dollar. It, too, has to keep sliding. Per our Advice Tracker (and the respective ETFs) we like
   
• the Australian dollar (FXA:US)
• the Euro (FXE:US), and
• the yen (FXY:US)
  
4. U.S. markets. Short the U.S. stock market (SDS:US) as well as her financial sector (SKF:US)
5. Precious metals: go long gold ((PHAU:LN) as well as platinum (PHPT:LN)
   
6. Bonds. Buy long bonds ONLY for income purposes. If my guesstimate of higher interest rates holds true, then long bond prices will suffer...