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Tuesday, October 14, 2014


What if we are at the beginning of another 10-year bull market in the dollar? Is it unthinkable that the value of the dollar could rise back to 120 on the index over that time? Let’s look at that chart again:

From a very long-term perspective, 100 on that index is certainly a possibility, and 120 is not without precedent. But if the dollar rises to those levels, even in the very short-term, volatile patterns of the past, it changes everything it touches. And the value of the dollar touches everything. So let’s think about some of the consequences over the long term of a rising dollar.

Chapter 2 – A Monkey Wrench for the Fed
A rising dollar is almighty inconvenient for a Federal Reserve that would like to eventually raise interest rates. Multiple regional Fed presidents and Fed governors would really like to see inflation in the 2% range prior to raising rates.

A dollar that is rising against the currencies of our major trading partners is inherently disinflationary, if not outright deflationary. (Pay attention to how often that word deflation occurs in this outline.) The current inflation rate is 1.7%. The Dallas trimmed-mean PCE inflation rate was actually negative in August and has been falling for the last five months, more or less coinciding with the rising dollar.
The makeup of the Federal Reserve FOMC voting membership next year is going to be decidedly “dovish.” Dallas Fed President Richard Fisher will retire, and his voice will no longer be present. Yellen and the entire team (with two notable exceptions) have been out and about using the words data-dependent, with Minneapolis Fed President Kocherlakota arguing that raising rates anytime in 2015 would be a mistake.

Look at what Federal Reserve unemployment and inflation-rate predictions are as of September 17:

Fourteen of the 17 members of the Fed (including the 12 regional presidents) anticipate that rates will be raised in 2015.  Most observers think the first rate increase will happen at the June meeting.
What happens if unemployment continues to fall toward 5.5% and inflation drops below 1.5%? Can this Fed – not you or I, but the aggressively Keynesian members sitting on that board – justify raising rates if inflation is only 1.5% and falling? Which is the more important data number, unemployment or inflation? Or do they both need to click into place?

If the dollar were to continue to rise and thus allow Europe and Japan to export their deflation to the US, it is not clear that the Fed would raise rates in June.
A rise in the dollar from its current 85 on the DXY to 120 over the next six or seven years will throw a monkey wrench into the plans of the Federal Reserve.

Chapter 3 – Every Central Bank for Itself
A rising dollar presents all sorts of problems and opportunities for the central banks of the world. Japan has chosen the most aggressive monetary policy in the history of the world and will, I believe, work to see the value of the yen cut in half over time. Notice in the chart below that it was only 20 years ago that the yen was at 250. It touched 150 less than eight years ago. Forty years ago it was at 357. Is it so unthinkable that the yen could retrace half that move? Not to the Japanese. That would take it into the range of 200 to the dollar. I made the case for such a move in Endgame and doubled down on the prospects for Japan in Code Red. Japan is a bug in search of a windshield. The yen is embarked on a multi-year decline.

Europe would clearly like to see a weaker euro against the dollar and other major trading currencies. Ditto for almost every central bank in the world. But a rising dollar creates special problems for China and some emerging markets, problems we will look at in later chapters.
In an important speech on Saturday, October 11, Fed Vice-Chairman Stan Fischer outlined the mechanisms for the international transmission of monetary policy. Fischer says the international effects of monetary policy “spill back” onto the US, and the central bank cannot make “sensible” choices without taking them into account.
[T]he U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account.
He ended with an assurance to all that the Federal Reserve would provide liquidity to the world in the event of another crisis. Because it is in our interest, he says. This will be the ultimate test of game theory, where it might take years to find the Nash equilibrium.
The bottom line? It’s every central bank for itself. No matter how much pleading there is from peripheral central banks, there will be no true coordination among the major central banks. (Hat tip to David Kotok for alerting me to Fischer’s speech as I was writing. He also pointed out that the unintended consequences of the feedback effect means that policymaking can be dangerous.)

Chapter 4 – The Man Behind the Euro Curtain
Was it only a few years ago that Mario Draghi uttered his famous line, “We will do whatever it takes”? Interest rates in Europe have collapsed since then, as the European bond markets believed that Mario had their back. He has not had to do anything of true significance to back up those words, and what he has done has been lackluster.
This week Mario was up on the stage in Washington DC, where he essentially said that the problems in Europe cannot be fixed by monetary policy but are fiscal and regulatory and require actions from governments, not from central banks. The Bundesbank has clearly held sway, at least so far as the prospects for European quantitative easing go. While Draghi hinted that he would like to do €1 trillion worth of QE, it is not clear exactly how he would go about that.
Mario is like the Wizard of Oz. He talks a good game and puts on a good show, but it is soon going to become apparent that he really doesn’t have any magic, at least not until the Germans allow him to open up his trunk of tricks. Right now they’re keeping it safely stowed away in Berlin.
German intransigence is going to precipitate a crisis in Europe. Italy has been in a recession. France is crossing into one. Spain is barely holding on. Even German exports are slowing. France and Italy are balking at meeting the 3% deficit targets mandated by the EU treaty. Germany has drawn a line in the sand; France and Italy fully intend to cross it. This should be interesting; but however it turns out, I don’t think it will be good for the euro.
How long can interest rates in Europe stay at the irrationally low levels where they are today? We touched on that question in past letters, so I won’t cover that ground again, other than to say negative interest rates in Ireland and France are as indicative of dysfunctional markets as anything one might postulate.
When Draghi loses the narrative, or his ability to simply jawbone the market to where he would like it to be, all hell is going to break loose in the European bond market. Exactly what will the safe-haven currency be? The Swiss can’t print enough francs. Even Norway doesn’t have that many kroner. It will be the US dollar. Implications in a later chapter.

Chapter 5 – The Wrong Side of the Trade
Close to 50% of sales and profits for the S&P 500 come from outside the US. A strong dollar will put a strain on those dollar-denominated profits. Not an insurmountable problem, as Japanese businesses have figured out how to thrive in a rising-yen environment for decades. But old US business dogs are going to have to learn new tricks in a rising-dollar world.
But a strong dollar is not just a problem for US exporters. It is particularly a problem for countries that are financed by the dollar carry trade. Multiple trillions of dollars have left the US courtesy of quantitative easing and have ended up financing all manner of trades and investments around the world. As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.
If you are a Chinese businessman and you can borrow dollars (which you certainly can) and you believe that your government is going to make the yuan stronger over time, you will be able to pay back cheaper dollars and make the difference on the carry (the difference between what US bonds pay and returns that can be earned in China). But what happens if the yuan begins to fall? That trade unwinds swiftly and negatively. And it unwinds at a time that is particularly inconvenient for China. Flood the market with too much money, and inflation becomes a problem. (The Chinese are in a different phase of the monetary cycle than the US is, so the problems are not the same.)
It is not just China. Those dollars have filtered into every nook and cranny of the world; and now, if those trades are unwound, investors and most specifically hedge funds are going to have to buy dollars to unwind their trades. That will force the dollar ever higher against various currencies; and while any one currency is not significant enough to create a structural difference that can impact global trade, together they will have a significant effect.
There is a crisis brewing in emerging markets. Most of the world’s hedge funds and investors are on the wrong side of the dollar trade. Unwinding that trade is going to be a bitch (that is a technical economics term). Worth Wray will be writing about that very topic in a few weeks. You do not want to miss that letter.

Chapter 6 – The Texas Carry Trade
A rising dollar is going to put pressure on oil prices in particular and on energy prices in general. And falling oil prices have a strong secondary effect on Federal Reserve interest-rate policy. Pay attention, there will be a quiz.
Over at The National Interest, Sam Rines of Chilton Capital writes that Texas has been the engine of growth for the US for the past five years:
Job creation might be a good place to start. Texas has created jobs – there is little arguing that point. For instance, we know the U.S. economy only recently gained back the jobs lost in the Great Recession. This is not true of Texas. While the United States dropped about 6 percent of employment, Texas lost 4 percent and recovered them all by August 2011 – nearly three years before the United States as a whole.
Here is where the numbers get interesting. From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period – meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or – at the very least – disproportionately Texas.
Choosing a different starting point – for example, in the trough of job losses – changes the extremity of the story. And there are all sorts of reasons for this disparity between Texas and the rest of the country, most of which miss the main point. In a conversation with Worth, Rines called the disparity the Texas Carry Trade. I like that.
The Texas story is by and large an oil story. We are far more diversified that we were in the ’80s, but oil is clearly the driver. Texas has been at the forefront of job creation because our borders happen to contain the mostly inhospitable scrubland known as the Permian Basin in West Texas, not to mention the coastal plays and those in East Texas. Much (not all) of the growth in oil has come from horizontal drilling and fracking. And while there are enormous amounts of energy in Texas, it is not necessarily cheap energy – not like it was in the “good old days.”
Seventy-dollar oil considerably restrains the enthusiasm of Texas oil companies, let alone the banks and individuals that finance them.
And it is not just Texas companies. The Marcellus play in the Northeast is responsible for hundreds of thousands of jobs. And it’s much the same story all over the US. Oil has been a significant portion of the growth of US GDP for the past five years. If you take the massive oil boom away, the US looks a lot like Europe in terms of growth and job creation. Which is to say, anemic.
Seventy-dollar oil starts to show up in the unemployment rate, which makes it more difficult for the Federal Reserve to raise rates.
I was talking with Joe Goyne, president of Pegasus Bank in Dallas. He is one of those entrepreneurial bankers who actually analyzes a loan personally rather than letting some computer determine whether it fits the criteria. (The country would be better off with a lot more Joes running the banking industry, but that’s another story.) Joe’s customers are a who’s who of Dallas. We were discussing my convictions about a strong dollar and what that would do to the price of oil. Joe offered, “You won’t believe the pain in Dallas if oil falls to $60.” We went on to discuss some details. Does $60 oil sound far-fetched? Joe and I both remember $15 oil. Texas has been through numerous oil busts. The running joke in the late ’80s was “Would the last person leaving Houston please turn out the lights?”
The late ’80s was an ugly time for Texas. Will the Saudis ever allow oil to dip below $60 again? Can they afford to cut their production that much? What will happen to Russia if Brent drops to $80, let alone $60? It’s not just Texas. And while the world might benefit from lower energy prices, they would create havoc in a few key regions. And throw another monkey wrench in Federal Reserve policy. And in terms of the oil price, gods forbid that peace breaks out in the Middle East. But, sadly, given current circumstances, it doesn’t look like we have to worry about that.

Chapter 7 – The Bond Bull Comes Stampeding Back
Many of us in the US look at Europe and wonder how interest rates can fall to such insane levels. And the answer is that bond markets have rationales all their own. The unwinding of carry trades means the demand for dollars will rise just as the Federal Reserve cuts off the spigot. Some people look at Japan’s flooding the market with yen as an antidote and hope that the ECB, too, will soon start printing; but that is not going to reduce the demand for dollars to unwind the carry trade.
Whatever Japan and Europe do, the growth of global liquidity is still likely to fall over the next few years; and that is an inherently deflationary event, especially in dollar terms.
In addition, when – not if – there is a renewed crisis in Europe, the flight to safety is going to put pressure on the dollar and further downward pressure on US interest rates. While it is not altogether certain that China will have a major crisis – although reasonable economic historians would suggest that is the probable case – if it happens it will put further upward pressure on the dollar as a safe-haven currency. God forbid those two events – crises in Europe and China – happen at the same time. Our necks would snap at the severity of the acceleration in the value of the dollar. The convergent crises would also trigger a global recession.
We’re going to see a return of the bond bull market with a vengeance. Almost the entire world has hedged its bets for a rising interest-rate environment and assumes a benign dollar market. Almost no one expects a falling interest-rate environment, yet that is precisely what we will get if the dollar continues to rise and we have a crisis or two.

Chapter 8 – The Third Leg of the Secular Bear Market
I was writing about secular bear markets in 1999. I was early to the party, as usual (although my friends will note that I’m often late to real-time, real-life parties). I noted in Bull’s Eye Investing that it typically takes three events to completely wash out a trend. We have had two significant corrections since April 2000, accompanied by two recessions. I think the next recession will give us that final third leg of the secular bear market, hard on the heels of another correction that tests (but maybe doesn’t quite touch) the lows of 2009.
At that point I will trade my secular bear beret for a snappy new secular bull Panama. And while we may see a significant correction out of the current volatility, I don’t think the final dénouement of the secular bear will come without a global recession.
Since most of you have been through this before, you can probably figure out what strategy you should choose; but I would suggest at least thinking about having some type of hedge/moving average/risk-dispersion strategy in your toolkit.
The point is to get through this next crucial phase with as much of your capital intact as possible, in order to be able to take advantage of the coming secular bull market, when it will be anchors aweigh. Remember, we always get through these things. It is almost never the end of the world, and betting on the end of the world is a losing proposition anyway. Specifics to come later (maddening, I know, but there are space limits).

Chapter 9 – Commodities in a Dollar Bull Market
This book outline is running a little long, but a quick word on commodities. In general, commodity prices are going to face downward pressure, at least in dollar terms. That includes copper, most of the base metals, oil, etc. Silver has clearly been in a very ugly bear market. I would continue to accumulate insurance gold, but I would invest in gold only in terms of yen or another depreciating currency. Bear in mind that precious metals – along with other commodities – can and will fall precipitously in the event of a deflationary shock… although the inflationary effects of an aggressive central bank response may ultimately drive the yellow metal far above its current price.

Chapter 10 – The Return of Volatility
The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. But I don’t think it will have the same results. The unintended consequences and the unknown spillovers will only increase eventual volatility.

For new readers, I invite you to read my books (co-authored with Jonathan Tepper) Endgame and Code Red. They pretty much lay out the background you need in order to understand what will be happening in the future. We are seeing the end of the debt supercycle and the beginning of currency wars. We’ll experience the throes of hyper-indebted nation-states trying to survive what they will see as irrational attacks by a bond market. “How can you not have faith in the government? We are doing our best to try to make everything work out just fine. As long as you cooperate.” Which bond markets have a nasty habit of not doing. Oh, you can placate them in the short term, but ultimately they want to be paid back in risk-adjusted buying power. And that is the one currency that many nation-states will no longer have. Now without major reforms and a significant restructuring of the social order.
A final thought. Businesses will keep on doing what they do, in spite of the machinations of governments and monetary authorities. Entrepreneurs will adjust. New inventions will be made. Over the medium term, life on earth will get better. I honestly do see a return of the secular bull market and a pretty cool third decade, an updated version of the Roaring Twenties. Only this time there will be no need for speakeasies. I fully intend to be around to enjoy it and am looking forward to being relatively optimistic about the future. I really don’t get much personal pleasure from writing these Debbie Downer letters. But my role is to not think about the world as it should be or as I want it to be, but to be as right as I can about the direction we are going. The ride could just be a little bumpier in the short term of the next few years. Fasten your seatbelts.
And for those of you looking for specific advice, let me point you to Jared Dillian, the new editor of my own Bull’s Eye Investor service. He has been finding ways to trade and invest in this market. Last Friday he wrote:

Guys, the price action has been bad for a while. And it is getting worse. The market is demonstrating repeatedly that it can’t hold its gains. In my 15 years of doing this, I’ve only seen worse price action twice: 2000, and 2007.

You can read about Jared and appreciate his baleful glare of a photo right here. Want to sit on a trading desk across from him? I want him on MY side of the table. See if you might want him in your corner as well.

John Mauldin

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