“I know what you're thinking. "Did he fire six shots or only five?" Well, to tell you the truth, in all this excitement I kind of lost track myself.” -Harry Callahan
Someone once said that you only have one chance to make a first impression. As the ramifications of the recent rate cut resonate, odds are that it’s going to be indelible.
After years of focusing investor attention on the risks of inflation, the market demanded—and the Fed delivered—a policy shift designed to alleviate credit market pressures.
In doing so, it effectively told foreign holders of dollar-denominated assets that every nation must fend for itself. That, when push comes to shove, the devil we know—inflation—is more palatable than the devil we don’t.
As the dollar slips to multi-year lows, it’s incumbent on us to understand the implications of this policy sea change. As such, and in the interest of education, we wanted to offer a few thoughts as they relate to the currency conundrum.
First, it would be helpful to familiarize ourselves with the underlying basics of the dollar dynamic. Kevin Depew wrote a fantastic primer
that, in my view, should be required reading for anyone trying to get a better grip on the subject.
For the last few years, while hiding behind the beard of hawkish vernacular, the FOMC has printed and pumped massive amounts of money into the financial system. That liquidity, while providing a rising tide for virtually every asset class, comes at a cost.
It’s been my long-standing belief that we will toggle between “asset class inflation” and “dollar devaluation.” While both could manifest, I don’t foresee a scenario that includes both a stronger dollar and
higher asset classes.
The Federal Reserve, if given the choice, would opt for hyperinflation over watershed deflation. With inflation, the rich get richer, the poor get poorer and the middle class steadily erodes. With deflation, everyone loses.
Wasn’t it Billy Ray Valentine that said that the best way to hurt rich people is by turning them into poor people?
We've been monitoring this evolution since 2002, opining that the 30% run in the S&P
has been masked by the 33% decline in the greenback (measured by a basket of currencies). That hasn't mattered to “us” but it's the central tenet of foreign angst and the seed that has sown Nationalization.
Think about it—if you’re a foreign central bank and you bought the S&P in 2002, you’ve lost money on the margin. That’s the Fed's chief beef with the dollar being the world reserve currency. While we’re enjoying the benefits of our economic “expansion,” they’re sucking wind in local currencies.
Put another way, and viewing our recent run with, as my friend Jeff Saut
likes to say, a different “measuring stick,” the DJIA
was up 2.8% last week following the rate cut. If you owned U.S equities with, for instance, the New Zealand dollar (which rallied 4.1% last week vs. the dollar), you’re in the hole for 1.3%.
That may seem like an obtuse perspective but it’s pertinent in the context of the worldwide economy. Americans have been slow to embrace the notion that our basis of valuation is eroding. We earn, spend and save dollars so, apples to apples, there was little impetus to pay attention.
However, as globalization was the perceived catalyst on the front of the tech bubble, it stands to reason that it’ll serve as a culprit on the other side of the ride. International investors own over 50% of total U.S debt, which basically means that they’re holding the trump card on policy.
It’s my opinion that the FOMC kept a tightening bias at the August meeting to appease those foreign holders of dollar-denominated assets despite the need to lower rates to spark demand and prod consumers to consume. (See The Master of the Fed Domain
In our finance-based economy, the velocity of money
and elasticity of debt
are essential ingredients to the upside equation. That is the crux of the credit crunch
that brought this conundrum to bear. Money stagnated and credit seized. The worldwide response, verbally and structurally, was in shock the patient back to life.
All things being equal, a decline in the dollar could be “asset class positive,” much as it has been for the last five years. But if the greenback finds a sustainable bid, it’ll likely serve as a clarion call that something entirely more disturbing is afoot.
At the end of the day, our financial health becomes a question of how far the dollar will fall before foreigners scream “Uncle Sam” and, by extension, unwind dollar-denominated positions without committing the financial equivalent of hari-kari.
And it leaves us, investors, in the unenviable position of gaming an invisible catalyst. For regardless of whether we’re wading into inflation, deflation or both, we’re left to wonder how many weapons the Fed has left in their arsenal.
For when they arrive at the last bullet in the gun, it will likely be pointed inward.
- NDX 2060 is the most recent breakout and can serve as a bovine backstop for those so inclined.
- There’s a lot of hand wringing over energy costs with crude tickling $80/barrel. The irony is, if crude trades appreciably lower, equities will likely be a house of pain.
- Countrywide Financial (CFC) is again flirting with the convert price ($18) from the Bank America (BAC) deal. Please keep this on your radar as both a structural and psychological proxy.
- While Goldman Sachs (GS) trades great of late, I continue to operate from the short side using (above) GS $214 as my technical stop.
- The health of the consumer, which drives 70% of the GDP, is critical to our economy. Given the recent news from Target (TGT), Lennar (LEN) and Lowe's (LOW), one has to wonder how much elasticity is left on their credit cards.
- “Yesterday I was 59, today I’m sixty. Yesterday I was 22. Don’t wake up at sixty and wish you had today to live all over again.” Muhammad Ali.
Position in gs, s&p.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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