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Cash Is Not King

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Is there not a disconnect between bonds and the dollar? I am amazed at the bonds ability to rally in the face of the dollar. Am I missing something or should I be thinking this is a golden opportunity. -jk


This is the trillion dollar question: why with a falling currency do we not see bond prices fall? In order to answer it, we need to look closely at what is going on, for it is unprecedented: the current imbalances in global markets and macro economic relationships are unlike any seen before. Because of the unique position of the U.S. dollar as the world's currency, the reaction by lending countries to a falling currency is not what normally occurs, at least for now.

Let's take Brazil (or it could be any number of countries) as an example. When a country like Brazil lives beyond its means and borrows from other countries to finance its consumption, it must issue debt, both domestically and internationally, and often runs trade deficits. Those debts are normally denominated in the currency of the lending country (or a world currency like the dollar), as typically developing countries don't have capital markets with sufficient depth to warrant large-scale financial and economic projects.

When the world realized that Brazil's fiscal and monetary policies were not sustainable without material changes, capital began to exit the country: lenders demanded higher returns for the higher risk. Brazil was forced to raise interest rates in order to curtail that exodus of capital. In other words, Brazil's currency came under pressure to depreciate in value as, on the margin, lending countries withdrew their capital. The rising interest rates began slowing the economy as capital costs became burdensome and corporate profits were impacted; this eventually led to material economic contraction.

The country was fighting market forces and because their debt was denominated in a currency they could not print, they eventually succumbed: they devalued the currency. Capital exited the country and immense amounts of domestic wealth were wiped out (the currency in which citizens owned assets was cut in half so to the rest of the world those assets were worth half as much). But the devaluation set the stage for lower interest rates (they no longer had to support the currency) and eventual recovery. This is how the capitalist process works: destruction of inefficient capital to make way for more efficient capital.

This "unwind" process looked like this: a falling currency, then falling stock prices caused by rising interest rates, and eventually a devaluation of the currency and falling rates. So the systematic process wiped out the wealth of the citizens (who were living beyond their means through debt), but also wiped out debt as they defaulted and re-negotiated. But the slate was wiped clean, with much pain, for a rise from the ashes, to re-build again.

There is no doubt that the U.S. is in a similar situation: we are running huge budget and trade deficits in relation to our GDP and consumer debt is extremely high relative to income; this is well documented. But the world is reacting much differently than it would to a smaller country given the same set of circumstances because the world has become highly dependent on our consumption base and more importantly, the debt we have issued to finance our deficits is denominated in our own currency, the world's currency.

The U.S. does not have to default on debt: we can just print more money to pay it off. As the world's lenders receive more and more dollars, they become over-exposed to it and risk just as much as the U.S. by demanding higher interest rates for more debt. The capitalist cycle is elongated in this way as foreign central banks have decided, at least until the present time, that in order to sustain economic growth in their own countries it is in their best interest to continue to recycle U.S. dollars received via the U.S. trade deficit into U.S. debt and thus keep their respective currencies from materially appreciating and impacting the abilities of their exporters to sell products to the U.S. This keeps the U.S. dollar from falling materially against Asian currencies and keeps U.S. interest rates low (artificially from an economic point of view), and thus supports U.S. economic growth.

This cycle can continue indefinitely, or at least until foreign central banks consider the risk of holding U.S. debt (i.e. risk of a material dollar weakening, an overstretched U.S. consumer, and massive budget and trade deficits potentially causing exodus out of U.S. assets) to exceed the risk of financial market and economic dislocations in their own countries (i.e. credit bubbles, inflation, excess capacity creation). They are unlikely to dispose of U.S. debt in a material way until this occurs, until the risks of holding this debt at current low interest rates exceeds the risk of causing financial dislocation in their own country. When this happens, U.S. interest rates must rise sufficiently to compensate for that risk.

So the process looks much different than that for other countries: a falling currency actually improves nominal asset prices because interest rates don't rise due to foreign central bank recycling of U.S. dollars into U.S. debt. Instead of raising interest rates to attract more capital, what happens is other countries are forced to print money as well (i.e. expand domestic money supply, that is literally print Yuan, Yen, or whatever to buy U.S. dollars). As a consequence, debt levels around the world have increased substantially, and "bubbles" of all types have been fostered.

A falling dollar is not accompanied by falling asset prices until this debt bubble is burst and rates rise rapidly.

For a clue on this again, watch the dollar/yen: a drop below 105, then 103, then 100 may be a pre-cursor to a point of maximum pain where market forces overwhelm central bank intervention.

An unwinding of this process may occur in a more rapid fashion than anyone has imagined due to intricate inter-market relationships involved and the tremendous amount of leverage present.

We used to have an old saying when we thought asset prices were going down: "Cash is king". But until other countries abandon their acceptance of printed dollars, cash will be dirt.
No positions in stocks mentioned.

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