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Regarding trade deficits, budget deficits, the USD and U.S. treasury yields, the most important point I took from those comments are that correlation does not mean causation, a point I tried to make yesterday when I noted that the perceived correlation between the USD and stocks (a positive correlation where if the USD increases in value so too do U.S. stocks) is dead wrong. Stocks have been advancing while the dollar has been getting crushed for the past 2 years.

We have spent a lot of time writing about how trends manifest themselves in asset markets: specifically the role that irrational herding-type behavior has on the creation and persistence of trends. This aggregate psychological manifestation of fear and greed - how much an investor is willing to pay for say the U.S. dollar - is very important to understanding how and when trends manifest. And often times, as we suggested in noting the non-correlation between the DXY and the SPX, these trends are independent of other macroeconomic trends.

But this is not to say that markets are only a function of group irrational behavior. There are laws of economics at work, and those laws, at least those of the Austrian School, do have an impact on macroeconomic trends - their sustainability and persistence.

John's point about the current account deficit being in excess of 5% and that representing a long term risk is a perfectly valid observation. Whether that 5% of GDP threshold will cause a greater appreciation of risk on foreign investors' parts remains to be seen. The self-reinforcing aspect of herding behavior could cause the current account deficit to go to 6%, 7%, 10% or more of GDP before the onset of the investor flight that John speaks of.

But make no mistake, just because past correlations are unclear on the impact of budget deficits and current account deficits on long rates and the USD does not mean that the laws of economics (at least those envisioned by Mises and Rothbard) can be ignored.

Countries cannot run record budget and current account deficits ad infinitum. Even one whose currency is the reserve currency for the rest of the world. Eventually, the risk builds up to a point where it exceeds the appetite of those taking it. No amount of past non-correlation (to coin a term) can change that economic law. But herding behavior can change the risk appetites of our lenders in the short term. Right now, we're seeing the manifestation of that herding behavior in terms of increased risk appetites, in terms of our lenders' collective ability to shrug off the declining dollar while budget deficits and current account deficits balloon.

They won't always be so magnanimous. And correlations aren't going to save us when they aren't.
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