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The Plan

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I put in a call to Mr. Practical late last night, not sure he was still there, hoping to get his take on the declining dollar the last two days. The bulls say this is great news for our economy and the stock market. The bears say a declining dollar will only help 13% of our economy export more and that it will make it harder to borrow funds from the rest of the world.

I unfortunately did not get a hold of him, but he was kind enough to return the call and leave me a message while I slept. Here it is in full.

"The U.S. dollar, like all economic articles, should be viewed outside of all the political hyperbole and opinion. One should not venture into the why or how, just the "is". I have heard more bunk from economists about how a "slow and moderate decline is beneficial to manufacturers" or that "a sharp decline is necessary to correct the world's trade and capital imbalances." The only fact is that it is declining. That in itself is nothing. The next step is to see what that decline is doing to U.S. bonds.

The U.S. administration is in a desperate battle to inflate; the U.S. is in debt and that debt is growing exponentially. When you are in debt you want inflation so that you can pay that debt back with cheaper dollars. And there is the quandary: the U.S. wants to pay back the debt to our foreign lenders with cheaper dollars, but if they were smart, the lenders would not want to be paid back in cheaper dollars. If foreign lenders see that the dollar is getting cheaper and cheaper, they may not want to lend anymore money. This will be reflected in U.S. bonds: bonds will go down and rates will go up.

Now if I was a foreign holder of U.S. debt and expected the dollar to drop, I would not wait around too long. But somehow these holders haven't sold bonds yet. Maybe they have been convinced that in the long run it is best to keep their dollars in the U.S. I don't know what is going on in their heads since they don't listen to me. And I don't think those foreign holders can keep buying U.S. bonds and just hedge their dollar exposure: by definition, the cost of hedging the dollar forward for ten years would negate any interest differential that exists. The situation, at least in the short run, does not seem rational to me, but then I am not a central bank, and that may be the telling fact right there. In the long run it will all make sense.

Only time will tell. Will the foreign central banks be willing to lose 20-40% of their loans on a decline in the dollar or will they blink? Just watch U.S. bonds to find out.
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