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Glasses Clink, Minyans Think


Mr. Practical, 'Ville editors drink in sage wisdom on currency markets.

Last night, fellow Minyan Editor Terry Woo and I were fortunate enough to share some time at The Four Seasons Hotel bar with the sage Mr. Practical.

Topics of discussions ranged from dollar de-pegging to insolvent banks, Shock and Awe to the Roman Empire among a number of other subjects that will remain between the fortunate few at the table. Some highlights from the discussions are detailed below for the benefit of the Minyanville community.

Yesterday on the Buzz, Toddo noted Qatar was the latest Middle Eastern country to discuss the idea of de-pegging its currency from the floundering dollar. Mr. Practical explained the implications of widespread de-pegging for both the currency and Treasury markets.

The Bank of Japan, or BOJ, tries to protect Japanese exporters by keeping the yen weak relative to the dollar. A weak yen means sales in dollars are more valuable in the local currency, improving business margins. To weaken the yen the BOJ buys dollars, making each yen worth fewer dollars (and hence dollars worth more yen). Note the reverse, as the dollar's most recent decline has coincided with an appreciating yen.

To facilitate this 'artificial' currency devaluation, rather than buy actual dollars, the BOJ buys U.S. Treasuries. Treasuries act as a proxy for the dollar, and as the chart below shows, the yield on the ten-year Treasury has mirrored the dollar's slide. As the dollar weakens, the BOJ must buy more and more treasuries to keep its currency low, helping push the ten-year yield down. Mr. P reminded us that bond yields move inversely to price.

Click to enlarge image

So, to de-peg from the dollar and let its currency float on the open market, all a central bank has to do is stop buying Treasuries. To force the issue and actually strengthen its currency, a central bank would start unloading its dollar reserves onto the market.

Japan and China hold huge Treasury reserves; $581 and $478 billion respectively at the end of 2007. Mr. Practical explained how a flood of Treasuries resulting from foreign central banks dumping dollar denominated assets would push interest rates up in the U.S. (lower bond prices mean higher yields) and pressure the dollar.

A weaker dollar pushes up commodity prices while higher interest rates crimp lending. Neither of these outcomes would help our already struggling economy.

Although he believes the dollar is unnaturally overvalued and must fall further to reach a more realistic level, Mr. P does not necessarily think there will be a mad dash to de-peg. As he wrote yesterday, "A collapse in the dollar is a de-facto bankruptcy by the Federal Reserve and the U.S. in general." Mr. Practical calls this is a disaster scenario.

Recall that Mr. P is firm believer deflation is in our future, so that he believes the dollar is still overvalued indicates the path he foresees leading to the broad decline of asset prices.

Risk is high indeed.
No positions in stocks mentioned.

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