Dollar Strength

The dollar appears to be strengthening, at least against other currencies. That is not unimportant for investors, but the reason why should not be overlooked: Quite simply, all countries/currencies are heading to hell in a hand-basket. The US is no exception, but its rate of decline is slower than most. As a result, it is perceived to be less risky than Europe or other fiscal basket cases.

Flight To Safety

The dollar’s strength is attributed to a ” flight to safety.” If true, it is only so on a relative, not an absolute, basis. Currency flows out of Europe and the BRIC country currencies where deterioration is occurring and anticipated to accelerate. Understanding what is happening in the US makes it rather hard to accept that we are considered a “safe haven.” We are in the sense that everything is relative. In a world of blind men, the one-eyed man is king. In a world of currency devaluations, the country debauching its currency the slowest is king, at least for a time.

The June edition of Contrary Investor explains:

As a really big picture comment, during periods of sovereign/government debt crisis, global capital flows to the asset or currency offering the highest perception of safety and quality.  At the moment that happens to be the US and the US dollar specifically.  Is the US problem free?  Far from it, but for now the weakest link in the global financial solvency chain is Europe.  It’s all about relative safety and risk when it comes to how global capital moves at any point in time. Receiving far too little attention over the last few months has been meaningful capital outflows from the BRIC countries (Brazil, Russia, India and China).  Euro area financial and economic problems are problems for the emerging economies that are heavily export dependent and commodity intensive.  Europe in aggregate has been a very large customer of the emerging economies.  The Euro area inclusive of the UK is China’s largest trading partner.  As the Euro area weakens, that implies forward weakness for the export driven emerging nations and heightened economic risk.  Hence, global capital is incrementally moving out of the BRIC countries as economic risk increases.

Secondly, and this is very meaningful, we have seen banking system runs in Europe.  Greece was the frontrunner, but Spain and Italy are not too far behind.  If bank solvency comes into question, depositors have a right to be concerned and they are voting with their feet in Europe by withdrawing money from these institutions.

So if we have capital leaving the BRIC countries and deposit runs on Euro area banks, to where is this global capital flowing?  Below is a table that summarizes select country US Treasury purchases over the past year that we believe tells a very important story.  Each month the US Treasury publishes global purchases of US financial assets.  Remember, in a period of global sovereign debt crisis, capital FIRST moves to the immediate perception of safety and quality.  What really are Treasury purchases by the foreign community?  They are purchases of dollars.  They are purchases of the perception of safety and quality.

Treasury Ownership By Country (billions)
Country	Holdings April 2011	Holdings March 2012	Difference
Spain	$7.3	$21.3	$13.0
Italy	24.2	23.4	(0.8)
Ireland	40.0	98.4	58.4
Belgium	31.6	125.7	84.1
France	17.7	31.8	14.1
Germany	61.3	60	(1.3)
India	42.1	43.9	1.8
Brazil	206.9	237.4	30.5
Russia	125.4	146.7	21.3

The implications in the table appear pretty darn clear.  The most troubled periphery Euro countries saw the most meaningful purchases of US Treasuries/dollars over the last year.  Global capital flight to perceived quality and safety?  If not, then what is this? Likewise the BRIC countries experiencing capital outflows are seeing simultaneous increases in UST/dollar purchases.  Hopefully connecting a few spots on the three dimensional chessboard, global capital flows influence relative currency values.  The table above tells us that US dollars are being bought and other foreign currencies are being sold as Treasuries are purchased by the foreign community.  And remember, relative currency movements, as explained above, influence global corporate earnings, commodity prices, etc.

US Treasuries

The idea that the US dollar and US Treasuries represent a safe-haven seems ludicrous.  There is no yield on bonds to speak of. What little there is produces a negative real return as the inflation rate exceeds the interest rate. The risk of capital loss if (when) interest rates return to normal levels is substantial. The following chart provides perspective:

The chart and this note were provided by Dylan Grice (as reported by Matthew Boesler):

It’s very difficult to see how government bonds are anything other than “risk assets” (let’s face it, all assets are). Yet insurers are buying them because they’’ve been told to “take less risk” (whatever that means) by the regulators.So they are taking more risk, and they will one day suffer the consequences. Banks in the eurozone are bust because they own so much of their local sovereigns’’ debt. But they were told it was OK to do that by the regulators. So they let their guard down.

Given Grice’s chart, one truly has to fall for the “this time it’s different” routine in order to feel safe in Treasuries.

Woody Hayes — Financial Analyst

Sport fans might remember the late Woody Hayes, Ohio State football coach. Mr. Hayes was known for his “three yards and a cloud of dust” offense. He had an aversion to passing, saying that only three things could happen when you passed the football and two of them were bad. If Woody Hayes were still alive and operating as a financial analyst, he might say there are only three that can happen if you invest in US Treasuries today: one is near impossible and the other two are bad.

The three things that can happen to interest rates are they can stay the same, decline or rise. If one rules out the likelihood of declines (can interest rates go negative as they did during the Great Depression?), then the other two possibilities are losers. If they stay the same, you lose purchasing power. If they rise, you lose purchasing power plus suffer a capital loss.

Treasuries as a Form of Minimax Strategy

To invest in Treasuries at this point seems to be resigning oneself to a near-certain loss, at least in terms of purchasing power. Is such a strategy rational? Game theorists believe it can be under certain conditions. This strategy is one that has been employed in “two-player games” which is not directly applicable to markets with many participants. Yet conceptually it provides a common ground for rationalizing Treasuries as a safe-haven.

The statistics website at the University of California at Berkely defines minimax as follows:

In game theory, a minimax strategy is one that minimizes one’s maximum loss, whatever the opponent might do (whatever strategy the opponent might choose).

If one’s view of the future were so negative that all traditional investment alternatives were expected to produce negative returns and you had to put money somewhere (think major institutions, etc.), then putting it where you expected to lose the least would be an appropriate strategy. In these uncertain times fund flows into Treasuries should not be surprising. The actions of European and BRIC countries suggest this “flight to safety” could be akin to a minimax strategy. Capital fleeing from the host country to US Treasuries may be doing so as the result of a belief that a massive loss is possible in-country while a small loss is possible in US Treasuries.

China Playing A Different Game?

China seems driven to ultimately have its renmimbi replace the dollar as the world’s currency. It has slowed, if not reversed, its holdings of US Treasuries not a simple achievement given its large trade surplus with the US. They have been increasing their gold purchases in an unprecedented manner which Contrary Investor describes as:

What we do know about China is that it is investing in gold in a manner that is unprecedented. Contrary Investor describes what is happening as an

… incredible acceleration in Chinese physical gold purchases through Hong Kong over the last year.  The numbers are truly off the charts relative to historical perspective.  From a pure longer-term physical supply and demand standpoint, not much else could be as bullish.  But the gold price as of late almost seems to ignore this new reality as it meanders.  As such, it compels us to suggest that for now global capital flows and the perceptions of currency safety are in most cases (such as this) trumping the reality of longer-term fundamental supply and demand in the greater commodity price equation.

If one believes the dollar, like other fiat currencies, is headed to its “intrinsic value of zero” (Voltaire), then ultimately gold and other hard assets may be the only safe haven. Gold has no counterparty risk and has been considered  money for the better part of 5,000 years. Fiat money is a rather recent invention, which when introduced was backed by gold. For a while this linkage preserved the purchasing power of paper money. Without the restraints imposed by gold, governments everywhere have abused the use of  the printing press.

Central banks, after years of off-loading gold, are now purchasing it to hold as reserves. What do they know that we don’t?

The Loss of Purchasing Power

Louis Woodhill, in a Forbes article entitled “Our Fiat Dollar Has Cost the United States $80 Trillion” estimates the loss to GDP:

The “bottom line” is that, over the 37 years from 1974 through 2010, our fiat dollar experiment cost us $74.1 trillion ($2011) in lost GDP.  By now, the total cost probably exceeds $80 trillion.  And, the meter on this economic debacle is still running.

One can only imagine the losses of other fiat currencies if the dollar is considered “strong” relative to them.

No Place To Hide

Steven Strauss, in an article not directed at currencies, raises the interesting question: “Why Doesn’t The Stock Market Reflect The Imminent Global Depression?” He lays out a strong case for a Depression, including citing others with a similar view (Lawrence Summers, Nouriel Roubini, Simon Johnson, Niall Ferguson, and Paul Krugman among others). Mr. Strauss concludes his article as follows (my emboldening):

So why is the stock market trading as though all’s well? The S&P 500 closed on June 15th at 1343. Based upon stock price divided by earnings (P/E ratio), the market now trades at about 21 times the prior 10 years’ average earnings. The long-term 10 year P/E ratio is about 16, so today’s premium over that long-term average is difficult to explain, considering the risks listed above. At the top of the bubble in October 2007, the S&P was at 1565. Currently, we’re only about 15 percent below that peak, and (again) the market isn’t reflecting the referenced risks.

Is it a case of short-term delusions, leading to later major stock market debacles? If so—is it time to go short?

Or does the market know something we don’t? Are the risks outlined above really not so bad? Is the market assuming losses will be paid by the government, so let’s party like it’s 2006? Or could it be that all investments at this stage have poor prospects—so there’s no place to hide?

I suspect the last statement explains the incongruity of the current situation. Central banks have flooded the system with multiple trillions of dollars. More money must be infused lest the world fall into another Great Depression (although it ultimately will end up there regardless).

This money has to go somewhere even though there is “no place to hide.” Some of it goes into stocks, lots of it go into bonds. Money flows from countries with perceived weak currencies to those perceived to have stronger currencies.

In a sense, it is like a game of musical chairs. When the music stops, there will not be enough chairs to accommodate all the players. This game is not worth playing, but it is one that cannot be avoided.