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U.S. DOLLAR TAKES ANOTHER TUMBLE

The biggest surprise for the markets today was a government report showing foreign purchases of U.S. assets slowed to $48.1 billion in October, the slowest rate of purchases in the last year. In September, foreign investors bought $67.5 billion and October was expected to be lower, but none of the analysts expected to see a number below $50 billion. In a Bloomberg article, Carsten Fritsch, a currency strategist at Commerzbank AG was quoted before the data was released by saying, “A number of about $50 billion would be significantly negative for the dollar.” This comes on the heels of yet another record trade deficit that widened more than expected to $55.5 billion in October. When the Commerce Department released the record trade deficit yesterday, the markets just yawned and said, “Let’s see what Mr. Greenspan has to say later today.”

After Greenspan spoke the markets yawned again. It was all about waiting for nothing to happen. They raised Fed Funds 25 basis points as everyone expected and left the text of their comments virtually unchanged. Of course Mr. Greenspan made a point to say that “inflation is well contained” and the bond market followed-up today by pushing interest rates lower. The spin in one of the Bloomberg headlines reads, “U.S. 10-year Treasury Gains on Optimism Inflation is contained.” Now you can go back to last Friday with inflation being reported higher than expected and the markets yawned. The actual numbers came out showing inflation increasing at a faster rate than expected, but don’t worry because even though the data shows increasing inflation, the Fed says it’s well contained…must be a good reason to go out and buy Treasuries. I am still of the belief that all the money crowding into U.S. government debt is a flight to the “perceived” safety of Treasuries, especially the shorter maturities.

Another item in the news had the Empire State manufacturing index higher than expected with its strongest report since July. New orders and shipments had very strong gains, but the warning comes from seeing the prices paid component rising and the prices received falling. This implies a lack of pricing power and should put a pinch on corporate profit margins if the trend persists. This report should have influenced bond prices lower causing interest rates to rise depicting the economic improvement. Instead, bond prices are telling us the economic improvements are not enough to write home about. For now bond investors appear to be listening to Mr. Greenspan’s inflation containment rhetoric, or simply have nowhere else to go with their investment dollars.

The dollar route continues, but long-term interest rates continue at historic lows. Ten-year Treasury debt paper only yields a little over 4% and 30-year paper yields only 4.7%. Our economy is heavily dependent on cheap financing to facilitate purchases with debt, since our savings are virtually non-existent. Even though we still have historically low interest rates, mortgage activity has been slowing which means we will not have the economic stimulus from mortgage re-financing that we have seen the last couple of years. The MBA reported its application index fell 1.0% with the purchase index falling 0.4% and the re-financing index dropping by 2%. The purchase index has declined three out of the last four weeks and the re-fi index has dropped four weeks in a row. Higher rates moving forward will clearly put pressure on home prices as real estate activity slows.

Much of the talk about inflation and the trade deficit is tied to the price rise that we have seen for crude oil. This garbage about inflation being well contained is nothing more than an excuse to justify artificially low interest rates to keep the economy moving. I’ve heard analysts predicting $30 oil in the future, but I’ve already gone on record saying the low will be $40, and it looks like I could be correct. OPEC wants more dollars per barrel as the dollar declines in value and will cut production to achieve that goal. Today crude oil had its biggest gain in six months by rising $2.43 per barrel to $44.25. The big surprise from the Energy Department came when they announced distillate inventories increased much less than what was expected. Analysts were anticipating a gain of one million barrels, but distillate inventory only increased by 37,000 barrels. Heating oil inventories are down almost 5% from the same period last year at a time when temperatures in the Northeast are running about eight degrees below normal. The cost of heating oil moved 6.4% higher in today’s trading.

The real story for commodities is the falling dollar. Most all commodity prices were higher across the board with a few exceptions. Crude was higher by 5.5%, heating oil +6.4%, gasoline +4.7%, meats up nearly 2%, copper +1.8%, silver +1.6%, gold +1.1%, cocoa +4.4%, coffee +6.4%, and orange juice +5.2%. Soybeans came down 0.6% and natural gas dropped 1.3%. Overall it sure looks like the falling dollar will bring some serious inflation in the very near future. When China ever gets around to revaluing their yuan to a market rate that better reflects their incredible growth, import prices to the U.S. will absolutely skyrocket.

More on Currencies

The situation for global currencies is incredibly complex. The dollar decline will have a number of negative effects here in the U.S. and for our overseas suppliers, who are also the owners of U.S. debt paper. The devaluation of the dollar is being orchestrated to inflate-away our current account deficits, but I have now read two excellent analyses that demonstrate the dollar devaluation will not be enough to correct the imbalances unless changes occur in U.S. consumption along with an increase in savings and investment. I’ve also been looking for historical precedent for prior dollar devaluations.

The essay, “U.S. Flying on Empty” by Peter George goes into great detail on Mr. Greenspan’s tenure as Chairman of the Federal Reserve along with recent statements, the ripple effect of declining currency values, and what I found of great interest regarding the PLAZA Accord of 1985. Following are two excerpts from Mr. George’s fine essay:

7. Why the strategy for a weak dollar won’t work.

Following the PLAZA Accord of 1985, France, Germany, Japan and the UK agreed to assist the US to effect a substantial devaluation of the US dollar in order to bring the US trade deficit back under control. At that stage it was running at 3% of GDP. Over the next three years the dollar exchange rate declined by an average of 50% against the currencies of the countries in the Accord. By 1991, five years after the Accord, the trade deficit had been completely eliminated and replaced with a small surplus, but the unseen costs were substantial. Two years into the slide, the deflationary effects on world trade triggered the crash of ’87. Two years later, despite a sharp and sustained bounce back in Western markets, the Japanese NIKKEI collapsed, forcing the nation into a 14 year recession from which it has yet to recover. The position the U.S. finds itself in today is more serious than 1985.

In the article Stephen Roach, chief economist at Morgan Stanley, was quoted as saying, “In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stock market crashed. America’s current-account deficit is now almost twice as big as it was then, so the total fall in the dollar – and the FALL-OUT in other financial markets – could well be larger. The WOLF is licking his lips.” (Our current account deficit is 5.7% of GDP, not 3% as in 1985.)  To get a better glimpse of what we are headed for next year, please take the time to read the full essay.

The second article I came across said very much the same thing, but from a different perspective. “A New Illusion: The Falling Dollar” by Kurt Richebacher makes the point that it will take more than dollar devaluation to correct the U.S. current account deficit. With reference to Mr. Greenspan, Richebacher writes, “In essence, he expressed the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. current account deficit. Clearly, American policymakers want a lower dollar, apparently entertaining strong hopes that this will take care of the U.S. trade deficit, and we suspect that they regard it as an easy solution for this problem.” He goes on to say, “The favorite American explanation for the huge and growing trade deficit is the U.S. economy's superior growth performance and lacking foreign demand. But the Chinese economy is growing much faster than the U.S. economy yet has a big trade surplus. So had Japan in the late 1980s, and so had Germany in the decades to the late 1970s. 

This explanation of the trade deficit with superior U.S. GDP growth is another illusion among many others. What crucially matters for a country's trade balance is not its economy's growth rate, but its internal resource allocation between consumption and investment. High rates of saving and investment make for a strong trade balance, while high rates of consumption make for a weak trade balance. America's unusually poor trade performance reflects extremely poor rates of saving and investment. Overconsuming and undersaving America lacks the necessary capital stock to increase its exports.

Please notice the sentence, “Clearly, American policymakers want a lower dollar…” I believe his statement is 100% accurate. The Fed and the Treasury want to see the dollar move lower. Are they going to get their way? So far through the dollar decline Japan has overtly worked to devalue the yen. China doesn’t have to worry about devaluing, because the direct link to the dollar has the yuan falling in lock-step with the dollar. So far the dollar devaluation has had a bigger impact on the appreciation of the euro, Canadian dollar, Australian dollar, British pound and Swiss franc. I believe U.S. policymakers are putting the big squeeze on Europe to devalue their currency and get on the global bandwagon of reflation (re-inflation of current bubbles to keep asset prices high).

For now I believe we are in the calm before the storm. With the Holiday Shopping Season upon us, nobody wants to tip the apple cart. Everyone needs to make their numbers over the coming two weeks as we close out the year. Foreign governments don’t want to jam us up right now because they want their exporters to sell all of their goods to holiday shoppers. Once the spending dries up after the first of the year, it will be time to play some global hardball in the currency pits. I believe the gloves come off after the first of the year and we’ll get a better idea of just how vicious the currency and trade wars are going to be.

As it stands, the report today clearly demonstrated a waning appetite for U.S. assets by foreigners. In January I fully expect Treasury prices to come tumbling lower because we have a huge quarterly debt re-funding that is scheduled to take place February 8-10. The last number I remember reading was $157 billion the Treasury will need to borrow during the three-day auctions. In the last 10-year auction foreign investors only bought 9.6% of the offering when they usually buy closer to 45% of the debt. It looks to me like the U.S. will have to offer higher yields in February to sell the huge load of debt. I’ll be looking for my entry point to short bonds in the very near future.

With the carnage in the dollar today it was a bit disappointing to see gold only higher by five dollars and silver up by eleven cents. The price movement in the mining shares is telling us this correction is just about done. Once the spec liquidation is complete the metals should be set for a nice run north. We could see some weakness in the metals for another week or so, but once we get into the heated currency battles early next year the game will change. I have 2005 pegged as the year gold and silver break loose and become a major bull markets in ALL currencies. As Stephen Roach put it, “The WOLF is licking his lips!” Bring it on!

I didn’t leave much time to comment on stock prices today, so here’s my parting shot. Today the Dow Industrials gained 15 points to 10,691, the NASDAQ Composite added two points to 2,162, and the S&P 500 tacked-on two points to close at 1,205. Stocks just refuse to go down! I don’t want to beat a dead horse, but this stock market is an accident waiting to happen. If you can make some money in general equities my hat’s off to you. I don’t like the risk. If foreign investors decide to bail out of U.S. stocks the bottom could fall out very quickly. Then I look at bonds and have to wonder how much more upside bond prices could have. That floor could fall out quickly as well. In my mind the risk once again outweighs the potential rewards. For me the safety of precious metals is the place to be! I’m ready for an exciting and profitable year in 2005!

Have a Great Evening!

Mike Hartman

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