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Today's Market WrapUp  05.21.2003  Mon  Tue  Wed  Thu  Fri  Puplava Archive

The Paper Chase
BY JAMES J. PUPLAVA, CFP

In the crime business, detectives know that money plays a very important role. ‘Follow the money’ is an old cliché. The same is true in the financial business. If you want to know which area is going to go up next, follow the money. In the larger context of the financial markets, this means follow credit and money flows. Central banks around the globe are creating oceans of money or credit that is finding its way into every nook and crevice of the economy and the financial system. Excess money creation during the 1990’s created a credit boom leading to financial bubbles in the U.S. stock market and malinvestments in the economy. Those malinvestments in the economy now represent excess capacity as cheap money and credit created an extraordinary investment bubble in not only the financial markets, but also excess capacity in almost everything but energy. There is now excess capacity in just about everything you want, and scarcity in everything you need such as energy.

Since the stock market bubble burst money and credit continues to flow freely in the U.S. and elsewhere. In the U.S money aggregates are all up year over year and are still growing faster than the economy.

As long as the Fed has the ability to create money and credit, that money is going to find a place to land or invest. Think of that money as a giant hive of honeybees. Wherever the hive lands, it has the ability to create honey for investors. Right now the hive has been chasing one paper asset after another. In the 90’s it was emerging markets and the U.S. equity markets. After the stock market bubble burst it began to chase yields, first in Treasuries, then mortgages, then emerging market sovereign debt, and now the Euro. This hive of money is so huge it dwarfs most markets and asset classes. The general destination of this money has been the bond markets because it is the only market large enough to accommodate it. This money hive is the $1-2 trillion that trades in the currency markets on a daily basis looking for high returns on paper. Most of it has been going into the U.S. Treasury market because it is one of the few large markets capable of absorbing this huge influx of money.

Because of America’s huge trade deficits, money is going into foreign hands since we pay for those goods in U.S. dollars. That money is either invested in the exporter’s country inflating that country’s money supply stock or the central bankers of those countries intervene in the foreign exchange market acquiring dollars that their domestic exporters wish to sell in order to prevent their currency from rising against the dollar. In order to buy those dollars they print their own money, which expands their money supply. With these newly acquired dollars, central bankers in turn wish to earn a rate of return on that money so they invest those dollars in paper assets. Over the last two decades, the final destination of those dollars has been U.S. financial assets, stocks, bonds, and money market instruments. They not only earned a great rate of return on those assets during the 80s and 90s, but they also saw those assets appreciate in dollars against their own domestic currencies. They made money from asset returns and then made additional returns from seeing the dollar appreciate against their own domestic currency.

That is certainly not the case today. Foreign investors may have made money in our bond markets but they lost money through the dollar’s depreciation. Therefore, these central banks must find alternative sources for those foreign currency reserves accumulating as a result of America’s monster trade deficits. In the 90s the answer to that investment question was easy; it was American financial assets which produced superior returns in comparison to investments elsewhere. Interest rates in the U.S. were higher, the American economy was growing faster than other nations, and our financial markets were producing double-digit returns. The influx of foreign capital into the U.S. financed our trade and budget deficits. The U.S. was no longer self sufficient in energy, manufacturing, and now capital. We began to import more energy (60% of our energy is imported from oil to natural gas), we began to import more of our manufactured goods, and because we consumed more than we saved, we also found it necessary to import capital to fund all of our consumption.

This story can be viewed by the graphs below, which show money expansion, credit expansion, and the lack of savings in order to support it. The American “new era” formula heralded as such a success throughout the 1990’s was simply a credit bubble. It translated into print, borrow, and spend. As we printed money, the money supply and credit increased. We borrowed and then spent that money. Savings shrunk with asset price inflation taking the place of savings. Foreigners supplied most of the credit with the U.S. absorbing close to 80 percent of the world’s savings.

With the U.S. churning out excess dollars, those dollars ended up in foreigner hands thanks to our burgeoning traded deficits. Foreigners then faced the prospect of what to do with those dollars. They went into our stocks, our bonds, our mortgages, and to a lesser extent, our real estate. The U.S budget and trade deficits are still growing at alarming rates, which means more exported dollars will need to find a home. It has become a game of paper chasing paper. You can see this money trail in the graphs below In the 90’s it was stocks and bonds. Since the stock bubble burst, it went into treasury debt and asset backed securities. This has led to the lowest interest rates in nearly half a century.

The problem now for foreign investors is the ocean of dollars that the U.S. is still exporting that has to find a new home. Foreign central banks are still investing those $500 billion dollars. Over the last 12 months, they have increased their Treasury holdings by $149 billion. They are still buying asset backed bonds. But increasingly those central banks, especially Asia where most of the traded deficits originate, need to find a new home other than dollar-based assets. The problem is the dollar.

As shown in the graph of the dollar index they have lost big money over the last 12 months. With America’s growing trade deficits, central bankers will need to either put all of that money back into dollars (they are still buying U.S. assets), convert those dollars into other paper currencies, or buy gold. Most of their diversification out of dollars has been into other paper currencies, mainly the Euro. However, Europe is also printing money, running budget deficits, and experiencing anemic economic growth. Eventually the Euro run will also end, so central banks and foreign investors have been searching out for other paper assets in which to invest. They have been buying the currencies of resource-rich nations such as the Australian and Canadian dollar, and investing in emerging market sovereign bonds. Emerging market debt, with high yields has been attracting record inflows of fresh money as investors play the paper chase looking higher returns in capital markets that are experiencing record low yields. Currently there are no large imbalances in these countries so money continues to pour into emerging markets.

The flight out of the dollar has begun and it simply has become a game of paper chasing paper. It has become a game of which central bank can push its monetary policy more aggressively than the next in order to depreciate its currency. The central bank pushing the throttle the fastest is the currency that becomes most vulnerable and also where the yields are falling the fastest. Over the last few years, that has been the U.S. But recently EMU is playing catch-up as their economies weaken and their budget deficits grow.

Eventually this paper chase will lead to a currency crisis somewhere. It becomes a question of not if, but when. It will also be a test of the financial system of what kind of fallout emerges when it erupts.

At the moment the paper chase continues with hot money jumping from one paper asset to the next. You can see this paper trail in the graphs below of the U.S stock market in the 90’s, the Treasury market over the last three years, and the Euro over the last year. However, all of that money will eventually have one final destination which is real money, and by that I mean gold and silver.

The final destination will be gold and silver with silver representing the greatest opportunity. Now the smart money has been going into the euro and gold. Smarter money is going into silver. If the Fed embarks on a policy of hyper-inflating the currency in order to avoid a depression at a rate more aggressive and uncoordinated with other central banks, you may see an all out flight out of the dollar. This is part of the equation that sets up my Perfect Storm scenario. It hasn’t happened yet. There is a gradual exodus out of the dollar but it hasn’t turned into a stampede. Foreign central banks have invested close to $150 billion in Treasuries over the last year so money is still coming into dollar assets. This is done because that money has very few places to go. Therefore, it simply chases one paper asset after another. Eventually it will all be going into hard assets in one form or another as central banks depreciate their currencies against each other in order to keep their economies and exports competitive.  At some point in the not too distant future, we should see another full-fledged financial crisis erupt. There is simply too much money sloshing around the globe, and too much credit and leverage in the financial system. As I said earlier, it is not a question of “if” but merely a question of “when.” The ultimate destination will be a flight to hard assets, especially silver and gold.

Today’s casino results were mixed. The blue chips barely made it into positive territory while the Nasdaq fell. There was simply too much background noise and confusion for the markets to digest from a weakening economy to terrorist threats. Volume hit 1.43 billion on the NYSE with winning issues beating out losers by a 19-13 margin. The VIX slipped .16 to 23.21 and the VXN fell 1.34 to 30.88, a record bear market low. The Nasdaq is ripe for a fall and represents the greatest risk for investors.

Copyright © 2003 Jim Puplava
May 21, 2003

Charts courtesy StockCharts.com

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