The Sacrificial Lamb?
To date the Obama Administration has thrown an unprecedented amount of stimulus at the economy, with the latest bit of stimulus being the $1 billion Cash for Clunkers program that lawmakers were “surprised” was depleted so quickly. Really? Who wouldn’t want free money thrown their way? Jon Stewart had House Speaker Nancy Pelosi on his show a few months ago and even he was asking her how he could get his hand on all the money flowing out of Washington, with his question to Nancy Pelosi below:
The Daily Show with Jon Stewart (04/08/09)
“Let me ask you a question. How do I, Jon Stewart, get in on some of this delicious TARP money? How badly in my own life do I have to screw up before you could give me say, not a billion, 500 million?”
Because the program was so successful Congressional leaders on Monday passed a $2 billion extension to the program with a vote pending in the Senate. But the question we have to ask is how much of future sales are we pulling forward and at what cost? Once the program expires what will happen to auto sales with unemployment continuing to rise and wages and salaries continuing to plummet? Will there be an extension to the extension?
There will be a price to pay at some point for the government’s recent largesse and that price tag increases with each and every new initiative coming out of Washington. David Rosenberg, Chief Economist & Strategist at Gluskin Sheff recently commented on the effectiveness of the government’s programs and questions if it may have reached the point of becoming unhealthy. His comments are provided below (emphasis added):
Breakfast with Dave (08/06/09)
The reason why we remain skeptical over the sustainability — the operative word for investors — is because the U.S. economy (or the global economy for that matter) has yet to show any ability that it can stand on its own two feet without the constant use of government steroids. At a time when the U.S. government is running a 13% fiscal deficit-to-GDP ratio, it somehow has enough in the coffers to try and perpetuate a cycle of spending by inducing a populace in which 20% are already three-car families, to go out and buy a new car to support a shrinking industry at future taxpayer (or bondholder) expense. Look at what happened in that first quarter GDP number — total GDP contracted around $30 billion at an annual rate, but when you strip out all the government activity, ranging from spending, to tax reductions, to benefit payouts, the decline exceeded $300 billion. In other words, without all the government intervention, the decline in GDP in 1Q would have been closer to an 8% annual rate, not 1%.
No doubt this is part of the government’s responsibility — to ease the recession pain, but when the deficit is already running at double the FDR levels of the 1930s relative to the size of the economy, at what stage does this unprecedented public sector incursion (into housing, banking, energy, insurance, autos, health care) into the economy become unhealthy? We may have already passed that point.
The Last Tool in the Shed?
If the U.S. economy can not stand on its own two feet without the monumental support of the government and current programs to date are merely slowing down the rate of descent in the economy, what tool is left to use? Perhaps the key lies with one of the last tools in FDR’s tool box, that being a devaluation of the U.S. dollar. As was seen in the Great Depression, once FDR devalued the U.S. dollar the economy began to turn around as deflation was arrested and exports picked up as U.S. goods became cheaper to the rest of the world. One of the most dreaded words to central bankers is deflation as debt remains a constant while asset values decline in recessions, thereby increasing leverage in the system unless the debt is either defaulted upon or paid back, while inflation makes debt cheaper as it is serviced with cheapened currency.
A devaluation of the USD would have several perceived benefits. As mentioned above, it would help revive exports and also make servicing our debt easier, and it could also have the knock on effect of causing consumers to spend more rather than sit on their cash whose value is eroded. Already the sell off in the USD appears to have helped to stabilize exports which have risen from the low seen in January of this year.
Kill Two Birds with One Stone?
One tool that is already being used by the Fed to help support the economy is its purchases of mortgage-backed securities (MBS), which it has already spent over $500 billion in purchases year-to-date. By purchasing MBS the Fed is helping to keep mortgage interest rates low which helps with home purchases as well as those with mortgages resetting. While the 10-yr UST yield rose back up to its October 2008 high in June, Fannie Mae 30-Yr mortgage rates were well below their October 2008 highs, no doubt helped by recent Fed purchases to help contain yields and provide liquidity to the mortgage markets.
Source: Federal Reserve
While the bulk of the subprime mortgage crisis may be behind us as most of the 2003-2006 vintage loans have undergone their initial reset, Alt-A and Option ARM resets are directly ahead of us and have the potential to weaken an already battered economy. However, if the Fed can keep interest rates low we may be able to skirt another mortgage disaster with Alt-A and Option ARM resets. CIBC’s Economic Insights publication from last month has some interesting charts highlighting how the coming reset in Alt-A and Option ARMs may not be as severe as subprime was in the last two years if interest rates stay anchored. Comments from their report are given below:
US Credit Defaults: The Next Wave is Less Scary
Call it a subprime wannabe—a new wave of mortgage payment resets is currently unfolding. Recall that the subprime crisis was triggered by the great mortgage rate reset of 2007, as payments on roughly $1 trillion of subprime mortgages that were originated in 2004 and 2005 were adjusted dramatically—leading to an affordability crisis and an unprecedented surge in mortgage defaults. The current wave is smaller, approximately $600 billion of Alt-A and Option ARM mortgages that were underwritten between 2004 and 2007, and are due for payment resets just about now and in the coming two years (Chart 1)…
While the potential severity of this new wave of defaults should not be understated, there is good reason to believe that the coming round of mortgage problems will be significantly less damaging than the subprime surge. A big reason for this is interest rates, which are now miles below their levels during the peak of the financial crisis. Subprime borrowers in 2007 faced a reset shock of no less than 400 bps, but the steep drop in Libor (Chart 2) and our benign rate outlook suggests that this shouldn’t be an issue for either Alt-A or Option ARM mortgages, at least until the end of 2010.
So, if the Fed continues its MBS buying program to help contain mortgage interest rates and provide liquidity to the mortgage market then it may help to alleviate the potential for an Alt-A and Option ARM reset shock. Moreover, by expanding its balance sheet to do so the Fed may also produce further weakness in the USD and ease deflationary pressures as a weaker USD leads to rising import inflation. Thus, by expanding its balance sheet to continue purchasing MBS the Fed can help to keep rates low but will do so by sacrificing the USD, which may in fact be the Fed and the Obama administration’s plan to begin with. In terms of reflating the economy, side-stepping another mortgage crisis while spurring rising exports via a weaker dollar may kill two birds with one stone.
The Sacrificial Lamb?
The Fed cannot have its cake and eat it too. It cannot keep interest rates low as well as have a strong USD, but a weaker USD may be in fact what the Fed is doing by expanding its balance sheet. While the Fed will not openly come out and state their intention to devalue the currency, that is at least what foreign countries are perceiving. China has openly stated its concerns repeatedly this year about the Fed’s expanding balance sheet and record debt issuance by the US Treasury, which isn’t surprising given their $801.5 billion holdings of USTs. While China continues to buy UST’s the country is increasingly focused on diversifying their reserves across the globe as the following article makes clear (emphasis added).
Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, Wen Jiabao, the country’s premier, said in comments published on Tuesday.
"We should hasten the implementation of our 'going out' strategy and combine the utilisation of foreign exchange reserves with the 'going out' of our enterprises," he told Chinese diplomats late on Monday…
Mr Wen did not elaborate on how much of the $2,132bn of reserves would be channelled to Chinese enterprises but Mr Qu said this was part of a strategy to reduce its reliance on the US dollar as a reserve currency.
"This is reserve diversification in a broader sense. Instead of accumulating foreign exchange reserves and short-term financial assets, the government wants the nation to accumulate more long-term corporate real assets."
C State-owned groups, particularly in the oil and natural resources sectors, have stepped up their hunt for overseas companies and assets on sale because of the global crisis.
China Investment Corp, the $200bn sovereign wealth fund, has been buying stakes in overseas resources companies and has taken a 1.1 per cent stake in Diageo, the British distiller.
In an interview published in state-controlled media, the chairman of China Development Bank said Chinese outbound investment would accelerate but should focus on resource-rich developing economies.
"Everyone is saying we should go to the western markets to scoop up [underpriced assets]," said Chen Yuan. "I think we should not go to America’s Wall Street, but should look more to places with natural and energy resources."
Not only is China diversifying away from the USD, it is also moving to strengthen the renminbi in terms of global trade, sidestepping the USD in direct exchanges with its trading partners, a move that is likely to weaken the USD in the years ahead. China’s ambitious plan is highlighted below in the following article from the Financial Times.
China has kick-started a major plan to internationalise the renminbi and the process is likely to be faster than many expect, according to HSBC.
If successful, this could lead to nearly $2,000bn in annual trade flows, or as much as 50 per cent of China’s total, being settled in renminbi each year by 2012, compared with less than 10 per cent today.
The move follows calls by China for the world to adopt a supranational currency to replace the dollar.
"China is beginning an ambitious scheme to raise the role of the renminbi in international trade and finance and to reduce reliance on the US dollar," said Qu Hongbin, China chief economist at HSBC.
"This will likely be a multi-year and gradual process. Yet, we believe the pace is likely to be faster than many expect…"
China announced a pilot programme last week that expanded renminbi settlement agreements between Hong Kong and five major trading cities, including Guangzhou and Shanghai.
Furthermore, this year the People’s Bank of China has signed a total of Rmb650bn ($95bn) in bilateral currency swap agreements with six central banks: South Korea, Hong Kong, Malaysia, Indonesia, Belarus and Argentina.
HSBC said China was still in talks with other central banks to form additional swap agreements and was likely to expand them to cover all the country’s trade with Asia, excluding Japan.
This would be followed by an expansion to take in other emerging countries, including those in the Middle East and Latin America, that needed renminbi to pay for their imports of Chinese manufactured goods.
"More than half of China’s total trade flows, primarily bilateral trade with emerging market countries, are likely to be settled in renminbi in the next three to five years," said Mr Qu. "This means that nearly $2,000bn worth of cross-border trade flows would be settled in renminbi, making it one of the top three currencies used in global trade."
USD Set to Retest 2008 Lows?
As was highlighted in last week’s article (Gold & Gold Stocks Setting Up for a Strong Second Half?) the cyclical bull market in the USD that began last year may already be over. What marked the start of the secular bear market in the USD back in 2002 was the 50 day moving average (50d MA) breaking below its 200 day moving average (200d MA). The break by the 50d MA above the 200d MA back in 2005 marked the cyclical bull market counter trend rally which subsequently reversed and marked the next leg down in the USD in 2006. Secular markets are characterized by long moves in the primary trend followed by shorter and sharper counter trend rallies. To visualize this you can see what a secular bull market looks like by looking at UST yields from 1954-1982, and an example of a secular bear market by looking at yields from 1981-2003 as seen below.
Source: U.S. Board of Governors of the Federal Reserve System
Source: U.S. Board of Governors of the Federal Reserve System
By comparing the chart of the 50d and 200d MA’s for the USD Index you can see how the chart resembles the secular bear market chart of yields from 1981-2003 above where in a secular bear market the primary trend down moves are longer in duration and greater in magnitude compared to the sharp and short counter-trend cyclical bull markets.
The USD Index may be setting up for a retest of last year’s lows as it is now marginally below the 61.8% Fibonacci retracement line drawn from last year’s lows of roughly 70.31. There is little support between the current level and last year’s lows and the index remains in a well defined bearish trend channel.
While the break of the 61.8% Fibonacci retracement line in the USD Index is only a marginal break and may whip saw to the upside, looking at equal-weighted indexes of the USD shows greater weakness than meets the eye. The USD Index is heavily weighted towards the Euro, which makes up 57.6% of the index followed by the Yen at 13.6%, thus the USD Index is heavily influenced by the Euro. However, I created an equally-weighted index of the top 10 countries that make up the largest share of global GDP, and my USD 10-Country Index has a clear break below its 61.8% Fibonacci retracement line and has a potential to witness a sharp sell off to support at last year’s lows as there is not much in the way of support below current levels.
Like my 10-Country Equally-Weighted USD Index, my USD Asian Currency Equally-Weighted Index composed of eight Asian currencies is showing significant weakness over the last few months and is well below the 61.8% Fibonacci retracement level and is marginally below its June lows.
The Fed and Obama administration may have no qualms with a weaker dollar ahead for the reasons mentioned above, with one added benefit of a support to the stock market. The USD displays a negative correlation to the S&P 500 and a weaker USD generally translates into higher stock prices. A significant breakdown ahead in the USD may be one catalyst that propels the S&P 500 higher, which would likely lift consumer confidence in the months ahead as consumer confidence shows a positive relationship with stock prices.
As there are many positives to a weaker USD ahead that would be a great relief to both the Fed and Obama administration, the USD may end up being the sacrificial lamb to help reflate once more our economy and stock market. Gold may be sniffing such an outcome as the Gold to Bond ratio is on the verge of a major breakout that would catapult it to challenge a nearly 30 year record seen in 1980 at the height of the gold bull market. A breakdown in the USD would certainly be a major catalyst to propel gold northwards and bonds south, which is why the USD should be a key watch point in the weeks ahead for such an occurrence. The USD may be the sacrificial lamb to be trampled by the gold bull and Fed and UST grandiose plans.
Gold to 30-Yr UST Bond Price
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