“Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies.
On the one hand, the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities. On the other hand, they cannot pursue different domestic and international objectives at the same time. (…)
The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.”
Governor Zhou, People’s Bank of China, 23 March 2009 (emphasis mine)
Most pundits are unaware of the relevance of the USD at this point in time. They’d rather skip the point. I listen to frequent complaints on the “unpredictability” of currency prices. Maybe, just being naughty here, the underlying reason is that trading the majors, ie USD/JPY or EUR/USD, is tantamount to singular trading capabilities for most. I honestly find currencies more predictable than equities, but a host of market players prefer to engage in stock trading with a long only bias. We have to bear in mind the extraordinary behavioral biases that have been engendered by decades of easy money -and it’s certainly addictive to go long with a Greenspan kinda put to cover your back.
Unfortunately, notwithstanding the difficulty of getting the dollar right, at this stage, it is a must. It is “the dollar” (and not “the Donald”) that will be the main driver of global financial market developments for the next couple of months -and even well after we transition into a new global economic regime.
In order to understand “the dollar”, we must understand the history of the International Monetary system (IMS), all the way from the Bretton Woods accord, where the USD was granted prime reserve currency status, to the Nixon letdown, and, finally, the Global Financial Crisis. And no, I am not forgetting the 1985 Plaza accord in between but it is hardly relevant from a structural point of view.
Please bear with me for some background. The role of the dollar as the primary reserve currency begins at the BW summit, and it is essential to understand why the newly bred system was flawed from the very moment of its inception.
- The Triffin dilemma (Robert Triffin, “Gold and the dollar crisis”, 1960), stated in broader terms, is not a problem related only to the dollar, but a potential conundrum for any national currency that might have played the same role. As an obviously self-serving Zhou correctly stated, “issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world.”
- Of no lesser importance is the fact that, both in the gold anchored regime that followed BW (35 bucks per ounce of gold), and in the fiat reserve currency system that ensued after 1971, monetary aggregates had no way to be maintained near magnitudes that ensured global money supply remaining at a steady percentage relative to the size of the global economy. I have always sustained that stable monetary aggregates are a concept that relates better to gross output than it does to gold, platinum, any other commodity. Not to mention the craziness of relying on the collective criterion of the pertinent Central Bank’s politburo.
- Gold (1944 to 1971), was unable to provide stable but flexible enough money because it was an anchor that showed no respect for the economic needs of money as a medium of exchange, and as a store of value. Monetary aggregates depended on the amount o mining and gold accumulation: an exogenous variable, and one that bears no correlation or resemblance to the function of the demand of money. It was a rigid system, and it did not adapt correctly to the needs of the global economy. Even Triffin himself expressed some concern about the fact that the 35 dollars per ounce price would yield slow additions to the monetary gold stock (Bordo and McCauley, BIS, Lisbon March 2016). Gold convertibility is why Triffin was so concerned, and it certainly compounded the trade-offs for national currencies that double up as reserve currencies for global trade.
- In 1971 Richard Nixon made the system lose its gold anchor -and did not replace it with some other. Monetary aggregates were from then on, allowed to grow freely. Apparently, that solved Triffins dilemma in its initial sensu-estricto formulation, that referred to the gold convertibility period. Well, conceptually it did, but, in practice, it did not, and it simply enabled what Jacques Rueff dubbed as “double pyramids of credit”. In plain English: inordinate, wild monetary expansion on both sides of the international trade.
- An unanchored prime reserve currency ended up delivering, four decades later, what some analysts refer to as the “everything bubble”. Needless to say, it follows up and greatly “improves” the Japanese Real Estate and equity bubble (1989), the Nasdaq bubble (2000), and the Real Estate and subprime mortgage bubble in 2008. Bubble blowing is now a grown up science, and will hopefully have a Nobel prize winner from now on. Kuroda-san and superMario are the front runners for the 2016 award. Bernanke is “passé”, and Janet lacks the necessary glamor.
So the dollar was empowered with an exorbitant privilege that allowed it to double up as a reserve and country currency but finally turned out to be, as John Connally shrewdly said, “everybody else’s problem”. That was the best deal the Americans ever made since they bought Manhattan from the Indian tribes.
Just as the Indian tribes lost a formidable piece of land for, well, peanuts, we, the rest of the world, have indeed inherited a “dollar” problem right now. It all began when the US began to make use of its exorbitant privilege. We, humans, tend to make use of privileges when we can find them. Inevitably, the US did as well.
- Initially, in 1946, the world was hugely short of USD. At the time, the US ran relevant monetary surpluses (Triffin’s motivation for the formulation of his dilemma), and the rest of the world was starved for dollars. The Marshall plan and other credit and money facilities helped bridge the initially tense situation.
- Soon enough, with the gold anchor still in place, Japan and Germany began to develop export-oriented economies and consequently started accumulating large current account surpluses. They ended up as dollars in their official reserves. America had learned to game the system and began to use its exorbitant privilege to support excessive living at the expense of other nations. Current account surpluses were rapidly left behind by the US.
- Come 1971, and Henry Kissinger, a wise man -and the Richelieu equivalent for Richard Nixon, understood that the demise of the dollar’s convertibility into gold would sap the global demand for the USD. So he created a de facto dollars-for-petrol narrative, to replace the previous dollar-for-gold mantra, and ultimately support the continuation of the USD as the prime reserve currency. In the agreement with the Saudis, the petrodollar was born. Saudis would price their oil in dollars only, and be “open” to reinvestment of the proceeds in US treasuries. The US would provide military support and weapons to protect them from the Israeli threat, in a carefully balanced quid pro quo.
- In the meantime, a considerable amount of dollars was being accumulated, belonging to other countries and residents outside the US. Some, like the Russians, were uneasy about holding USD deposits at US banks because they would be subject to retaliation on any major international policy disagreement. Kennedy further helped the matter, establishing a lower taxation level for dollars held outside the US. The Eurodollar market was then born and it became the largest source of international finance by the end of the century. A great business for the City. The Mayfair Real Estate pricing bubble roots can really be traced back to that time. But nothing lasts forever. Today’s Eurodollar market demise (corporate eurodollar repatriation, no new trade dollars if a border tax ends commercial deficits) poses a major threat to London. Funds offered are insufficient and funding tensions are already evident in the TED spread. By and large, the potential downsizing of the Eurodollar market in London is more relevant for the City, than the much overhyped “Brexit”. The Eurodollar market also qualifies as the epicenter of the ongoing worldwide dollar shortage.
- When Asia became a relevant exporter to the developed world, the US revisited the Saudi deal essentials. It made sense to stick to what was working. The US engaged in a (more or less explicit) third deal and agreed to ignore the currency manipulation of the yuan. A Yuan that needed to be lowly priced in order to fuel their export machine. It comes without saying that they would channel their account surpluses into US Treasuries. That is how China got away with massive currency manipulation: they became the main banker for the US Treasury, in exchange for being allowed to hollow out the US industrial base. It was a money for jobs deal, and Detroit was to foot the bill. Not surprisingly it has been the Detroit base that precipitated “the Donald” to power. The Chinese outsmarted the Americans on that deal. You can’t always win, right? The result was trillions of excess USD parked as reserves at the PBOC. They are precipitously selling them back to the global currency market as I write.
- When the GFC hit, back in 2008, Bernanke’s profligacy immediately drowned the international market with USD, and it did so at a time when QE was only being undertaken by the UK as well. Additional iterations took place. The world became awash with dollar liquidity. Debtors to be soon found out, and used the easy dollar policy to issue bonds for a total amount close to 10 trillion USD (according to BIS estimates).
But eventually, things began to head south. To briefly recap, the once buoyant eurodollar market lost most of its inflows, Bernanke had stopped printing USD (thank God), and everybody and their dog had issued bonds nominated in dollars. That set the stage. Lift dollar interest rates slightly, reduce the dollars being pumped out by the US commercial trade deficit, and the potential for a USD global financial short was unleashed. From then on, the world was just waiting for a catalyst to generate a new bull market in the dollar.
The consequences of an incorrect and unanchored IMS, combined with increasingly lower interest rates and permanent global trade disequilibrium’s generously lubricated with abundant money creation, have been dire.
- By allowing global monetary magnitudes to grow freely, an Austrian theory depicted boom-and-bust economy was evident in no time at all. All of a sudden US public and or trade deficits did not matter, and the world could profit from Triffin’s dilemma in reverse. The wider the commercial deficit, the more monetary stimulative global monetary policy was going to be because on the back of those dollar reserves, the exporting country was also going to increase its monetary base (double credit pyramid).
- Stimulative monetary policy fed on itself, leading to a relentless build up of a massive debt overhang, financialization, and the birth of bubbles of all kinds that ended up in the ongoing “everything bubble” that we are witnessing now.
- Education languished in a culture where it has been easy to become rich in the thriving financial sector developed by such and easy going environment.
- A massive overhang of worldwide dollar-denominated debt ensued -and was an almost inevitable corollary of the policy.
- The system lived on supplementing disposable income with capital gains in the different financial and non-financial assets. Those gains were essential to maintain animal spirits in the model, but they have brought extraordinary shelter inflation in many countries, generating cost driven pressures that potentially feed on inflation and largely generate social unrest.
- Productivity is stagnant because of CAPEX attrition and malinvestments, not to obviate the concurrent and previously outlined disaster in the educational component of our potential workforce.
Global financial and economic stability of an economy in such shape is NOT compatible with a strong dollar, inflation, or, when it comes, recession.
1.- A strong dollar is a killer.
Yet it will be difficult to keep taming the dollar bull. Odds are against Central Banks, but they will be resilient in their efforts to contain the dollar. Right now, I think the PBOC has been blackmailed into submission by uber-school-bully Donald. They are on the way to undo all their USD reserve cushion while trying to flood the world with dollars and stabilize the renminbi: a suicidal policy (and not the first one they’ve been up to). Yellen is trying to sound as hawkish as possible, but simultaneously refraining from giving the USD a lift. Other CBs might join in, but a fresh Plaza Accord to depreciate the dollar is unlikely, given the tense, Trumpian atmosphere between leaders.
In the meantime, facts are stubborn, and they all argue in the direction of a dollar shortage and the corresponding dollar strength.
- QE3 tapering is the clear starting point for the USD bull of the last three years. No additional USD are being printed and pushed into the market -and we very much doubt that the current FOMC will start the printing presses again. They have learned their lesson (sadly, we are all paying their tuition fees). A Trump Fed (three nominations or maybe more) might be a different issue altogether. It is essential that Yellen stands up to Trump and does not fold in (like Burns did to Nixon) or quit. It is one of those twists of fortune that Yellen might end up being the lesser dove (and evil) we can have at the FED.
- Trade deficits have improved for the US -when compared with the apocalyptic percentages of GDP shown in 2006 and 2007, just before the GFC hit. Global trade is not growing, and it is unlikely that we will see US trade deficits soar again. Not with Trump for sure. That takes care of a substantial portion of the yearly contribution to double pyramid of credit and dollars due to unbalanced international commerce. Less dollar creation is the result.
- Crude oil prices began a serious downtrend, substantially decreasing the amount of Eurodollar liquidity generated by the petrodollar segment of the market. Regardless of a further repricing of crude even up to 60 dollars per barrel, I doubt that this will reactivate the flow of petrodollars into the Eurodollar system. Saudi Arabia and Co are unlikely to send massive amounts of dollars to the Eurodollar market in the foreseeable future.
- Chinese liquidity requirements have exploded. Credit growth required to roll over existing bad debts is pressuring liquidity in Chinese money markets. Returning USD denominated loans and bonds has become a nightmare for Chinese corporates. Total Social Financing (TSF) growth this January, certifies the difficulties. With such credit growth, it will be difficult to keep the renminbi trending up -in spite of recently implemented higher interest rate levels. Anyway, and via their daily interventions, they are now the main UST seller and dollar provider in international markets. How long will they keep depleting their USD reserves for?
- Interest rates came up modestly in the US, but it was enough to tighten financial conditions and generate the fear of not being able to pay the USD denominated debt costs. More to come according to Janet -just yesterday. Inflation, cost inflation, however timid, is back and it will not give them a lot of room to drag their feet on rate hikes. Interest rate differentials are likely to keep supporting the USD.
The result of the combined interaction of the abovementioned trends is that the USD came up strongly in all the crosses. Divergent monetary policies with Japan and Europe don’t give grounds for hope of a turnaround by market forces. The world is flooded daily with EUR and JPY and starved for USD. Unless we get a new Plaza Accord, or Yellen quits and a Trumpian uber-dove takes over, or the PBOC literally dumps at least an additional half a trillion USD in reserves in the open market, I do not see how this can change. Of course, nowadays nothing can be counted out beforehand. No trade is 100% foolproof.
A couple of simple charts can help visualize the dollar short for yourselves.
- The average cost of the cross currency basis swap in the USD crosses (Zerohedge).
- The increase in the cost of liquidity swaps in USD.
- The tensions in the Ted spread (Acting Man).
2.- Inflation can also be a killer.
I have been skeptical about the chances of inflation coming up ever since the GFC. Last January I suggested that a change in my stance was coming. As I said then, I have no doubts that demand-pull inflation is in serious hibernation. But cost-push inflation has been coming up ever more prominently on our radar screen. I side with Edwards that considers the fall in AHE growth in January a statistical glitch. My feeling is that unit labor costs will continue to mount (I have been saying this for more than a year now). Bargaining pressure is enormous when shelter, energy, and the cost of living are up. Workers have their backs against the wall.
So I think that unit labor costs will keep pushing up. The first chart shows unweighted labor costs and understates the trend. The second chart helps see the incidence of a weighted approach to AHE changes.
This moderate inflationary revival is a lose-lose proposition. If energy and shelter continue their uptrends, and the pool of skilled labor remains stagnant, wages should follow their uptrend with a short lag. Alternative outcomes are not more encouraging.
- if wages don’t keep up with costs, real disposable income will suffer.
- if disposable income is weak, retail sales (70% of the US economy) will be weak -unless we resort to significant credit growth again.
Lower real rates should not be helpful to financial assets. Any way you slice it, this already significant uptick in inflation should be a negative for the economy and for bonds. I will remain flat to short duration in my fixed income portfolio. Just one caveat: nothing in the markets is behaving how it should, so why would inflation’s consequences break the rule? Using the BTFD rule is much much safer!
The Fed is caught between inflation and the need to tame dollar strength. Let’s remember that inflationary pressures will impede effective dollar-weakening policies by the Fed. To that end, they are keeping as quiet as they possibly can, particularly regarding rate rises and the impact on the dollar, but that is not a sustainable dollar depreciating narrative. Internally they need to lift rates to preclude an inflationary scare and achieve some financial market stability. But both internally and externally (as a reserve currency), they’re terrified about a likely bullish stampede in the USD -and the Trump denigratory tweets that were sure to follow.
I think they have to raise rates and accept dollar strength but admit to seeing their position as untenable. Who knows what they will end up doing. We are all going to need good luck this year, and I’m willing to share it with you readers. I will hold on to my dollar longs and hope to be back, both physically and financially, alive. That will be next month. In the meantime, I have to keep my spirits up: winter is tough, but spring 2017 ain’t that far -and I plan to enjoy it. We only live once that I know of.