“Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the market.”
- John Maynard Keynes, 1935
The 20th century British economist John Maynard Keynes was a veritable trove of quotable quotes. The above may be the most famous, yet many others are appropriate to economic circumstances time and time again. Today is no exception. The above quote is taken from his 1935 book The General Theory of Employment Interest and Money. To paraphrase, we Americans are very good at following the pack. Whether this applies to the stock market or the housing market, this trait comes back to bite us. It has, time and again.
The propensity to gravitate toward the trend also helps explain why those whose viewpoints eschew the trend make easy headlines. In recent years, they are often not taken seriously until after a particular economic bubble has popped. Some of these individuals buck the trend, only to be wiped out for calling the top too early. In 1998, the great hedge fund manager Julian Robertson became convinced that the Nasdaq had run its course. He began to actively short the tech sector. The resulting short position losses, along with several bad long positions (notably US Airways), and bad currency bets, ended with Robertson shutting Tiger Management in February 2000. The Nasdaq peaked on March 10, 2000, a mere three weeks later. Such an example illustrates another notable Keynes quote; “The market can stay irrational longer than you can stay solvent.” Others, like John Paulson in 2007, had more fortuitous timing and made a killing when their target (in his case, subprime mortgages) deflated.
Currently, one of the top trades in the news is the Dollar Carry Trade. A quick explanation; A carry trade occurs when a trader borrows money denominated in a certain currency order to buy assets in that currency. He does this with the expectation that the real value of the debt will erode over the time period he will own it, because the underlying currency will decline. With respect to the Dollar Carry Trade, many eyes in the investment world are paying very close attention to this trade due to its close relationship to other markets, especially the Gold trade (no uncrowded space at the moment) and the global equity markets. In the past month, several prominent economists have publicly predicted a swift, destabilizing unwind to this trade. Of these, Nouriel Roubini has been the most prominent.
On Wall Street, Roubini has earned the name “Dr. Doom” since 2006 for not only predicting the real estate collapse, but the rapid domino-effects it would have on the banking system and consequently the financial markets. In a recent Financial Times editorial, and also in trading verbal punches at a conference with commodities investor Jim Rogers, Roubini has made his view clear: the Dollar is due for a swift appreciation that will reak havoc on the markets. However, one needs to interpret the most extreme viewpoints with a degree of moderation. While a currency trade, especially one that is crowded, can turn on a dime, an investor needs to take a long look at the current position of the US Federal Reserve, and also the history of carry trades, in formulating a comprehensive thesis. In the opinion of this writer, Roubini is now playing the part of the epithet he most definitely earned, and little else.
In the past year, the Federal Reserve Bank of the United States has unleashed an unprecedented amount of liquidity into the world economy. As a noted scholar of the Great Depression, Chairman Ben Bernanke surely knows more than the average central banker of the potential destruction caused by deflation. High inflation is bad, but deflation is much worse (the logic behind this will be the topic of a future commentary). After six months of dollar appreciation, the Fed responded to the looming possibility of a depression-like vicious cycle of deflation. In his March, 2009 testimony to the House Financial Services Committee, Bernanke announced that the Fed would commence a program of Quantitative Easing. (This took the form of the Fed purchasing its own Treasuries, in order to keep rates artificially low). It was at this point (Refer to Chart A) that the US Dollar resumed its downward trend. Among other tools in their arsenals, other Western governments have been doing much of the same thing. The end result is the devaluation of the US Dollar and other fiat currencies. Thus, the trend remains in place for traders to borrow the USD to fund asset purchases, with the expectation that the real value of the debt will erode, because the underlying currency will decline.
Chart A
US Treasury Secretary Timothy Geithner announced that the Fed ended its QE program after the latest Treasury Auction earlier this month. Nevertheless, the Federal Reserve remains determined, by all means possible, to prevent what happened in 2008 from happening again. One method they continue to utilize is the devaluation the US Dollar via low interest rates, and therefore inflation. Inflation year in and year out is nothing new. In fact, since the Federal Reserve was created in 1913, the US Dollar has lost 95% of its purchasing power. The bulk of this decline has been since President Nixon took the US off the Gold Standard in 1971. Since then, it has lost 80% of its purchasing power. Prices going up overtime, and the dollar being gradually devalued are part of a continual trend.
Additionally, the Federal Reserve has very little room to maneuver with respect to interest rates and indeed the US Dollar. If rates are raised, the Fed threatens to derail the fragile economic recovery. For recent news conferences, Bernanke and Geithner have concocted very carefully worded statements regarding their stance on the dollar. They continue to claim that they support a strong dollar. Yet their actions of the past year suggest otherwise, including the fact that they have not expressed any intention to begin raising rates for “quite some time,” which many on Wall Street have translated into around late 2010. According to the transcript of the most recent Federal Reserve Board of Governors meeting, several members, including the Governors of the St. Louis and Dallas branches, are beginning to express concern that such low rates could lead to high inflation in the next five years. Given the state of the current economic recovery (or lack thereof, some might argue), combined with Bernanke’s track record and his philosophy of inflation over deflation, I fully expect these concerns to be ignored for the time being. The Fed will likely condone a steady decline in the dollar now and in the near future. This paves the way for the Dollar Carry Trade to continue for years.
Using a certain currency for Carry trades is encouraged via the systematic devaluation of a country’s currency, whether it is Argentina in the 1980’s, Japan in the 1990’s, or the US today. With systematic devaluation, there is not a great danger of any particular carry trade blowing up in the midst of such policies. Since the mid-1990’s, many currency traders have used the Japanese Yen as a funding currency. This began when, in the wake of the deflationary fallout from the Japanese Real Estate Bubble, the Japanese government began lowering interest rates in earnest. A 0% rate was ultimately instituted in 1997. Since then, and indeed for the greater part of this decade, the Yen was the carry trade of choice throughout the financial world. It took until 2007 for the Yen’s real effective exchange rate (simply put, the exchange rate when adjusted for inflation) to reach its low. As the credit crisis began in 2008, the Yen rapidly shot upward against other currencies, notably against the Australian Dollar (Refer to Chart B). In mid-2008, the US Dollar was hitting its lowest levels in decades against numerous other world currencies. With the onset of the credit crisis, this trade quickly unwound beginning in August 2008, until March 2009 (Refer to Chart A). This “flight to quality” lasted until March, when the Federal Reserve announced its Quantitative Easing program. As mentioned earlier, this is (not coincidentally) when the US Dollar resumed its decline. Therefore, the US Dollar is gradually replacing the Yen as the carry trade of choice, in addition to the October-March uptick being unwound. Both are contributing factors to the growth of the Dollar Carry Trade in the past six months. As with the Japanese example, carry trades have the potential to last for years, if not decades.
Chart B
Once again, I will repeat that Dr. Roubini is correct in that a currency trade can snap in either direction quickly and relentlessly. This is particularly true in any trade which is crowded. A swift reversal can result in a selloff, or a swift tick upward can result in a “short squeeze” if the crowded trade is on the short side. As one can see in the charts, Roubini is indeed right that a currency reversal can be swift and disruptive. This is particularly true for the US Dollar, by which commodities and many other financial instruments are traded.
As I am writing this, it has been announced that the Emirate of Dubai is asking its creditors for a delay in the repayment of over $50 Billion in debt. This was the debt taken on this decade to transform Dubai into the metropolis it has become (and less than 33% occupied, with the world’s tallest building at that!). The US Dollar is rising more today than it has at any other time in the past eight months. The reversal is quick, and the short-term outlook is volatile. Roubini will inevitably get additional facetime on CNBC and Bloomberg if the dollar has a brief uptick for the next two weeks to a month. Ultimately, I think this will prove to be a head-fake. Compared to European Banks (Standard Chartered and HSBC in particular) and indeed Governments, the US has relatively little exposure to Dubai, although I am by no means an expert on the matter. What I do know is that the Federal Reserve’s policies are in place for a gradual devaluation of the US Dollar. Therefore, Dubai should not prove to be a very disruptive event, and I forecast the dollar to resume its secular decline anywhere from two weeks to a month from now. In any long-term pattern, there will be corrections. This will prove to be no different than countless others throughout history.
I hope everyone had a Happy Thanksgiving. Have a great week.
Respectfully Yours,
Matthew R. Green
November 27, 2009
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