Friday, February 5, 2010

Issue VII - Sovereign Debt 2/5/10

Dear Readers,

The US Dollar has continued to strengthen after briefly falling in the first couple of weeks in this year. What has transpired goes against much of what I have written so far in this newsletter regarding the Greenback. As I write this (Thursday morning), sovereign debt concerns in Europe with regard to Greece have spread to Spain. This continues to drag down the Euro. The Dollar Index is now over 80 for the first time since early July 2009. I continue to see flawed logic in this. First, the composition of the Dollar Index (USDX) is a relic that does not accurately reflect the Dollar’s position within the global economy. The Index’s composition does not guide investors away from the real problem: that sovereign debt issues are affecting, and will continue to affect, all Western economies. Second, investors need to realize that the United States has the same, if not worse, problem sas Europe. Why investors are fleeing the Euro for the “safety” of the Greenback is mind-boggling, yet can be understood in the context of a post-2008 crisis world.

The Dollar Index is a trade-weighted measure of our currency’s strength versus a basket of six other currencies. It is weighted as follows; 57.6% against the Euro, 13.6% against the Japanese Yen, 11.9% against the British Pound, 9.1% against the Canadian Dollar, 4.2% against the Swedish Krona, and 3.6% against the Swiss Franc (Refer to Chart 1 for a visual rendering). The index was established in 1973 in the wake of the dismantling of the Bretton Woods monetary system, which formally ended with the Smithsonian Agreement after Nixon took the US off the Gold Standard in 1971. The main reason for the Euro’s heavy weighting is due to the combination within the USDX of the former currencies of France, Germany, Italy, and Spain upon the introduction of the Euro in 1999. As investors have become more skittish about the health of Western currencies, the USDX has become a primary determinant in the day-to-day fluctuations of the markets. This practice is flawed. We live in a global economy, yet the value of the USDX is 86.4% determined by Western currencies; the other 13.6% being Japan, a poster child for profligate spending.

Chart 1 - Composition of the Dollar Index

In my opinion, to accurately weigh the US Dollar in relation to the global economy, the currencies of Mexico, Russia, Australia, Brazil, China, and a few of the petro states at the very least should be included in the basket that makes up the USDX. (China still pegs their currency, the Yuan, to the Dollar.) Furthermore, the composition of the Dollar Index has not changed for more than a decade. The possibility of China decoupling its currency from the Dollar has been the subject of debate recently, and I will be commentating on this in a future newsletter. In short, the USDX does not accurately reflect the true position of the Greenback within the world economy, instead measuring it against a basket of currencies whose backing governments have similar debt problems.

European markets are tumbling today on the concerns of a debt contagion (Spain’s Bolsa Index was down 5% on Thursday), and as a result the US Dollar is continuing its rally that began on November 26 with Dubai’s debt scare. This is nothing less than absurd. It takes a great leap of faith to surmise that the Euro zone’s fiscal problems are greater than those of the US. For example, the Greek economy, ground zero for the Euro’s problems, comprises merely 2% of the Euro zone economy. Compare that to California, representing 13% of the U.S. economy. Greece cannot print its own money to get out of a fiscal bind because it is part of a currency union, and the same goes for California. Thursday morning, the Euro’s problems were compounded by fresh concerns, this time over Spain’s debt. Spain’s economy represents 13% of the Euro zone’s economy, comparable to California. However, keep in mind that in the US, states that make up more than 5% of GDP, such as Illinois, and Florida, are not far behind California in terms of fiscal problems. (California’s current budget gap for 2010 could be as high as 50%, Illinois’ as high as 45%). In the same manner, Portugal and Ireland could be next in line in the Euro zone (Refer to Figure 1 at the end). Neither of these nations approaches the size of the bigger US states, which means that their troubles would impact the Euro less than a larger US state would impact the Greenback. Either way, what will ultimately transpire is either the default of individual states or a series of bailouts, which in the end will hammer both currencies.

Financial journalist Daryl Montgomery blogged earlier this week, “While it is generally not recognized, US states are part of a de facto currency union for the dollar. Their fiscal problems should be considered as analagous [sic] to European countries that are part of the Euro zone. California is essentially in default and is only being kept afloat by constant cash infusions from a number of federal stimulus programs. It represents a much bigger drain on the US dollar, than Greece does for the euro.” Indeed, California’s ongoing budget crisis is a canary in the coal mine, a representation of the bigger problems to come. In June 2009, the Obama administration refused to guarantee the promissory notes (IOU’s) that were issued by California to close its budget gap, saying that it had no legal authority to do so, and that the state should solve its own problems. It will be interesting to see what transpires as the problems get bigger. In a similar manner, the European Union has not expressed willingness to bailout its individual troubled nations, yet with Spain, Ireland, Portugal and others next in line, this could change.

Finally, the flawed logic of seeing the Dollar as being stronger than the Euro is illustrated on the federal level as well. To begin, Greece’s debt fears began to ease earlier this week when it submitted to the EU a plan to slash its budget deficit to 3% by 2012. Regardless of whether that happens, there is no way the US will be slashing its deficit to anywhere near that by 2012. It will be fortunate if we are below current levels in two years. On Monday of this week, President Obama submitted the 2011 Federal Budget. It contains a deficit of 11% of GDP. Looking closer at the numbers, 40 cents of every dollar will have to be borrowed or printed. Compounding those problems are the aforementioned problems with the states. Eventually, California (the 8th largest economy in the world if taken by itself, one place ahead of, coincidentally, Spain) will need a massive federal government bailout, and it’s only one of several US states that have serious fiscal problems. Why, in spite of this, are traders selling the Euro and buying the Greenback? Because the US is viewed as being in better fiscal shape than the Euro zone? Am I missing something here? Both currencies are well on their way to being devalued.

The economist Nouriel Roubini mentioned earlier this week that currencies of commodity-based economies such as the Brazilian Real and Aussie Dollar will outperform other currencies in the next few years. This appears to be a complete reversal from Roubini’s earlier position that the US economy will experience a deflationary cycle. Does he believe that the Dollar will decrease in value? He didn’t go so far as to say that, but such was implied. Unfortunately, the USDX will not reflect this because it is made up of only Western currencies and one Asian currency from a nation that, more or less, has been in recession for the past 20 years. Obviously, all of the Western currencies will trade down against their Eastern counterparts in the Forex markets, but my concern is that, like we saw today, too many investors will take the USDX and its strengthening to heart. They should be looking at the big picture, the global economy.

Postscript to my last commentary:

Originally, I planned to continue my Gold/Silver ratio argument this week and predict what might happen to those on the short side of the trade if Silver were to rise above the $20 mark. Yet, Silver has continued to fall this week on the heels of the strengthening Dollar, so I decided to push it back.

That said, in the two weeks since my last newsletter, the ratio has risen from the low 60’s to as high as 73 at one point Thursday morning, closing just under 70. Silver alone lost 6% on Thursday. This was the most volatility that the ratio has seen since October 2008. If Silver falls to $14.75, that would represent a 61.8% Fibonacci retracement (in other words, $14.75 is a major support level). If the price does not hold at that level, it is likely that the ratio could exceed 75 in the short-term. As history has shown, those levels do not sustain for long. Investors should be salivating over the opportunity that could present itself. Despite the volatility, I stand by my previous letter’s prediction that the ratio will fall back below 60, and possibly as low as 50-55 in 2010.

Respectfully yours,

Matthew R. Green

February 5, 2010

Figure 1:

Top 10 US States in GDP Overlaid within World GDP Rankings

Country (US states in bold) 2006 GDP (millions)

1 United States of America 13,843,825
2 Japan 4,383,762
3 Germany 3,322,147
4 China 3,250,827
5 France 2,772,570
6 United Kingdom 2,560,255
7 Italy 2,104,666
8 California 1,812,968
9 Spain 1,438,959
10 Canada 1,432,140
11 Brazil 1,313,590
12 Russia 1,289,582
13 Texas 1,141,965
14 New York 1,103,024
15 India 1,098,945
16 South Korea 957,053
17 Australia 908,826
18 Mexico 893,365
19 Netherlands 768,704
20 Florida 734,519
21 Illinois 629,570
22 Turkey 607,419
23 Pennsylvania 531,110
24 Ohio 466,309
25 New Jersey 465,484
26 Sweden 458,966
27 Belgium 453,636
28 Indonesia 432,944
29 Switzerland 423,938
30 Poland 420,284
31 North Carolina 399,446
32 Georgia 396,504

Source: International Monetary Fund