Submitted by Paul Bordsky via Macro-Allocation.com,
It seems monetary policy is exhausted and the next exogenous lever to pull would be political fiscal initiatives. If/when they fail to stimulate demand, there would be only one avenue left – currency devaluation. If/when confidence in the mightiest currency wanes, we would expect the US dollar to be devalued too - not against other fiat currencies, but against a relatively scarce Fed asset.
Seriously Squirrely
On February 3, New York Fed President Bill Dudley noted financial conditions are considerably tighter than when the Fed hiked rates in December, and, though its members are not yet ready to draw conclusions about the policy path, the FOMC will surely consider such tightening financial conditions in its future deliberations. He further noted that a weakening of the global economy and additional dollar strength could have significant consequences for the U.S. economy. Bingo.
It seems we have been on the right path by arguing the Fed has taken control of dollar policy. Less clear is that the Fed acknowledges an inevitable global de-leveraging, and in such an environment a strong dollar would attract global wealth and capital to the US, which in turn would fund bank deposits and capital markets. (It is unlikely the Fed would acknowledge such a policy so economically hostile to its trade partners.)
To be sure, Dudley’s is a voice to heed. The New York Fed has a very special role in the Federal Reserve System. Not only does its president have permanent FOMC voting privileges, but the New York Fed represents Wall Street, and perhaps more significantly, the Fed’s majority shareholders. One could reasonably suspect that with Fed board members Daniel Tarullo and Jerome Powell, who generally do not comment on Fed policy, Dudley’s remarks reflect the willingness of core financial operators to endure less than optimal lending and/or yield curve conditions.
Weakening US and global credit and equity markets are hinting that policy makers may be losing their grip on the general perception that they have the collective ability to control demand and output growth. This week, the European Commission reduced its forecast for 2016 and 2017 growth in the UK. The Bank of England left its policy rate unchanged and signaled its intention to hike rates is less straightforward than it used to be.
Meanwhile, in the US this week productivity fell sharply, jobless claims were again higher than trend, but the unemployment rate fell to 4.9%, average hourly earnings rose sharply (2.5% year-over-year), and hours worked expanded. Such wage inflation provides the Fed cover to normalize rates further, which we argue it wants to do to maintain a stronger dollar.
Despite the rhetoric coming from monetary policy makers and whatever economic releases may be used to support their objectives, the real economy will do what it will do. Global trade continues to wane. The Baltic Dry Index (below) is plumbing five year lows.
Growing evidence suggests that the global economy is rolling over, as has been our core view, and that global monetary policy makers, after six years of highly unconventional policies meant to synthesize demand by goosing the financial system, have emptied their bag of stimulative tricks.
Again, we think the Fed will do whatever it takes to strengthen the dollar, including maintaining its normalization process if necessary, so that the US could import global wealth and capital amid a global economic slowdown.
Gold Redux?
Five years ago I wrote a comprehensive report with Lee Quaintance called Apropos of Everything, which sought to make sense of the global monetary system in an environment of excessive and increasing systemic leverage. The long report argued quite radically that the current global monetary system would ultimately fail (all have historically) under the weight of unsustainable leverage, and would likely be replaced by a system with a fixed exchange rate, probably using gold as its anchor. It is impossible to know now whether we were wrong or just very early.
My suspicion then was that before such an event could occur, the US dollar would likely gain significant strength against all major currencies. My rationale was that, unlike any time in history, there are no competing currencies with a value fixed to anything scarce. All currencies are created in fractionally reserved banking systems overseen and protected by each economy’s political dimension, which, in turn, always has incentive to choose short-term fixes over more rational long-term economic options.
In today’s monetary regime, the US has the strongest and best reserved banking system of any major currency (thanks to past QE), and the depth, breadth, fairness and oversight of its capital markets are without peer. This implies that were a global de-leveraging to occur, global wealth and capital denominated in other major currencies would be exchanged en masse for the world’s major reserve currency – King Dollar. Its unrivaled hegemony would gain stature among all fiat currencies in a global economic downturn.
To date in 2016, default-free treasury yields have dropped significantly. Whether this is due to the perception of a slowing US economy and falling inflation or the result of capital flight from abroad – or both – is unclear.
If the global economy has indeed reached crunch time, as we suspect, then we would expect the spot price of gold to move higher, and it has. Gold has been the best performing asset in 2016, rising almost 9% through last night.
Conventional wisdom argues that Treasury bonds and gold should move in opposite directions: bond prices should rise and gold prices should fall in a disinflationary or deflationary environment, and gold prices should rise and bond prices should fall in an inflationary environment. This understanding is incomplete in a very meaningful way. History shows that gold prices rise during periods of price deflation when its driver is systemic balance sheet de-leveraging.
Applied to today, if elevated leverage levels across global government, household and corporate balance sheets begin to overwhelm and crowd-out production and animal spirits, then consumer demand and the prices of goods and services should begin to decline.
One of the first places we would theoretically see struggling output is in natural resources because their production and consumption are directly impacted by economic activity. Consumer commodity prices are tougher for credit policy makers to manage because consumers do not borrow to buy a gallon of gas or a loaf of bread.
Obviously, we have seen commodity price deflation and negative sovereign yields begin to take root across the world over the past two years. Our reading of the evidence suggests that the commercial marketplace and capital markets are experiencing and anticipating global deflation from de-leveraging.
Finally, the political dimension is beginning to react to the loss of its economic power, as one would think it would have to in a global economy characterized by excessive leverage. How else might one explain the popularity of “extreme” presidential candidates on the right and left in the US? What was political radicalism a few years ago has become popular reality today. The masses in the world’s largest and most sophisticated economy are revolting against the political center. The implication is obvious: the status quo no longer serves the people.
We are pleased with the way our long Treasury and long gold positions have fared in our model portfolios so far this year, offsetting our long equity positions. We are considering whether to use some of our significant cash positions to add to these positions.
It seems monetary policy is exhausted and financial de-leveraging and austerity are naturally being imposed on economies. We should expect continued debt deflation, asset weakness and output contraction. The next exogenous lever to pull would be political fiscal initiatives. If/when they fail to stimulate demand, there would be only one avenue left – currency devaluation. If/when confidence in the mightiest fiat currency wanes, we would expect the US dollar to be devalued too - not against other fiat currencies, but against a relatively scarce Fed asset.