Tuesday, October 20, 2009

The Myth of The Strong Dollar Policy

Here are five great myths and/or lies of the modern financial system:

1) "The check is in the mail"

2) "I'll call you right back"

3) "We are long-term investors"

4) There is a secret cabal of gnome-like creatures that manipulate the gold price (up or down, depending on your druthers)

5) "The United States believes in a strong dollar"

When the strong dollar policy was formulated by Bob Rubin in 1995, it was sincere and served a purpose. After all, the Treasury market had experienced a horrible sell-off the previous year and the buck made all-time lows against the JPY and DEM in 1Q95, prompting the last bit of multilateral currency intervention in which the US was an enthusiastic participant.

And one could argue that the policy served a useful purpose throughout the 90's; by maintaining tight monetary conditions, it replaced some element of Fed rate tightening, while at the same time affording the US a useful (positive) terms of trade shock. It was only a decade ago that oil flirted with $10/bbl!

However, in the Noughties, a decade dominated by global imbalances, the bond conundrum, and a host of other resource misallocations, it's been quite clear for some time that the strong dollar policy is a farce worthy of Rabelais. It's a well-known fact that the strong dollar policy is a hollow one, and Macro Man can only conclude that in diplomatic circles, it must represent the epitome of poor taste for JCT, among others, to reiterate their support for what has become a "strong dollar" policy (emphasis on the quotes.)

'Tis a pity, really; the strong dollar policy once served a useful purpose, and it's not difficult to envisage it doing so again. By failing to withdraw its support of an overtly strong dollar when one was no longer desirable (quite the contrary), the US Treasury has done America and the rest of the world a disservice.

Of course, it's a tad rich for JCT to dance around someone else's linguistic parlour tricks; after all, he is the undisputed master of speaking in a literary code of his own devising (remember 'strong vigilance'?!?!). And even in the currency realm, the Europeans have their own form of linguistic semaphore; when Europe warns of "excessive volatility" in currncy rates, they are really moaning about the level of the euro.

For if it really were volatility that Europe cared about, then they should be chuffed to bits. As the chart below demonstrates, one month realized vol in EUR/USD has collapsed in recent months and is now, at 6.9%, at the low end of the post-Bretton Woods range.
Belatedly, of course, the Europeans seem to have noticed that the Chinese aren't exactly playing "good neighbours" when it comes to global currency policy. And so after years of American financial diplomats trudging to Beijing to wag their fingers at the unrecalcitrant Chinese, Messrs. Trichet and Juncker will be making a similar pilgrimmage over the next couple of months.

For some reason, Macro Man can't shake the Kim Jong-Il/ Hans Blix scene from Team America from his mind, though he suspects that feeding the European worthies to a shark tank would probably not escape notice.

The best that the Europeans can probably hope for, however, is if the Chinese response is something like this:



Meanwhile, Brazil has re-instituted a punitive tax on foreign capital, a week after Turkey was rumoured to be contemplating a similar arrangement. Taxes on capital, moaning on currencies, nothing on interest rates. You can almost literally see the wagons circling as each country looks out for #1.

It's entirely possible for this liquidity/positioning/DGDF rally in risky assets to continue through year end; in many ways, it's in everyone's best interest for this to happen. But Macro Man can't shake the feeling that we're all repeating the mistakes of the last cycle (in fast forward, no less!) and that when the reckoning comes, it won't be much fun.

45 comments:

Anonymous said...

And yet, it keeps on going forward, MM.

Btw, the Turkish Supreme Court said charging a tax (10%) for local purchasers of Treasuries are unconstitutional. The govt. might get rid of it all together according to a press article today as the tax revenue from locals run only around $150 Mil.

USD/TRY is arguably low given overnight rates are at historical low.

A.

Nemo Incognito said...

Carbon content import taxes here we come.... quite ironically, this is likely to come from the Europeans first. They seem to be a lot less squeamish about protectionism.

Charles Butler said...

Looks like the general opinion (or hope) seems to be that if you take away leveraged purchases of securitized garbage mortgages, the problem goes away - and the party can resume exactly where it left off.

Too amazing for words.

Anonymous said...

That government should announce it will impose a 4 percent tax on foreign SALES of fixed-income securities before their maturity and stocks, starting yesterday. Now that would underline the 3) through 2) until 1), should 5) occur by some kind of strange quality plight.

As the CME points out “many of the [trading] houses hold quite a lot of physical gold and would welcome using it more efficiently” and they welcome that view by allowing their physical gold to be pledged as collateral on all exchange products. That collateral will be stored safely at J.P. Morgan Chase & Co.'s bank in London, should anything occur at their so hedged margin req. Starting yesterday too.

Nemo Incognito said...

just what would it take to derail dgdf, aside from RMB revaluation?

Anonymous said...

An unexpected AND larger than unexpected rate hike.

Anonymous said...

From what I saw, climate change seems to be a non-issue. I won't count on it yet.

Anonymous said...

When oil price keeps rising and long bond is forced to go down?

Anonymous said...

How about a bond market collapse that in turn, triggers equities plummeting and a flight to safety?

-Ivanovich

Nemo Incognito said...

See the bitch of this is that you could get:

1) Rate hike to cool markets.
2) US looks even more bankrupt as effective borrowing rates rises.
3) Bonds sell off due to credit risk.
4) More DGDF.

It might interrupt the flow of the trade but I don't think a rate hike is necessarily a deal breaker.

Anonymous said...

if the mkts hold in there on the BRL story, it could be another short term positive for the AUD...if you were a fund that wanted EM equity market exposure, commodity exposure, and no political risk - where else would you go ?...and the CAT results don't hurt either...

E

Nemo Incognito said...

This is the problem - unless China does SOMETHING in which case that could push rates up and lead to the whole death spiral trade this is looking awfully like a positive feedback loop to me (or a "reflexive process") for the Soros/Duquesne/Indus crowd.

Anonymous said...

agreed Nemo. It also surprises me a little how bullish the RBA are on China going fwd...they don't seem to be that worried that it's all going to implode...given the M2 growth I'm not so sure, but am willing to concede that their economic intel would be better than mine...makes me think AUD potentially has a long way to run on some of the crosses, assuming no major black swan events...

E

Anonymous said...

NI 11.33

a "surprise" credit event?

Nemo Incognito said...

China's a potential blowup but not 2010 - 2011/12 maybe but only after inflation goes totally ape and my lean hogs position hasn't really got moving yet.

CTA's must be having a field day with this kind of thing.

Steve said...

A few buck-turners:

--rapid rise in real rates (could be through deflation as opposed to rate hikes). This really goosed the yen in the '90s.

--gross inbalance in PPP, though in MM's previous post it is clear that this is a long-term item.

--weakening of the other currencies through USification exportation / beggaring.

--downmove in stocks and or commodities.

I agree with MM, a weak dollar is the lesser of all evil cures. The key is, at what point does "policy" stop working. The Japanese were the last ones to want a strong yen in the '90s, but that's what they got, despite repeated intervention.

Tony said...

There is a secret cabal of gnome-like creatures that manipulate the gold price (up or down, depending on your druthers)

Who says it is a secret cabal of gnome like creatures? It is secret only for morons who cannot see what goes on in the face! They are human beings (some of them despicable, no doubt) working in the Treasury, FED, JP Mprgan, Citibank & company!

Anonymous said...

I have to interrupt you here, what Rubin did with 'strong dollar policy' was a way to let the markets know that the dollars fluctuations weren't fluctuations that were being directed at other countries as an economic weapon. Instead it was being done to help the US 'grow' it's purpose seems to indicate that we have struck out on a path and will follow that path until rhetoric changes. It allows other countries to position themselves appropriately to mitigate whatever action the US is taking.

Anonymous said...

Revelation 18: When the kings of the earth who committed adultery with her and shared her luxury see the smoke of her burning, they will weep and mourn over her.Terrified at her torment,they will stand far off and cry:" 'Woe! Woe, O great city,O Babylon, city of power! In one hour your doom has come!'"They will say,'The fruit you longed for is gone from you. All your riches and splendor have vanished,never to be recovered.' The merchants who sold these things and gained their wealth from her will stand far off, terrified at her torment. They will weep and mourn and cry out: " 'Woe! Woe, O great city, dressed in fine linen, purple and scarlet,and glittering with gold, precious stones and pearls! In one hour such great wealth has been brought to ruin!'

Crisis Management said...

I seem to remember "brutal" as being the special FX codeword. As regards gold:

1. In 1980 the COMEX turned "long liquidation only" and broke the Hunt brothers.

2. In the 1960's the London Gold Pool operated to protect Bretton Woods. Fed minutes in 1967: "Of greater concern, however, was the fact that the drain on the pool was accelerating again..."

3. As we all know under FDR the Fed essentially stole half of the private citizen's gold.

Central banks manipulate foreign exchange rates, gold is just another currency. Gnome cabals, I would have to leave for someone else to comment on.

Anonymous said...

Inflation in China? As the same as in US, when there is no wage grow, it is hard to see where the inflation coming from.

Anonymous said...

Anon @ 3.29, Chinese CPI composition means the key swing factor is food prices - Food 33%/Residence 13%/ Services 26% / Manufactured gooods 29%.

Anonymous said...

Anon 3:29

Claiming that inflation is not possible without wage growth is ridiculous.

- It happened in the US all through the 1970s
- It happened in Latin America 1970-1995 (ish)
- It has been going on in African dicatatorships for at least four decades

And despite all the ignorant comments from Wall Street analysts, local and state taxes (and healthcare costs) continue to climb much faster than GDP or wage growth

Try watching your Bloomberg screen less, and the real world more

Anonymous said...

Derail DGDF? Surely the implication of beggar-thy-neighbour currency policies is that no nation wants a weak dollar, given that a significant part of the world's consumption still occurs in the US....so at the moment they are all failing miserably, apart from the BoE.

Responder said...

Strong vs. weak dollar policy is just that, a policy, and should be influenced through fiscal and monetary policies depending on the position of the economy, relative of course to many other variables such as the political economy. Moreover, as a political tool we often hear bipartisan rivalry over the need for a "stronger" dollar due to consequences from the "other side". Yet, when the public sector speaks to the masses, it sites the strengths of a weak dollar to support export industries during this "finanonmical crisdown". Even yet more the international field is mired by dollar pegs, most notably that tied to petroleum, trade policies (think Yuan think countervailing duties), and a general weakness in lending rates MM showed via the EUR/USD trades (if not LIBOR).

So what should be done? Nothing. The Dollar is not the sterling pound and thus holds no aristocratic requirement to be nobly "strong". No, the USD is a game seeker, finding markets where it isn't afraid to get dirty. This strategy, I believe, is what makes the dollar truly strong due to its vehicular nature as a global currency. Lastly, the limited volatility of the USD (along with its strong reputation) allows smaller countries (if not firms) to acquire USD as their reserves. They do this becuase they know that sooner or later it will be strong again.

Anonymous said...

Anon 5:33,

well, you should be able to separate large economies from small economies. Large economies can be price makers, while small economies are largely price takers. This means that American and European or maybe Chinese can affect world demands then world prices on commodities by changing their consumption, while Latin American or African really do not matter.

US in 1970s experienced a wage inflation until the beginning of 1980s. Yes with oil shock you see some back and forth in inflation in US in 1970s, but the general trends of both did coincide.

China before 2000 was largely price taker. Right now it might gradually move to a price maker. Without wage inflation, consumption would react to any price increase, especially for food and service, which is 59% of CPI. And the easy money right now flows to stock markets, real estate, and infrastructure. Then in China, the wealth effect is not that large because of limited use of consumer credits. So no, I just do not see a huge inflation in China in a while.

Anonymous said...

anon 5:33

"local and state taxes (and healthcare costs) continue to climb much faster than GDP or wage growth"

well, if a country has a progressive income tax system, then the tax revenue should grow faster than GDP or wage if there is any positive prowth.

Anonymous said...

One wonders how much of that foreign capital is going to flow back into Brazil after this intervention.

Anonymous said...

Anon 6:53

Once again, you confuse cause and effect.

The US was forced out of Bretton Woods (because the dollar wasn't worth what pompous bureaucrats said it was) in 1971. The oil price spike happened in 1973, following the Yom Kippur war

Oil prices didn't cause inflation, unless you want to argue that time moves backwards. OPEC raised nominal oil prices to compensate for the lower purchasing power of the US dollar

Anonymous said...

Anon 6:57

Clearly, you are one of the more mathematically illiterate members of society...

Government spending cannot grow faster than GDP long term -- and it has already been growing faster than GDP for almost five decades. Look it up before you make an ass of yourself; the US went from the world's largest creditor to the world's largest debtor.

Even Obama's own CEA head has shown (in earlier research) that raising taxes by 1% of GDP lowers long term GDP growth by 3%. Its a losing proposition.

Idiots like you are why Wall Street is now insolvent and needing a taxpayer bailout. Go get a honest job and stop trying to screw the rest of us over with your quack economic theories

pebird@pacbell.net said...

"Government spending cannot grow faster than GDP long term -- and it has already been growing faster than GDP for almost five decades."

So what is long-term, 75 years, 100 years, 2 lifetimes?

I have a different time horizon, but that probably makes me an idiot.

Macro Man said...

Play nicely, children....

Anonymous said...

Macro Man ... Number 4 is true!

leftback said...

The dollar will certainly be strong enough for everyone to buy it again when the time comes to take off the RISK-ON trade and book profits for the year.

Those calling for a bond market blow-up are really assuming a level of idiocy on behalf of US Govt and Fed that seems unwarranted. A recapitulation of Japan's experiences seems likely: transfer of UST market from foreign to domestic investors, a zig-zag pattern of asset values, with the $ alternating between safe-haven and carry trade funding currency.

[Cue the usual ritual abuse of LB as being a clueless tool etc.., for not understanding the differences between US and Japan, the US is different, superior, inferior, more indebted, more socialist, more capitalist, more diverse, more flexible, more more more .... ]

Anonymous said...

LONDON (Dow Jones)--Bank of England Governor Mervyn King said Tuesday that heightened regulation can't prevent the financial speculation that results in bank failures, and called for a serious review of the structure of the banking sector whose goal would be to eliminate institutions that are too important to fail.

Shame that the BoE were not responsible for bank supervision

Anonymous said...

Part of the other BS about DGDF and "short the treasury market" is that there is a lack of appreciation for just how f*cked the private sector is at the moment. The public sector is the only thing that is keeping GDP numbers above water!

leftback said...

"heightened regulation can't prevent the financial speculation"

Oh yeah? You have no idea how much wreckage there would be in the commodity markets if US and UK both introduced limits on position sizes in crude, metals etc.. it is a house of cards fueled by hot money.

Crisis Management said...

>> Cue the usual ritual abuse of LB as being a clueless tool etc...

Anyone who saw the 2001 Argentina devaluation firsthand is alright in my book. Even if you are out there driving down the value of my PM along with the other gnomes.

Charles Butler said...

Naked Capitalism linked to your piece. That's where they all came from. She's plagued with them.

Anonymous said...

anon 7:30 PM and 7:34 PM,

I am not sure what you are smoking but it seems that you have no idea of your own tax system and cannot grasp the idea that different kinds of economies face different sets of constraints on their policies.

Sorry, but yeah, you are always going to be screwed by wall street.

Anonymous said...

LB,
Absolutely right. The money would be tripping over itslf looking to get out ,but as we know the price door is never wide enough for everybody to get through at a price they like. yet people never accept that truism no matter how many times it repeats.No, they just know the greater fool not able to get out will never be them ,oh yeh !

LookingForYield said...
This comment has been removed by the author.
Nemo Incognito said...

I think we're getting to the nub of this DGDF issue as per outlined by LB and that's this: who in the US is going to take up the slack of the treasury market? I can see banks having to hold them to provision for losses on, well, everything, but if these earnings keep coming up positive and the workouts keep getting done then that demand will logically be exhausted.

Then, we come to retail. Looking at mutual fund flows into EM anything these days I'm not sure that they are to be relied on any more than Mrs Watanabe.

Anonymous said...

The gnomes are called Greenspan and Bernanke and Blankfein and Arthur Levitt and Larry Summers and all those other f***ing parasites who ingest newly printed dollars and crap out inflation on the rest of us. Hey wow, those guys are all jewish and all of them are incredibly powerful without ever once having been elected to office! What a freaking coinkydink!

Macro Man said...

Damn, they also all have vowels in their names, two ears, and white skin.

Didn't you get enough of a beatdown on Question Time last night?