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February 05, 2004

Currency Wars, Budget Woes
by David Chapman

What is one to make of it? In the month of January the Bank of Japan (BOJ) spent a whopping US$67 billion (later revised up to $71 billion) defending the Yen. Over the entire year of 2003 they only spent US$187 billion. And what did it accomplish? Well, not a lot. The Yen started the year at .9375 and ended the month of January at .9468, a small rise.

Of course the BOJ is not the only one spending bundles of money to defend their currency. The Europeans have been at it as well but definitely not on the same scale. Here in Canada we lowered our interest rates to try and discourage the Cdn$ from rising. If one thinks of a country's currency like a stock one would think that they would be happy that their currency was rising and that it is negative when it is falling. But in our mixed up world the Europeans, Japanese and Canadians view their rising currency negatively and the US views their falling currency positively.

Trouble is the world has geared itself towards exports (globalization) and a rising currency makes the country's exports more expensive. On the other side the US views their falling currency as positive because it might encourage jobs and plants to come back to America. Unfortunately for America that is unlikely to happen as the plants and jobs were exported to countries with fixed exchange rates and very low wages like China and India. And unless wage costs in America fall to the levels in China and India too often what is happening is that it is American companies themselves that are exporting plants and jobs out of the country. Needless to say while it does wonders for the bottom line of the company it comes at a potential huge cost to the domestic economy.

Indeed the news on outsourcing and transferring of jobs overseas is not only ongoing it just seems to get worse. Recent announcements of significant layoffs include Eastman Kodak (EK-NYSE), IBM (IBM-NYSE), Schering-Plough (SGP-NYSE), Tyco (TYC-NYSE)), Verizon (VZ-NYSE) , Toy's 'R' Us (TOY-NYSE) , SBC Communications (SBC-NYSE) and Sprint (FON-NYSE) all just in the past 3 months. These companies alone announced over 58,000-job cuts grant you in some cases spread over three years and not all necessarily related to outsourcing. There are numerous other companies that are also announcing closings or transfers. These are generally well paying jobs and there is little on the horizon to replace them except for McJobs if even that.

No wonder the last jobs report showed such sluggish growth of only 1000 jobs. This month's expectations are for growth of at least 160,000 jobs. Given the ongoing job cuts announcements we will be surprised if it is that strong. The non-farm payroll numbers are notoriously inaccurate and subject to numerous revisions so the December numbers could be revised up even if the January numbers are below expectations. On another note though, it is well known thousands will be losing their unemployment benefits over the next few months.

The US has two main deficits. Budget and current account. These deficits are currently running over $1 trillion per year and require roughly $2.7 billion per day to finance. Total US Federal debt totals roughly $7 trillion or almost 63% of GDP. This number differs from what one might find in the Federal Reserves Flow of Funds, as the Flow of Funds is only domestic budgetary debt and not debt related to the current account deficit. The debt has roughly doubled since 1990. Despite some recent improvement in the monthly trade deficit numbers because of the weaker US Dollar, it is still growing at roughly $40 billion/month. According to a recent budget tabled by President Bush the US budgetary debt appears destined to grow further over coming years.

The growth in the debt is largely attributable to the massive military and security expenditures following 9/11 and comes at the expense of the domestic economy. Both these areas may provide some degree of job growth going forward. The US has over 700 bases in 130 countries around the world so there is a price to global empire. We are always reminded of the eventual costs of global empires to other former great empires including most recently Russia and Britain and in more ancient times, Rome and Greece.

The US current account deficit is made up of the trade deficit (the biggest portion 90%) plus the balance on investment income and unilateral transfers. Today the US has shifted to what has been called the "Roman" imperial economic paradigm (Executive Intelligence Review, December 26, 2003) where the US no longer produces its own goods and exacts from (the colonies?) around the world in the form of imported goods. It goes one step further in that they export jobs and import goods. And taking it another step the populace is kept happy with their own form of bread and circuses with the latest episodes of "Survivor" or "Fear Factor" or ongoing distractions such as the Laci Peterson murder case and Michael Jackson. Even murder and child molestation is just another form of entertainment.

The countries of the G7 are growing increasingly concerned about not only the state of the US$ but also the growing deficits including the very high levels of private sector debt particularly the consumer that in 2002 reached 110% of disposable income and the ratio has grown further since. Curiously the G7 meets this weekend and we are sure that issues regarding the US$ and their growing deficits will be raised. Whether it will go anywhere is another issue and the simple answer is that it probably won't although it may trigger another round of currency intervention. Listening to numerous US politicians lately defend the budget deficits they are convinced they don't matter. Well in the short term they do provide a high degree of stimulus but ultimately they are dangerous and drain the country of its resources leading to bankruptcy and depression.

The Europeans concern has even reached the stage where they have discussed the possibility of the introduction of capital controls (Daily Telegraph, December 4). It was mused that controls would not be considered unless the Euro reached a level of $1.35. The recent high was $1.28. We are of course reminded that currency and capital flow controls was a mainstay of the Bretton Woods Agreement during the 1950's and 1960's. The Bretton Woods Agreement ended in 1971 when President Nixon took the US off the gold standard. Floating exchange rates then became the mainstay of the 1970's and remain with us today. But overall the Europeans appear to be more accepting of the rise in their currency, as they do not seem to be indicating either lower interest rates and seem willing to over stimulate their economy in order to increase demand.

The Japanese on the other hand along with some other Asian countries are the prime financiers of the US's burgeoning foreign debt. The Japanese in particularly have sharply increased their holdings of US securities and of course are by far the largest holders of US debt followed by China. This is becoming a problem for them as well as a continued decline in the US$ will lower the value of their holdings. There has been musings to diversify more of the holdings into gold or Euro holdings but this is a two edged sword as that would put pressure both on the US$ and on US Treasury bond prices. Their only ace may be in their large holdings in how they can pressure the US. They certainly can't continue to spend their way to financing the US debt because they are going into debt themselves to finance this activity.

Everyone is in a catch 22 position. The Fed doesn't mind occasional bumps in the US$ to the upside because that allows them to maintain a possible more orderly decline of the US$ and prevents an all out run. Of course this could eventually happen anyway. The Japanese on the other hand may be in a worse position as continuing to spend money at the rate they did in January is unsustainable. But it is only unsustainable to the extent that they can't find anyone to take their Yen. As a central bank they can create Yen to whatever extent they want and sell it for dollars as long as there are speculators or others willing to take the Yen from them and give them dollars. But ultimately this is a game that will run out of room as well especially if the Japanese stock market started to fall where we suspect a lot of this money has gone.

In the US, the huge rise in the stock market over the past year has been fuelled by a massive credit expansion, coupled with tax cuts (now spent) and ongoing low interests that remain below the rate of inflation. This is a situation that cannot carry on without negative consequences. The thinking seems to be that it can and that an endless source of liquidity will be provided to the market to maintain the illusion of prosperity. Real wages for the majority of the population have been falling for years while they have been maintaining the illusion of their life style on the credit card. At some point it will be unable to continue. Just because we do not as yet appear to have reached that point doesn't mean it will not happen.

The stock market rally of 2003 has the feeling of the sucker rally of 1930 that was seen following the stock market crash of October 1929. The question is "Is it March or April 1930" (the market topped on April 16, 1930). No matter. What followed was an endless downward spiral that did not bottom for another two years. We are currently about a year and half from the last four year cycle bottom in October 2002. If as we suspect we are in a secular bear market then the market could be topping now although it is possible to hang for a little while longer but most cycles top out by the first week of February. It will start slow and have numerous counter rallies but if a death spiral into 2006 and the next 4-year cycle low is correct then we have seen the top.

We are showing a weekly chart of the US Dollar Index. The chart basically starts with the US Dollar's rise in 1995 to the top in 2001/2002 and the subsequent fall. Note how market on the way down mimics the rise with often support and resistance coming at old areas of support/resistance. Currently we are the second last stop where considerable support can be seen in the 85 area. A rebound lasting a month or two that takes us back to resistance around 90 and even up to 92 can not be ruled out. This may already be underway.

Once firmly through the 85-support zone the next drop is down to the lows of 1992/1995 centred on support at 80. Below that would be new territory and projections could take us down to 40. The US Dollar Index is displaying possible characteristics of a massive head and shoulders top with a series of lower shoulders. The 40 level would be a possible target if we were to firmly break under 80. We loath to think of what type of crisis that might be occurring if that were to happen.

Currency wars and budget woes. Markets are overconfident that the Fed will continue to manoeuvre interest rates and liquidity favourably to allow the economy to grow and the market to continue higher. This is mislaid confidence. A falling currency and ongoing huge deficits is not healthy long term. And the charts especially for the US$ is telling us this.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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