"Sorry, son, all my money is tied up in currency." - W. C. Fields
W . C. Fields, the irascible comic and actor (1880-1946) was never short of witticisms - whether about money, sex, drink or kids. His views on money however were probably too close to the truth to be funny. Had he lived today, rather than retorting to the passing beggar as he did, (see quote top of page) he might have said, "Gladly son, all my currency is tied up in funny money." No, that's not humorous either. It rings too true for the US dollar if the recent parade of big numbers is any guide.
Yes, it is fact that the US dollar has already fallen significantly these past few years and that we have been joined by much company in our long-term views. Apart from the few counter-trends throughout the dollar decline, we were there for the whole ride to date - a volatile one at that. But that's only a normal pattern; to be expected in politically-charged currency markets. Another counter-trend may again be in the making at this time. However, in our view, the US dollar bear market is not yet over for a number of reasons.
As such, we can't see our way to agreeing with those who coo that the dollar may have already put in a soft bottom. Most of all, we are totally flummoxed by the view that there exists a large "dollar short" in the world. Seriously? It couldn't be more opposite as we'll explain.
We have our economic and financial theories underpinning the view that the US dollar will yet fall further against the Euro. At least one last down-leg is likely, one that is liable to be convulsive. That may not happen right away. However, in this Global Spin™, we'll take a break from theory and just talk about numbers .... BIG NUMBERS! We'll explain the implications of these enormous figures for the US dollar in the conclusion.
A New Millennium of Big Numbers
The world of wealth and markets has been flirting with round numbers in recent times. At the beginning of March, speculation was that the S&P 500 stock market index might hit 1200 - a welcome round number. At the time of writing this expectation has not yet become reality. But, in recent months, even bigger quantities have been approaching notable thresholds. In that regard, let's consider a number of these new milestones ... starting with $1 trillion.
That's the size that the US current account deficit will hit (annual current US dollars) in less than two years according to some forecasts. As it is, the US current deficit is already at a record high, equivalent to 6.3% of US GDP. That's a lot of dollars flooding the world's markets and treasuries every year. As is well known, the US has been borrowing close to 80% of the world's excess savings recently. But significantly, almost all of this borrowing has taken place in the form of US dollars, and is not denominated in foreign-currencies. Generally lenders (certainly so some notable foreign central banks) have elected not to convert US dollar proceeds (whether generated by interest payments or exports ... etc.) into their own domestic currency. That means they have put off the day of reckoning when they will eventually do so ... at least in part. When, is anybody's guess. But it is likely to happen at some point as these types of financing flows do eventually reverse if history is any guide. When it happens, it will trigger pent-up downside pressure on the US dollar.
A point we make is this: How can there be a global "dollar short" when the rest of the world has been rapidly accumulating dollar assets and liabilities in unconverted US dollars?
The Nettle Behind Net Numbers
So far we only examined net numbers ... for example, exports minus imports or liabilities minus assets. The world of financial assets is many multiples what the "net" numbers may indicate.
For example, the latest report from the Bank of International Settlements (BIS) reports that the international positions of reporting banks around the world had punched through the $20 trillion mark as of the third quarter-end of 2004. That's another big round number. It represents an increase of more than 50% in less than two years. Or, looked at another way, it suggests that an amount equivalent to approximately 25% of annual world economic output has taken wing across international borders in one way or another in less than 24 months. It's an indicator of the rapid spread around the globe of a dollar-centric financial boom and a global inflationary bubble of money and credit. In fact, by the time you read this report, updated BIS statistics will most surely show that international banking positions (as it is still called these days, as opposed to global US dollar carpet-bombing) will have more than doubled in the first five years of the third millennium - by more than the entire growth of prior human history!
The key to see is that much of the liabilities behind these positions are inside the US dollar bloc. It is US-dollar denominated debt mostly owed by USdomestic borrowers. What that also means is that when the time comes to pay off the liabilities, the debtor won't be converting foreign currencies into US dollars. Not unless they want to borrow in foreign currency.
The key to see is that it represents a very different situation than existed during the LDC crisis of the late 1970s or other emerging market crisis. As these countries and entities had to pay-off US- denominated or other foreign-currency debt with foreign currency, a "short position" in the US dollar then really did exist in the macro sense. That is not the case today. The opposite is true - the world is flooded with dollars and dollar paper.
It's All Really Small Potatoes
$20 trillion, as big as it seems, by some counts is small spuds. In the early months of this year another round number rolled into view - the $100 trillion mark for global securities wealth (bonds and stocks only). The last time this number veered into view was late 1999 by our count. Despite continuing high bond issuance and supple fixed-income prices, an equity bear market cut short the advance during 2000-2002. Looking ahead, if stock and bond market valuations stay stable, the $100 trillion mark may be breached for the first time sometime over the next year or so (although we are crossing our fingers on this speculation). If so, it would represent almost a doubling in securities wealth relative to world GDP in less than 10 years. That's a lot of securities ... and, again, a lot of US dollars. According to various indices, some 40% of that amount is represented by US stocks and bonds, which is certainly an outsized amount for a country that accounts for approximately 27% of the world economy. Net, net, we don't see a dollar-short here either, nor small potatoes. The rest of the world is over-weighted in US assets - incidentally, sacks and sacks of assets that have been underperforming in past years.
Now for the big enchilada! Elsewhere an even bigger round number has almost surely been breeched recently - the $250 trillion mark for global over-the-counter (OTC) derivatives markets. That figure refers to the notional value of these instruments, in other words, the total underlying value that the derivatives are based upon. These shady financial instruments (we say shady because they trade in the shadows of the unlit non-listed dealer trading markets) have been growing like there's an emergency, almost tripling in notional value in a period of only 2 years.
It represents a most interesting development: A gaggle of interest-sensitive financial instruments with a call upon a quarter quadrillion in underlying value having emerged upon the world stage, virtually from nowhere. (Welcome to the new world of quadrillions!) At the pace of growth recently, by the time it takes to read this report (say 10 minutes or so) net new calls on about $3 billion will have been created. It is a nice business if you are one of the five major money-center banks that has a corner on this market. Yet, it's likely that very few would know that such a big financial juggernaut exists. That wouldn't be surprising. As already said, these are financial instruments that are not quoted in the sunlight of daily trading sheets. To top it off, they are complex instruments. Why have these OTC markets boomed so rapidly in recent years and what implications does it hold for financial markets?
The answer to the first question is the easier one. The main reason that OTC derivatives trading has soared, is because of the rapid growth of just one category - interest-rate derivatives. These have boomed in notional value to over $200 trillion in size recently (another round number). But why has this type of OTC derivative soared in recent years? We are not exactly sure ... but we have our theories. As the chart on page 3 of this report suggests, it has a tight correlation to the interest-rate spread in the US - in other words the US carry-trade. Many financial players have borrowed money at low shortterm interest rate levels and bought higher-yielding, longer-term bonds. That's been very lucrative. But, it is also very risky. Bond prices may fall, or the interest spread may narrow. Therefore some of this risk has been laid off in the derivatives markets. Ergo, we identify part of the reason for the boom inthese instruments. There are other reasons as well. All in all, it hardly represents a development that will support the prices of US bonds into perpetuity. And remember, these are the primary, dollardenominated assets that underpin a substantial portion of world-wide foreign currency reserve positions. Again, we can see no dollar short here.
The Short of It - A Long Ways to Go
The world is flooded with dollar assets. Moreover a lot of US liabilities to the rest of the world are held in US dollars. Seen over the long-term, there is no US dollar "short position." The exact opposite is the case: The world currently chokes on overpriced US dollar assets. It represents a vulnerable position for the US and its investors.
The reality of this view is even more substantial if you agree that economic power will continue shifting to Asia over the next decade, or that the Euro will become a more prominent reserve currency.
Yes, counter rallies should be expected from time to time in the US dollar. It'll shake off the easy riders from capitalizing on the final phase of the dollar decline versus the Euro and other currencies.
In our global portfolios we remain significantly underweight US bonds and/or are emphasizing shorter-term yields in this area. If fact, we have held this position for some time. While on the one hand, our euro-denominated bond positions have proven to be rewarding strategy, the underweighted position in US bonds has only recently begun to pay off.
The BIG NUMBERS argue that the time to reverse long-term views on the US dollar is not yet.