Submitted byAftab Singh of Gresham's Law
Huh? When the Fed expands its balance sheet these days it’s actually bullish for the dollar!?
If you ever happen to acquire an inclination for being the subject of disrepute and ridicule I highly recommend endorsing the conceit alluded to in the title. Apparently this issue is ‘so obvious’ that even gold bugs and government officials can reach common ground via the contention that I’m deluded. My folly — if you will — is to maintain that dollar debasement can be bullish for the dollar vis-à-vis other currencies at present. Since this long-standing conviction of ours is once again being corroborated by price action in the currency markets I thought I’d attempt to convince you that I’m not completely crazy. Here I outline why dollar debasement is bullish for the dollar against other fiat currencies in this environment.
Central Bank Notes & IOU Claims Upon Central Bank Notes:
This story should be familiar by now, but nevertheless it’s important to review it briefly: — from the early 1980s to the late 2000s the ‘private-sector’ was on a trajectory that involved ever-increasing doses of leverage. Towards the end of that period the economy reached a maximum capacity for leverage and thus the reverse corrective trend began. Since accumulating debt is like shorting Federal Reserve notes, the prospect that characterized the start of this corrective trend was a ‘short squeeze’ in Federal Reserve notes – i.e. a widespread appreciation of Federal Reserve notes against stuff or equivalently a broad decline in asset prices. Since this has been quite uninviting for the established classes the result has been a policy of monetary debasement. In the current irredeemable fiat currency systems of the world this amounts to central bank balance sheet expansions. The rudimentary aim of this policy is to maintain the existing stock of IOU claims upon central bank notes by debauching the central bank notes themselves.
The Extrapolative Misstep:
I think that the above is understood by a decent proportion of the investment community, however I believe that even these well-enlightened investors erroneously presume that this dynamic is bearish for the dollar against virtually everything. To be sure – I maintain that owning central bank assets (notably gold) as opposed to central bank liabilities is a worthwhile speculation, but I scarcely imagine that one should indiscriminately own foreign central bank notes against Federal Reserve notes. The reason is fairly simple when looking at the world holistically: the dollar lingers on as a major component of global central banking assets – resultantly; dollars still constitute a decent proportion of the ‘backing’ to many foreign central bank notes. So if you own gold against dollars for fear of monetary dilution via manipulations of the Fed’s balance sheet – I would suggest that you should own Federal Reserve notes against dollar-dependent foreign currencies for fear of implicit manipulations of global central bank balance sheets that would result from those manipulations of the Fed’s balance sheet. In a twisted irony it would seem that foreign central banks are forced into being at least as profligate as the Fed due to their holdings of dollars and IOU claims upon dollars. The only way a central banker can avoid this implicit profligacy is by contracting their respective dollar-dependent balance sheets – but this is unpalatable in so many ways.
The way we have explained this over recent months has been to compare it to the US housing market. As mentioned a while back:
One must note that houses did appreciate against at least one thing during 2007-2009; housing derivatives! If you owned a house in the US, you no-doubt found that you could purchase more and more housing derivatives with your house as the housing collapse unfolded!
The above conceit is not difficult to understand — we all know that derivatives are premised upon their underlying assets. As the underlying rises and falls the levered derivative of one higher order moves in the same direction but with (usually) greater ferocity. Naturally then a housing derivative can easily become worthless with a less than 100% wipeout of the value of the underlying asset. In this way the deteriorating asset can appreciate against at least something — the derivatives that depend on it!
When it comes to the currency markets we have a similar scenario, but a great proportion of the investment community draw a blank and maintain that what must be bearish for the dollar against most things must be bearish for the dollar against its de facto derivatives – currencies that are ‘backed’ by dollars.
This is one pillar of my bullish stance on the dollar against other fiat currencies (the other being the unwinding of the implicit short positions on federal reserve notes via the medium of debt). If they debase the dollar, they debase them all – so if you believe that a) the Fed will be profligate and that b) foreign central banks will be slow to move away from the dollar, then maybe you should own dollars against dollar-dependent fiat currencies and not the other way round!
Analogously speaking; an expanding Fed balance sheet is to dollar-dependent central bank notes as a surprisingly abundant housing stock is to a bullish housing derivative!
The Balance of Assets & Liabilities for Irredeemable Fiat Currencies:
The more technical reason for this dynamic is that irredeemable fiat currencies trade at perennial discounts from imagined would-be ‘pars’. Before the early 1970s there was at least some vague attempt at maintaining redemption at some specific ‘par value’. This meant that if the market were to doubt the integrity of a currency issuer then that currency would fall to a ‘discount from par’. This would invite either a correcting drain on reserves (due to redemptions at par value), an outright debasement (more snidely referred to as a ‘revaluation’) or some kind of intervention to forestall the inevitable. But since there is no clearly identifiable promised ‘par’ at present we have a scenario where currencies trade at perennial discounts to the value that would be par if redemption were to resume with immediate effect.
The above characterizes the fact that fiat currencies are promises for maybe something (but probably nothing) at perhaps some time in the future (but probably never). In this way, the dollar-backed fiat currency represents a doubly precarious asset – for it’s a promise for maybe something maybe later (but probably nothing, never) for maybe something different at perhaps some later date (but probably nothing, never)!
Uh oh! They’re going to try to debase the dollar to ‘boost exports’!
Whereas this is rather exciting as a speculator, it’s quite frightening as a subject of a confused government. As Kyle Bass pointed out in this recent interview, the US government is probably going to try and ‘export themselves out’ of this problem by destroying the dollar:
How do you solve a problem where you’re running a 10% fiscal deficit? You’re not going to get growth in the absence of private sector credit demand, so the government’s idea right now is that we’re going to export our way out of this. And when I asked a senior member of the Obama administration last week ‘how are we going to grow exports if we won’t allow nominal wage deflation?’ And he says ‘we’re just going to kill the dollar’ I said ok – more you mean. So that’s the only answer – it’s a dead answer, but that’s where we’re headed. So if you made me the Tsar what would I do? I’d go out there and I’d try to cut a bunch of things, and GDP would drop and unemployment would go up and I’d be the persona non grata. But it would be the right decision for our country for the next ten years.
All I can say is that government officials are suckers for mechanistic and retrospective ways of thinking (they linearly correlate past movements and act on them going forward). It’s quite possible that they’ll become frustrated when the currency markets move ‘the wrong way’ in spite of all their efforts to ‘kill the dollar’. In this case they may justify over the top expansionary monetary policies. In this case we would have a platform for severe inflation where monetary authorities keep the debasement schemes at full blast until they see the results they want (a falling dollar vis-à-vis other currencies). I would imagine that the dollar would have to appreciate greatly for some time before they would see the results that they seek.
This is a really dangerous dynamic that has a good chance of coming to pass. For whereas central bankers basically know that they can’t expand their balance sheets to infinity without risking vicious price inflation, it would seem that the Fed is at a complete loss as to why its balance sheet expansions might actually lead to an appreciation of the dollar against other currencies (at first).