Submitted by Brian Rogers of Fator Securities
Welcome To The Currency Wars
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” --Milton Friedman, The Counter-Revolution in Monetary Theory (1970)
Welcome to the Currency Wars
After a long and unintentionally extended (thank you Hurricane Irene) vacation in South Carolina, I am back on the desk. I was asked yesterday to comment internally on the recent decisions by both the Swiss National Bank and the Brazilian Central Bank. Both actions, in my view, have potentially exposed everyone in their respective societies to the specter of higher inflation while the benefits of these rate cuts/currency pegs primarily accrue to their export sectors. Is this a big risk? You bet it is. These central bankers are crossing their fingers and praying that inflation remains tame as the US and Europe slow down and likely enter another recession. However, what if inflation doesn’t cooperate? What if inflation remains persistently high, even as over 50% of the global economy enters a recession? How will the new consuming patterns of the approximately 2.7bn people living in China and India change historical pricing correlations? If the price action of Brent crude is any indicator, these central bankers should be afraid. Very afraid.
First off, the Swiss peg. In my opinion, it’s a sign of a very desperate central bank that is closing its’ eyes, crossing its’ fingers and betting everything on red. My bet is that they will lose control of the peg soon, likely before the end of the year. This undermines the entire notion of the Swiss franc as a ‘safe haven’ currency and will make gold and silver all that more valuable during the next crisis phase. The Swiss have now made their currency nothing more than a leg in a carry trade. By fixing a peg level, the central bank has placed a huge target on their backs and told fixed income investors to arb away! You can now borrow short-term in CHF, lend long-term in a riskier currency and know that the CHF leg of your trade is safe at 1.20.
Remember the Japanese intervention back in March as the JPY rallied after the earthquake? The government got involved in the FX markets at 79 and promptly caused a sell off that went all the way to 85.5. However, with enough time the market simply overwhelms the efforts of even the most ardent money printers. The USD/JPY is now 77.42, or approximately 2% stronger from the original point of intervention.
In Brazil, the BCB cut their short-term SELIC rate from 12.5% to 12% using the excuse that this move was needed as growth is slowing. For sure there is some truth to the idea that growth in Brazil is and will continue to slow. The recent GDP numbers came in slightly below expectations of 3.2% at 3.1%, however, this is down from an annualized number of 9.27% just going back March 2010. So the trend is clearly downward and much of this attenuation is due to the much stronger BRL which at 1.65 is fully 34% stronger than it was in December 2008 at 2.51. Also moving up slightly is the unemployment rate which has moved up to 6% after recently bottoming at 5.3%. However, offsetting this data which points to economic weakness has been some rather uncooperative inflation data. The BCB’s target inflation rate is 4.5% with the upper band at 6.5%. The problem is that all of the recent data have been coming in above the central band. Just recently the IPCA Inflation number on a YoY basis recently came in hotter than expected at 7.23%, over 73bps higher than the upper end of the band. And yet in the face of such data, they cut rates 50bps. It’s important to understand that the Brazilians and the BCB have their own nasty history with inflation in the 80s. They have spent the last few decades diligently working to build a reputation as a hawkish, inflation fighting institution. Despite this, just like the Swiss, they have in one surprise announcement thrown inflation fighting out the window in favor of a weaker currency.
Let’s look at Brent crude briefly. Despite the recent spate of bad economic data and warnings of impending recessions, Brent continues to trade firmly above $100bbl, currently sitting at $115.34. Anyone focused on WTI is missing the mark, Brent is the global oil standard, even here in the US and it is only down 9% from its April high of $126.74/bbl. It is fully 239% above its’ 2008 low of $34.04/bbl. If we do go into recession, it does not appear like a weak oil price will be there to help us as before. And with central banks globally poised to print to infinity to promote weaker currencies, you can bet that the price of oil, grains, metals, fertilizers and other inputs will remain high. Could the Arab Spring morph into a Western Winter?
The central banks of the US, Europe, Switzerland, Japan, Brazil and China (via their peg to the USD) are all actively suppressing or cutting their interest rates, buying their own sovereign debt or actively intervening in their currency markets. These are all very different activities with different costs and benefits but the one thing that they all accomplish is an increase in fiat currencies. As one bank prints or otherwise weakens their own currency, by definition they strengthen someone else’s. This causes the exporters in the stronger currency to lose earnings and growth. Which causes them to try to weaken their currency and by definition, strengthen someone else’s. In the current economic environment where the US is the dumping ground for the rest of the world’s excess supply, this only works so long as we are increasing our own debt levels. But our debt threshold as a people, economy and government has been reached, breached actually. Which means we are now forced to devalue our own currency to maintain our mountain of debt, by definition strengthening the rest of the world’s currencies. Unfortunately, this means we’re trying to increase our own exports at exactly the same time every country is trying to do the same thing. So we devalue to make our exports cheaper. And then they devalue to make their exports cheaper. And then we devalue again. And then they devalue. Rinse, wash, repeat.
In my opinion, the Swiss and Brazilian moves signaled the true beginning of the global currency wars. The depreciation race to the bottom has begun. Trade wars will be next. This is just getting started. Once FX interventions fail, governments suffering from falling exports will attempt to protect local champions via protective taxes, tariffs and the limiting of certain imports. Affected governments and industries will retaliate for their own loss of exports and so on and so forth. Welcome to the currency wars.
Wither the Euro
Which brings us to Europe and the highly imperfect Euro. The only solution for Europe is a consolidation of fiscal authority at the national level, something like a United States of Europe. This will allow for the issuance of a Eurobond and allow the proverbial debt can to be kicked down the road a bit further. However, even this imperfect solution will never fly. There were times in the mid-2000s where the powers that be in Europe tried to pass a unifying constitution and they were soundly rejected. And this was when the economy was strong, jobs plentiful and the cost of integration viewed to be relatively light. In the current economic situation, however, integration seems unthinkable. All of the recent local and regional elections in Germany, Finland and elsewhere seem to verify this viewpoint as voters continue to elect politicians who will not support more bailouts or further losses of national sovereignty. Europeans are voting for less integration rather than more so this is a non-starter in my opinion. Which means more EUR weakness and eventually an unwind of the currency union. As investors exit the EUR, some will buy CHF and test the SNB. They lost billions earlier in the year on market interventions. They will lose billions more on this one until they eventually capitulate.
The currency union will fail not because the current political leadership wants it to, quite the opposite, it will fail because the people of Germany are Germans and don’t want to be equal members of a broader European concept called United Europe. Same thing for the Dutch, French, Belgians and others. This will ultimately kill the hope some hold out for the Eurobond concept. No fiscal union.
Print More Euros? Nein!
So the other option is massive printing, aka the preferred option of one Ben S. Bernanke. In my opinion, the ECB is really a proxy for the Bundesbank. The Germans, having a particular history with money printing to solve debt problems, will be loath to support much more printing and the polls in Germany so little support for this “solution.” Trichet will continue to print as the banking crisis worsens but at some point he will simply have to pull the plug and allow the chips to fall where they may. The Germans will not repeat the mistakes of the Weimar Republic, even if it means the breakup of the decade or so experiment called the Euro.
This means a banking crisis is coming. The major European are all under-reporting their exposure to the PIIGS because they are reporting net, not total exposure. They have hedged some of their PIIGS risk in the CDS market but in a modern-day banking crisis, the value of those hedges will approach zero as counterparty risk will surge once one of the main banks begins its death spiral. Redemptions will hit the hedge funds, forcing them to liquidate and further rendering the value of any protection they wrote worthless. A hedge only has value if your counterparty is financially able to deliver on the contract. With Greek paper implying at least a 40% haircut, the big banks in Europe are toast. And that’s only discussing Greece. If Italy comes under further pressure, forget it, game over. Italy is way Too Big To Bailout.
Could the US Fed end up purchasing European sovereign debt in an attempt to prevent a collapse of the Euro? Although it doesn’t seem too likely today, I wouldn’t bet against it completely. If buying more PIIGS debt helps keep the banks alive another day, then buy they will. Don’t be too surprised if it happens. As the Swiss and Brazilians just showed, all options are on the table.
This will affect the US banks as well, particularly the large derivative players. Counterparty risk will surge, funding will dry up and capital levels will be questioned in detail. And this particular leg of weakness doesn’t even consider the capital that may need to be raised from the FHFA lawsuits announced last week.
This will force the US government to enact the bank nationalizing powers of the Dodd-Frank Act to ring fence the good assets (assuming there are some) of the major US banks that come under fire. In turn, this will put significant pressure on the US government as the FDIC is forced to make good on billions of dollars of deposits. In addition to the billions being lost on the GSEs, the government will be forced to spend billions on the banking sector while teachers lose their jobs to austerity. This will further roil US politics as both major parties will want to bailout the banking sector but neither will want to move first! You think we had gridlock over the debt ceiling debate, you ain’t seen nothin’ yet!
The 30-yr Bond Bull Says Goodnight
The end result will be an eventual eroding of faith in the US government’s credit. The market will eventually wake up and realize that monetization is the one and only way our government can kick the can down the road without immediately collapsing the economy. Which means fixed income investors will lose ad infinitum. Imagine a pension fund or insurance company with a 5-8% real return hurdle rate. How can they possibly stay in 10yr Tsys with a negative real yield? They can’t. The vigilantes will eventually stir and move into other asset classes en masse. This shift out of public assets and in to private assets will represent a change in preferences that has lasted since 1980, over 31 years. The death of the long-term bull market in govt debt will mean the nail in the coffin for the USD and the US’s role as sole superpower. It will also mean incredibly interesting things for the ultimate reserve currency, gold.
Bottom line: now is a great time to get out of govt paper and many miles away from the large US and European banks. I am a broken record on this but you should own gold and silver miners, fertilizer companies, oil companies and water companies. Some technology stocks could make sense and reasonable exposure to Asia and Latam. Corporate bonds of companies providing any of the products listed above (gold/silver, fertilizers, oil and water) makes a ton of sense. I would avoid the large multi-nationals here as I think trade wars are coming and their cash flows from foreign operations are about to come under fire.
* Fator Securities LLC, Member FINRA/SIPC, is a U.S. entity and a member of the Fator group of companies in Brazil. The comments below are from Brian Rogers, who is employed by Fator Securities (Brian’s opinions are his own and do not constitute the opinions of Fator Securities or the Fator group of companies).
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