Submitted by JM
Dollar Got Me Down: A Down Dollar Roadmap
All the talk about a dollar currency crisis is getting ahead of itself. Quoting Mises won’t make it happen overnight. It takes years, even decades for a reserve currency to dissipate. Instead of wholesale collapse, the most likely outcome is a steady decline in the dollar over an extended period of time. Of course there is a tail possibility of a collapse, and that is why hedges exist. But the high likelihood trend is persistent policy action to drive the dollar lower with respect the United States trading partners’ currencies, combined with a decline in the dollar’s use as a vehicle currency. This means serious dollar weakness for the next three years (or more), but not collapse.
The Case for No Collapse
A currency collapse isn’t an issue of preferences or sore feelings about getting screwed by any given printing press. As long as there is minimal rule of law there will be contracts legally required to settle in a given currency. This is the interlocking stability of debtors and creditors that inflation will impact by diminished term risk, but as long as contracts remain, the dollar is going nowhere. The currency is bound tightly to political order, which is more stable than anywhere else in the world.
Second, there is a network of liquidity providing and withdrawing institutions made up of central banks. If a currency makes a multi-sigma move and the central bank that issues the currency can’t handle the strain itself, other central banks can act in concert to assist. Note the massive central bank currency swap action that stopped the herd of Mrs. Watanabe’s from skyrocketing the yen back in March. This can just as easily be accomplished for the dollar or the euro or the dong.
Further, the dollar holds a privileged place as it is more than a mere national construction. Like it or not, the dollar is still viewed as more desirable than many emerging market currencies. The dollar holds a special place in the world. It is the reserve currency, meaning it is a standard of valuation for international commerce. More than this it is the vehicle currency for much of the world’s debt. This international interlocking network of debtors and creditors makes the dollar even less capable of “collapse” than the good old boy central bankers club.
So you have a clear signal that the dollar is going to slide into the gutter for the next few years thanks to the Fed. This dollar weakness will become self-reinforcing when international debtors and creditors decide to ditch it as the vehicle currency. Technology and preference to not be screwed will make this happen. At the same time, there will be bouts of major volatility in the dollar as the interlocking network of debtors scramble to pay off their creditors from time to time. This volatility will diminish as the dollar’s role diminishes. There are ways to take advantage of these trends.
Some Right Tail Exposures
CME All the vol talk to CME, of recent “poison the silver spikenard” and “clearing evil CDS” ill fame. CMS has a much more lucrative money-maker than these doo-dads that have potential as a great way to exploit the end of the dollar as a vehicle currency. This is because their currency settlement technology is catching up to the realities of a world that doesn’t want dollars. CME makes it possible to not use the dollar as a trade vehicle so much. Here’s a clue to the future: CME launched a postexecution clearing service for nondeliverable forwards on the U.S. dollar versus the Chilean peso, marking the first step in offering clearing services for over-the-counter foreign-exchange transactions. Imagine that a transaction can be marked in a currency and then a nanosecond later it is converted into another currency. This is going from high latency to low latency in touching the stinky dollar. In effect, technology makes getting out of the dollar easier than ever, because conceivably CME can hold a “settlement account” for anybody in any currency. CME is placed to live off the skim.
TIF A weak dollar is easier on the rich than it is on the poor. Because of costs of entry, people with low incomes are forced to store their wealth in dollars, so they will be mercilessly screwed by the Fed and the politicians. This screwing of the dollar makes exports cheaper, hopefully creating jobs for younger people. These young people really need the jobs, because they bear the brunt of funding all the welfare, transfer payments, retirement benefits, paying the medical bills for people that have smoked for the last forty years, bailing out mismanaged union pensions, contributing to bank executive bonuses, funding congressional pay raises, and buying school supplies and aerosolized mace for their kids. They also need a therapist on retainer.
However, the wealthy take much less of a hit because their wealth is more allocated into real assets. Because they are wealthy, they spend their money on high-end goods. Further, as the dollar continues its decline and inflation pressures pick up, there will be persistent over-blown fears of hyperinflation that will drive even more wealth into real assets. A part of this will end up as shopping sprees for the better halves. In a word: Tiffany’s.
SINGY The growing rich versus poor divide combined with a steady dollar decline will help airlines because there will be plenty of people flying out this country for better opportunities and societies that respect capital. Southwest is the most financial stable of the airlines, and there will be plenty of people filling their seats as they fly out of here. Further, when the Gramma and Grandpa want to visit their almond-eyed grandkids, it will increasingly require a flight to the Orient and not a road-trip.
WYNN As the dollar continues its unrelenting decline, people will be more willing to throw their lot in with gambling what dollars for a random payoff based on well-defined probabilities as opposed to rigged financial market payoffs. Further, as emerging world incomes move up as the dollar moves down, gambling is a sweet spot. Wynn understands that there are two things about China that cannot be broken. One is that a Chinese mother will never ever choose anyone over her only son. The second is that a Chinese person’s eyes gleam most brightly when they are gambling. Wynn Resorts provides international exposure to eye-gleaming high-rollers and it has a CEO that verbally flips off the American establishment for killing the dollar every time he gets on Bloomberg TV.
The Center: Commodities and the Carry Trade
It is natural to throw out the gold card here. No offense, but I refuse. Gold is a measure of financial system risk and uncertainty in general. But it is now a levered position on general uncertainty, so real chaos will screw it as a derisker. Also, general uncertainty eventually comes to focus on specific issues, and since it is expensive, there is no justification to buy up here. Now a declining dollar does make a case for commodities, but as the heightened sense of risk fades, commodities with more inelastic demand (demand that is relatively insensitive to price) are better.
Also, because emerging markets will develop and become increasingly financialized, these countries will have less organic demand for gold as a store of value. Their societies will become less cash/hoarding-based and more credit-centric. That is to say: if the “developed” world goes all mad max and we live off hard-tack and true little house on the prairie grit, China and the “emerging” world won’t use silver coins when they go to Applebee’s for Dim Sum.
Finally, it will take nothing short of a calamity to get to a gold standard. Any such calamity will delever the crap out of real assets like gold as people rush to dollars to settle their dollar debts. Also know that a gold standard takes all the economic adjustment pressure off the currency and on the labor and capital markets. Emerging societies that place a high premium on employment won’t like this at all. The gold standard may be stable in a local sense of currency stability, but it is very unstable in a broader social sense.
It is likely that the United States will have sustained low interest rates anchored to Fed policy compared to less demographically challenged countries (fewer old people getting assistance from taxes on the young). As a result, just like in Japan, the already massive carry trade will continue to spew out of the front end of the yield curve. It will grow like the Blob, enveloping everything and then collapsing everything in periodic return crashes. It is only natural that investors will want to get out of dollars and buy higher yielding local currency debt and equities. There will be shocks when people cash out when they need liquidity in dollars.
The Left Tail Hedge is Term Risk
If you want cheap exposure to shocks, buy vol. Since it probably the most mean-reverting of all things in the universe, it is reliably cheap only when it falls below its long term average. Even so, there is a carry cost to factor in. And be careful of the vol you buy. Those ETFs don’t give you the bang for the buck you may expect. See below. Normalizing the price action of VIX, a VIX ETN, and a VIX ETF show major tracking error exactly when VIX provides the most bang. This can lead to severe disappointment. VIX call spreads are well-understood way to cheapen this exposure.
Keep in mind that tail-risk killers won’t let the uncontrolled chaos manifested in volatility run around butt-naked for long. So a hedge needs to function not only for quick-reversing tail events but also for extended grinding dollar rallies that no type of volatility picks up very well. Pure term risk is the solution to capturing dollar rallies here. When I say “pure”, I mean minimize hybrid betas: combining credit risk with the term risk screws up the hedge.
So the natural exposure to term risk is long dated, dollar denominated bonds. In my experience, static hedges don’t work well. So you need bonds liquid enough to trade to make this hedge cost efficient. Buy when they are cheap within your system and sell when they are rich in your system. The coupon can fund volatility exposure or accumulate cash that can be reallocated to risk.
As credit risk increases with United States debt levels, protection could make the hedge too costly to keep. This credit risk will either force the hedge to become static, or the term risk component to be eliminated. Hedges based on systemic liquidity stress like TED spread widening are an alternative.
Sayonara
Guess what. If you believe what I am saying, then you believe we are pretty much following Japan. Almost everything I’ve said comes straight out of Japanese contemporary history. Our demographics are more favorable (better young tax-payer/old check-taker ratio). Our debt situation is different but still a disaster (less corporate debt; more household debt; government debt like a mushroom cloud just like Japan’s did in the nineties, naughties, and now). However, Japan’s debt is not external. Generally people and businesses are both creditors and debtors, so impairments to on one side benefit the other side. Also, when the declining dollar hits incomes sufficiently, there will be less need for Japan (and other marginal buyers) to manage its currency by buying Treasuries. They will look elsewhere for sales: emerging markets. But this will work itself out over slow as molasses.
The “exodus” theme I threw in is different from the Japanese experience, and this is no wonder. It is much less likely in recent history, but not rare either, for a Japanese family to uproot and become a stranger in a strange land. It was more common in the past. Japanese culture is more homogeneous, elders are respected because they lived responsibly over the years, and there is an implicit belief that, despite poor government and institutions, society as a whole will not permit egregious exploitation. The United States has none of these things. Instead, there is a fractured sense of community that exploits division and interlocking handouts from which everyone directly or indirectly benefits. It has baby boomers—arguably the most selfish, irresponsible jackasses the world has ever seen. And it has a government that has always been happy to kill its sons in wars for things even less tangible than a barrel of oil.
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