Prediction #1: U.S. Dollar Bears Will Remain On the Run in 2012

Since its March 2008 low the U.S. Dollar is up 13% against a basket of the world's most widely held currencies, including the yen, sterling, franc, loonie, krona, and of course the beleaguered euro.

How is this a problem for portfolio manager Axel Merk, the self described "Authority on Currencies"? After all, according to Merk's written after-the-fact letters he claims to have traded out of and back into the euro just in time to surf its wild gyrations.

Merk moved his fund management business to California a number of years ago, where he has been beating a steady 'demise of the U.S. dollar' drumbeat ever since. This past year Merk Funds even took to deploying amusing anti-Dollar cartoon propaganda while routinely touting the superiority of the euro over the U.S. dollar.

Continue reading the full article at Seeking Alpha here.

Investment Implications of Prolonged Financial Repression

Interesting read from Joe Roseman, former head of Moore Capital PM and Head of Macro Research, on the investment implications of 'prolonged financial repression'. Some highlights:

One of the issues that appears to have really confused economists is why corporates have steadfastly refused to participate in a new capital investment cycle? Why has new hiring been virtually non-existent? 

Standard econometric equations get this wrong because equations can’t think. Econometrics will look for the last time that interest rates were this low, looking at what worked before. 

I would argue that such equations do not have the requisite history built into them to recognise a period when three out of four cylinders in the engine of growth have been impaired. Econometric equations can’t think, but Sir Martin Sorrell of WPP certainly can. 

To quote Sorrell; “Most importantly, post-Lehman and the several corporate crises, we have seen a concern, or even fear, amongst Chairmen and CEOs and in the boardroom about making mistakes and a consequent emphasis on cost containment and unwillingness to add to fixed expenses and capacity.” 

Sorrell goes on to say that “Western-based multi-nationals are said to have over $2tr in cash on their balance sheets, but unemployment remains at stubbornly high levels, with only increases in temporary employment and limited expansion in fixed capacity in Western markets. Hence, a willingness to invest in the brand and maintaining or increasing market share, rather than increasing capacity and fixed expenses.” 

Governments don’t have the cash so print it. Households don’t have the cash so borrow it when they can. Banks don’t have the cash so skim it from savers. Corporates have the cash and just hoard it.

And the possible investment implications?

Not everywhere in the world has the same macro-impairment as the major Western economies, thereby allowing many corporates to develop growth strategies based outside of the G7. Having a cheap(er) currency certainly helps those companies. 

The market seemingly does not value cash sitting on the balance sheet highly. I wonder if that is a mistake. Cash, it is argued, offers optionality to the holder to take advantage of falling (asset) prices should they occur. On the same basis it may also be being undervalued on balance sheets.

I wonder if standard tests of “value” are missing the true value of the cash sitting on balance sheets? In a world where black swans are as common as starlings, having high net cash balances is a major plus. I also wonder whether that same optionality to use cash to buy cheap assets should also be valued higher.

In closing, he wondering whether the M&A department of foreign corporates would view weak currencies, like the pound or U.S. dollar, as an opportunity to acquire cash-rich businesses in the UK or U.S., respectively.

Full writeup here.

Timeline of International Currencies

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Breaking: Greece May Drop Euro & Reintroduce Drachma

From Germany's reliable Der Spiegel comes the predicted but potentially destabilizing late-Friday news bomb:

Sources with information about the government's actions have informed SPIEGEL ONLINE that Athens is considering withdrawing from the euro zone. The common currency area's finance ministers and representatives of the European Commission are holding a secret crisis meeting in Luxembourg on Friday night.

Given the tense situation, the meeting in Luxembourg has been declared highly confidential, with only the euro-zone finance ministers and senior staff members permitted to attend. Finance Minister Wolfgang Schäuble of Chancellor Angela Merkel's conservative Christian Democratic Union (CDU) and Jörg Asmussen, an influential state secretary in the Finance Ministry, are attending on Germany's behalf. 

According to German Finance Ministry estimates, the currency (Drachma) could lose as much as 50 percent of its value, leading to a drastic increase in Greek national debt. Schäuble's staff have calculated that Greece's national deficit would rise to 200 percent of gross domestic product after such a devaluation. "A debt restructuring would be inevitable," his experts warn in the paper. In other words: Greece would go bankrupt.

The European Central Bank (ECB) would also feel the effects. The Frankfurt-based institution would be forced to "write down a significant portion of its claims as irrecoverable." In addition to its exposure to the banks, the ECB also owns large amounts of Greek state bonds, which it has purchased in recent months. Officials at the Finance Ministry estimate the total to be worth at least €40 billion ($58 billion) "Given its 27 percent share of ECB capital, Germany would bear the majority of the losses," the paper reads. 

In short, a Greek withdrawal from the euro zone and an ensuing national default would be expensive for euro-zone countries and their taxpayers. Together with the International Monetary Fund, the EU member states have already pledged €110 billion in aid to Athens -- half of which has already been paid out.

A slow motion bank run in Greece, Ireland, etc. has been taking place since this time last year. Any credible whiff of news that a Eurozone member might drop the euro currency could trigger a panic, rapidly accelerating the move out of euros, not just in Greece but other European periphery nations, into safer currencies.

Continue reading the full article at SeekingAlpha here, including thoughts on which currencies stand to benefit most from this development.

Timing the Inevitable Decline of the U.S. Dollar

One of the most heavily debated macro topics is the future of the world's reserve currency, the seemingly almighty U.S. Dollar.

Neither the fact that scores of prognosticators have been predicting its demise for decades, nor that when the financial going gets tough (as it did during the 2008-2009 financial crisis) everyone wants it, has dissuaded today's dollar bears from taking a dim view of the greenback's future.

America's Exorbitant Privilege

Barry Eichengreen

Berkeley Professor Barry Eichengreen’s new book, Exorbitant Privilege, explains the U.S. Dollar's historic rise from international monetary obscurity prior to World War I, to surpassing British pound sterling in importance by 1924-25, to its dominant post-World War II position which it continues to occupy today.

Professor Eichengreen opens with the point that while we now live in a multi-polar economic world the financial system and monetary order still revolve around a single currency (the U.S. Dollar).

Some might be surprised to learn that approximately 75% of all $100 bills circulate outside the United States. The reserve currency holdings of the world's central banks are largely in U.S. Dollars or U.S. Dollar denominated assets (e.g., U.S. Treasuries).

What precisely is the 'Exorbitant Privilege' conferred on the United States by the special role its currency plays in the global financial system?

Professor Eichengreen calculates that the U.S. dollar’s status as the world's reserve currency is worth 3% in U.S. national income per year. In other words, having the world’s dominant reserve currency allows the U.S. to run an annual $500 billion current account deficit.

Some may remember Vice President Cheney's quip that "deficits don't matter", or Nixon Treasury Secretary Connally's response to foreign governments, critical of the U.S.’s profligate Vietnam and Great Society spending, on how the U.S. Dollar was "our currency, your problem". It is this 'Exorbitant Privilege', a term coined by French leaders in the 1960s who railed against the fact that American paper currency could be exchanged for "real stuff", which Professor Eichengreen views as unsustainable.

Are Reserve Currencies Analogous to Computer Operating Systems?

Economists explain the U.S. Dollar's rise and dominance through a principle called 'network externalities' (or 'network effect'). Similar to how significant interoperability advantages in computing can be achieved through the adoption of a single operating system (e.g., Microsoft Windows), the widespread use of a single currency (the U.S. Dollar, and previously British pound sterling) can lead to mutually beneficial economic efficiencies.

However, in a world where 'Currency Converter' is one of the Top 10 most downloaded smartphone apps, determining exchange rates and making currency conversions can now be performed quickly and simply by a vast number of people. Just as the computing world is moving towards multiple operating systems (i.e., Windows, Mac, Linux, Google, iOS, etc.), Eichengreen believes the world will transition to three principal reserve currencies: the U.S. Dollar, the Euro, and the Chinese Renminbi (Yuan).

The Euro and the Renminbi: Assessing the U.S. Dollar Bridesmaids

On the currency topic du jour, Eichengreen believes that "euro gloom and doom is overdone". Just as a default by Los Angeles County won't spell the end of the U.S. Dollar, a default by Greece and/or Ireland won't bring about an end to the euro.

Germany is the one country, in Eichengreen's view, which could afford to abandon the euro without suffering catastrophic economic consequences. However, Eichengreen sees this as unlikely. Germany's next generation of leaders, while not having been around for the birth of the EU, are nevertheless heavily wedded to the European Project. Further, Germany benefits from a weaker euro via more competitive exports. If Germany were to leave the euro then the reintroduced Deutsche Mark would shoot up in value and risk choking off the German export led economic renaissance currently underway.

When it comes to the Chinese renminbi becoming a reserve currency, Eichengreen acknowledges that China needs to make significant changes. For starters, the renminbi will need to become freely convertible. China will also need to develop deep, liquid capital markets and make fundamental changes to its overall development model.

However, these and other changes may come quicker than many expect. A short time ago there were basically zero Chinese companies settling international transactions in renminbi; now 70,000 do so. Two U.S. multinational companies, McDonald's and Caterpillar, have issued renminbi-based bonds. Currently most of these changes are occurring in "China's financial petri dish" (Hong Kong), but China has set a target of making Shanghai a preeminent world financial center by 2020.

Timing the Decline of the U.S. Dollar?

Eichengreen assigns a very low probability to a sudden collapse of the U.S. Dollar. But could it happen? In short, the answer is yes.

A spat over Taiwan or rising tensions in the Asia Pacific over China building its first world class navy in 600 years could cause China to suddenly stop funding U.S. deficits. A more confident and assertive China is likely to continue to flex its newfound muscles, a subject I previously covered in more detail here.

However, what Harvard’s Larry Summers termed "The Financial Balance of Terror" is likely to prevent a catastrophic scenario from unfolding. Similar to how President Eisenhower threatened to dump the U.S.'s vast British bond holdings during the 1956 Suez crisis if British forces didn't leave the peninsula immediately (which they did), Eichengreen believes that China and U.S. officials will attempt to work out their differences through diplomatic back channels as opposed to openly fighting it out in financial markets.

A more likely scenario would be a sudden loss in investor confidence, like the one experienced by Greece last spring, in the U.S.'s ability to get a handle on government spending. Eichengreen notes how the ratio of U.S. federal debt (a relatively high 75% of GDP) vis-à-vis tax revenues (a relatively low 19% of GDP) is rapidly approaching the danger zone.

From an investment perspective, investors should continue to expect currency volatility under the current U.S. dollar dominated international monetary system. Further, the U.S. Dollar will continue to be the world's safe haven currency in times of crisis for the foreseeable future. However, according to Eichengreen a change in the international monetary order is all but inevitable within a decade.

The Biggest Loser (Besides the Irish) in Ireland's Ongoing Debt Crisis

Noted economic historian Barry Eichengreen has written perhaps the most scathing damnation of this week's Irish bailout. I strongly encourage reading the full piece.

Professor Eichengreen takes aim at Germany in particular. In the below passage he compares the Irish bailout to Germany's own hopelessly burdensome WWI war reparations, which played a key role in the rise of the Nazis and perhaps the Great Depression:

"Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor. Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?"

The short answer to Barry's question is, of course, no.

Irish Bailout Rejection Fallout

European sovereign bailouts may wind up becoming a lot like Department of Defense contracts in that the only thing contract signing signifies is the beginning (rather than the end) of negotiations. For example, if the new Irish government rejects its bailout as expected there may be an attempt to stem the ensuing crisis by negotiating down the hopelessly high bailout interest rate of 5.8% (or 7.25% depending on how it's calculated). And Ireland's controversial low corporate tax rate of 12.5%, rumored during the height of the drama  to be on the table for european 'harmonization', may also be revisited.

Any such renegotiations should be viewed as window dressing aimed at delaying the final reckoning. The fundamental problem is that Ireland is insolvent. No amount of additional liquidity or tax rate bargaining alters this inescapable fact. Faced with this prospect, Europe's current leaders are struggling to determine who will take the biggest hit from Ireland's inevitable default.

Who Will Be the Biggest Loser?

Arguably the key issue to keep an eye on is whether senior Irish bank debt holders will be forced to take losses. If in fact Eichengreen's suggestion of 100% haircuts on insolvent Irish bank debt is adopted the ramifications for Europe's banking system would be difficult to overstate.

The below chart is helpful to understanding the implications of an Irish bailout rejection/and or default.

(click to enlarge)

The U.K. is Ireland's largest creditor with approximately $220 billion in exposure, so any Irish bailout rejection and/or default will weigh heaviest on Britain. Royal Bank of Scotland (RBS) and Lloyds TSB, which were previously placed on government life support, are particularly threatened.

An Irish rejection of the bailout will put substantial pressure on the still fragile British banking system, which post-bailout consolidation is now home to three of the world's five largest banks (including #1 RBS).

(click to enlarge)

In spite of the current austerity push in the U.K., the government participated in the Irish bailout and pledged approximately $10M to "a friend in need". An Irish Times editorial, reflecting the long and conflicted relationship between these two nations, greeted British 'kindness' with a degree of skepticism.

It's would appear that the U.K. (an EU member which never adopted the euro currency) helped bailout Ireland because rescuing a neighbor is politically more palatable than what would have been necessary if Ireland's debt situation had further deteriorated: recapitalizing the British banking sector (again).

A Lonely Lady

But if at some point an Irish default is inevitable, and the Eurozone nations align to protect their euro based banking system, Britain may well find itself the odd man out. And since further bank bailouts by parliament are politically DOA, Mervyn King and the Old Lady of Threadneedle Street may be left to step into the breach to recapitalize British banks. Any such Bank of England support would be coming on top of calls from the Cameron government for further quantitative easing to reduce the effects of government budget cuts and nagging inflation. In other words, sterling would be forced to do even more at a time when the currency is already stretched thin.

It is worth briefly reviewing the history of pound sterling in the 20th century. In the 1920s one pound fetched almost $5. The country was forced off the gold standard during the September 1931 Sterling Crisis, resulting in a sharp devaluation. Following the massive accumulation of debt during WWII, the pound was devalued again in 1948. This was followed by a further 15% devaluation in 1967. Following a severe recession in the early 1980s, the pound has traded as low as $1.03 in March 1985. Overall, there is well established history of devaluation when the going gets tricky.

While the recent plunge in the euro has provided a relative respite in what had been a steady weakening trend in the pound, Britain will bear the foreign brunt of any Irish bailout rejection and/or default. Further compounding this problem is China's curious financial support to Europe's 'Club Med' nations, but not Ireland, and Britain's total debt position which stands at a whopping 5x GDP (the world's largest total debt/GDP ratio). Based on these and other factors one can make a very good argument that over the medium-to-longer term the pound will continue its long drift downwards. Several ETFs are available to hedge against this risk.

New York vs. London vs. The World's Great Cities

A recent NY Times op-ed comparing New York's virtues to the world's great cities sparked a debate amongst friends on how The Big Apple compares to London.

I've been in London for all of seven weeks now, but here are some observations:

• Conversations in London are a lot more interesting, possibly due to the quality of the education system and high-brow media (i.e., Fox vs. BBC, or FT vs. WSJ); definitely a higher general level of awareness of what's happening around the world in London
• Food is surprisingly good and more reasonably priced than expected in London, probably due to the still favorable exchange rate of the U.S. dollar. However, New York probably has the edge here.
• Tap water is not as good in London, and Brita filtering only partially addresses its shortcomings (I came from the San Francisco Bay Area and Hetch Hetchy spoiled me)
• Tube vs. Subway: both aren't much fun; the Tube is more bearable and impressive in terms of its reach; central London is also surprisingly walkable so i rarely take the tube. London also has a nifty bike rental program.
• (Very subjective) Music is more to my liking in London; my first trip to the gym was greeted with an Armin van Buuren live set, something I don't think I've ever heard at a U.S. gym.
• Livability: London is definitely more livable than NY, and not just because the buildings are shorter. London's less densely populated and the weather is better. Nooks and crooked streets lend character; ample green space for dog lovers, and you can take your dog on public transports; citizens are trusted to drink alcohol in public, etc.
• Timing: it's a fascinating time to be in London with what's happening in Europe, although perhaps the same could soon be true for U.S.

While they both have their respective strategic advantages, here are some of London's: more cosmo/international experience sans empire. The Brits, with their global history, are a little more at home around the world than Americans, and arguably the rest of the world feels more at home in London than in NY. London perhaps also has a geographic/time zone advantage over New York: in the morning you can trade with Asia, and in the afternoon you can trade with America. Also, many of the world's most fastest growing financial products (currencies, derivatives, gold, etc.) are heavily traded or headquartered in London, not NY. Overall, London is more international than NY.

'la romantique'

In terms of NY vs. other worldly cities, with the U.S. still in the throes (and largely in denial) of its relative decline, living in NY could have the bittersweet feeling of being on location of what was until just recently the world's center of gravity. NY is obviously still good. But to use the metaphor of a great social event, you know you arrived late as the party is clearly fading. In fact, I believe NY's zenith probably was in 1962. Cities like London and Paris (here's a cute New York vs. Paris blog), which have had plenty of time to come to terms with their loss of empire, may perhaps feel more comfortable in their downsized shoes.

If you're looking for the world's the most up-and-coming dynamic places right now, then Shanghai, Singapore, Sydney, Cape Town, Dubai, Hong Kong and Mumbai would trump both New York and London. I also agree with the NY Times author that Chicago, which seems to be doing relatively well in terms of popularity, is the quintessential American city.

What do you think?

World Bank President Zoellick Gift Wraps Gold $1400+

'Tis soon to be the season of giving, and the monetary gifts to gold owners are getting off to an early start.

Not to be outdone by Federal Reserve Chairman Ben Bernanke's recent 'QE2' goody bag, World Bank President Robert Zoellick has penned an editorial in the Financial Times calling for a global monetary debate on returning to a gold standard of sorts.

Zoellick's proposal is for a basket of the world's leading currencies - the dollar, euro, yen, pound, and renminbi - to be paired with gold (which he describes as "an international reference point of market expectations") in a new Bretton Woods styled monetary order.

Gold really didn't need much of a reason to finally poke its head above $1400/oz, but Zoellick's op-ed and the gold chatter that's sure to follow will almost certainly provide the nudge.

Meantime gold owners can sit back, grab a bag of popcorn, and enjoy what's about to happen to the price of your Au.

Tim Geithner and European Bloodletting

Stephen Fidler, the Wall Street Journal Brussels Chief, has a post today on the European attitude towards Tim Geithner's visits to the U.K. and Germany next Wednesday and Thursday, respectively.

The situation is this: even with the nearly $1 trillion "Euro TARP", as it's being hailed, the market is telling us that the European debit crisis is unresolved. And the reason is that both the math and political calculus suggest a Greek default, and possibly further European debt "restructuring", is inevitable.

With regards to whether the U.S. desires a strong or weak Euro, Mr. Fidler states "But where do U.S. interests really lie? Surely more in a strong euro than a weak one. A weak euro equates with a strong dollar which runs counter to U.S. efforts to power its economy by boosting exports and keep its current account deficit in check."

True, but surely that's not the whole story.