Wednesday, 23 April 2014

Is it possible to break the Dollar's stranglehold?

That last run up from the bounce off support on the 14th April seems to have legs. There was a pull back from its high point yesterday but the signs are that today's trade will carry it higher. As you can imagine I'm feeling sick at losing the opportunity to make more out of the move. If only we could transport ourselves a couple of days into the future. But we can't so we have to frame our best guesses, make our choices and live with the consequences.

There will come a day when all that money, pumped in to shore up the US economy will shrivel up and we will have an almighty crash. If only I knew when that will be.

China prepares for a rainy day

Which takes me neatly back to the Dollar trap. What will become of all those reserves that are being built up by the emerging markets, especially China. These are savings put aside for a rainy day: to help them cope with consequence of a global crisis.

The scenario is this. Some thing will change sentiment and suddenly all those wealthy and institutional investors who have been happy to buy and own assets in developing markets  will have a change of heart and decide that the profitable home they found for their assets with in fast growing markets is not as safe as they thought. Result: a precipitous pull out and flee to safety. This flight of capital puts pressure on the developing countries' exchange rates which their governments cannot accept. They use their dollar reserves to prop up the market for their currencies - that is why they built up those reserves in the first place. Speculators shorting the currency, it is hoped, would be frightened off knowing that there is a wall of money which will prevent them getting their own way.

The follow through from this will be a battle over the value of the dollar. Investors fleeing to quality would push up the price of the dollar and push down the value of the more risky currencies. The central banks of the weak currency countries will support their own currencies' values by selling dollars. Another dollar trap, for all the action is likely to happen at once as a crash occurs. The drama will be played out in the commercial and investment banks which will be having to cope with sudden capital outflows which will devastate their balance sheets.

An effort is being made to improve the structure of the currency markets by broadening the range of currencies that are held as reserves. The IMF has a system of SDRs (Special Drawing Rights) which are on offer to countries as alternatives to the dollar as reserves. At present SDRs are a based on a combination of Dollars, Euros, Yen and Sterling. There is a suggestion that the Chinese currency should be added to this group, partly as a way to promote its importance as a reserve currency. Countries trading with China could hold the currency specifically to support their own rates. And China would not be obliged to go to the dollar find security. There are many hurdles to be jumped before the Chinese currency achieves this status.

Other markets will be sucked into the spiralling vortex

In a crashing international market stock and commodity markets will be impacted as worried investors run for the exits. It's not going to be a pretty sight.

Thursday, 17 April 2014

Tit for tactics

Today we have a long review of the next section of the Dollar Trap by Edwar Prasad. This deals with the impact on exchange rates of US Dollar policy. It reveals that a no win war is being waged as the US tries to bully its partners into appreciating their currency values against the dollar in order to avoid making strong fiscal measures at home. But more of that later.

US market

My prediction of a stock market crash appears to be failing. After a sharp pull back the US markets are on the rise once more. I lost a bit of money by taking the middle of the day pull back as a sign of returning weakness. I was wrong and I paid. But my venture was just a toe in the water so little was lost.


I resisted the temptation to go back into gold. That decision saved me a packet of money.


And I am sticking with GVC which is doing OK and is about to pay out a 13p quarterly dividend. I am bracing myself for a fall as the share goes ex dividend on Wednesday next week.

World trade imbalances

At the heart of the Dollar's problems is serious global trade imbalance. To oversimplify, The US and most other developed economies run up foreign exchange deficits as their consumers and governments live beyond their means and they fail to export enough to balance imports. At the same time developing countries, led by China but including other far east countries and countries such as Brazil have thriving, fast growing economies driven by their capacity to export.

We have already seen what these surplus economies do with the savings they generate,and that this creates a trap for them: they seek a safe haven for their savings in US dollar bonds. But there is another side to the argument which is: what happens to exchange rates? 

In the period leading up to the 2008/9 crash the US complained bitterly that the currency policies of its trading partners contributed to the trade imbalance. Their weak currencies gave an unfair advantage to exporters.

The developing countries responded: that easy money policies used by the developed countries resulted in excessive capital inflows into their weak financial markets as funds from the developed world sought high yielding opportunities in the developing world. In themselves these funds did no short term damage but they created asset bubbles. There was also a serious risk that these funds were likely to leave precipitously when market conditions changed leaving disaster in their wake. This was exemplified by the 1997 Asian financial crisis. It is argued that currency appreciation would attract more of these undesirable funds.

Therefore the developing economies had a second reason to keep their exchange rates low. (The first being to keep growth and employment levels high).

Currency wars

A war of nerves about exchange rates had broken out. The US put pressure on China and other countries to allow their currencies to appreciate giving developed countries the chance to export more and import less. The developing countries held the line.

Immediately before the 2007/8 financial crash the IMF attempted to broker a peace. The attempt failed dismally. The US used strong arm tactics and forced the IMF to put pressure on China to avoid currency weakening tactics. The plan backfired and the IMF had to withdraw humiliated. 

The two sides retired from the battlefield hurt but determined to continue with their policies. The US continued to preserve a strong dollar to maintain cheap commodity purchases. China kept a weak currency to keep its economy strong and growing.

The reason for this impasse is that the US will not use fiscal measures to control its domestic deficit. The political costs are too high. Voters would not tolerate,higher taxes or reduced public expenditure to keep the economy on course. Therefore monetary policy continued to be lax. And easy domestic monetary policy generated cheap credit which leaked out and found its way into vulnerable developing economies. 

An example of the political problems caused by using fiscal means to ameliorate domestic problems can be seen in Germany. Gerhardt Schroeder tightened fiscal measures to help his country overcome a financial deficit. He lost the next election because of the pain he inflicted on working people. His policy succeeded and Germany is now an economic powerhouse. But the benefits were felt too late for him to survive politically.

Quantitative easing

The US kept its economy going by injecting cash. It did not have the same political implications at home, but grave problems were exported.

The bottom line of all of this, as I see it, is that FX rates are a zero sum game. If the dollar is strong, then, by definition, other currencies are weak. Persuading developing countries to allow their currencies to appreciate may weaken the dollar but the advantage to the US is minimal compared with the impact on countries which have to deal with poverty in large parts of their population. And why is the US so reluctant to allow the dollar to weaken, it is because it would have an impact on the cost of importing commodities.

Capital controls

The final result of this standoff is that emerging markets have formulated plans to control the inflow or outflow of capital. This is regarded by economic theory as a bad thing. But the emerging markets fear the effects of flows that create asset bubbles and then credit crises as they ebb and flow. The IMF has attempted to discourage or prevent such measures but has been forced to concede defeat.

The ultimate solution is for emerging markets to develop deep capital markets of their own. These would offer domestic investors a safe have for their savings and would provide more effective means for channelling foreign investment funds to the most productive or safest havens. But countries, such as Malaysia who are at the forefront of developing such capital markets find themselves overwhelmed by foreign money. They are forced back into the arms of the dollar to build reserves to help them cope with the volatility that this kind of money brings in its wake.

And what about the home front

As I read this sad tale I was struck by the fact that, as I have suggested many times, some of this money is inflating asset classes in domestic markets of the developed countries. No one seems to be aware, as developing countries very obviously are, that this type of asset inflation brings with it the inevitability of market volatility. No one is building reserves to cope with that volatility when it comes.

Friday, 11 April 2014

Push me pull you

It's turning out to be one of those push me pull you downturns. Friday and Monday were convincing down days. Then Tuesday called a halt and Wednesday saw the recovery of about half of the loss of the previous two days. Yesterday started fairly well but then the rot set in and the Dow ended with a 260 point loss. Today has come but not gone. So far it seems to be respecting a horizontal support line that goes back to the end of November. If the Dow breaks that support the next challenge will be in the 15700 to 15900.region. with diagonal support originating in March 2009 meeting a horizontal line which goes back to August/September last year.

We don't know what will happen but we do have markers to guide us as the US market pulls back.

The big problem is that the pattern of other markets following the US seems to have broken down so it is no longer clear if European markets will follow the US lead.

Tuesday, 8 April 2014

All the eggs in one basket

My new year has begun and I am feeling modestly smug about my decision to stay out of the market. I have a couple of worries. Will I be able to make money this year or will I just avoid losing it as the market tumbles? Could this be another year when I think things are going to turn out badly only to be second guessed by the market? Is my belief in GVC with its massive yield fully justified or should I worry that the market does not see it as a bargain? Should I be taking advantage of gold's faltering bounce back from its dip?

Good questions with no clear answers. As ever I will just have to go on worrying  and then act as my mood dictates.

And then there is my growing understanding of the Dollar Trap. The more I read the more fearful I feel. See below for the next ghastly episode. It really is a story by Edgar Allen Poe. Evil stalks the financial corridors and disaster lurks behind every creaking door.

All those eggs in one basket

All that money accumulated by emerging markets as their balance of payments surpluses continue has ended up, mostly, in one place: US Treasury bonds. And there it sits, trapped. Its sheer volume means that China, and the other bond holders are in a bind. They cannot reduce their holdings. If they sell, or even curb the rate at which they buy prices will start to fall. And with that their reserves would begin to fall in value which means very nasty hole would appear on the asset sides of balance sheets across the world.

In the 1920s/30s something similar happened in France. Its holdings of UK Sterling bonds were great and as the French attempted to break away. Its sales of bonds gave a spur to an already weakening Pound. Its Sterling holdings fell in value, and the French central bank became technically insolvent.

A trap if ever there was one. China is increasingly aware of the problem but sees no way out.

Can the US continue to go on borrowing forever. In theory yes. The debt can roll from one generation to the next and given that the interest rates that it  pays are so low the US is in a strong position. Additionally all the time that Dollar FX rates remain high repayments are also manageable.

In addition the US has a big plus which is helping it to handle what otherwise looks like an intractable problem. It holds external assets and these assets are much higher yielding than the treasuries which it continues to sell. Therefore, as it pays out interest, it earns interest and dividends at a very satisfactory rate which go a long way to offsetting its costs.

The opposite is true of the US creditors. Their unflagging desire to buy US bonds ensure that prices stay high, yields remain low.

All those eggs in one basket are good for the weaver but disastrous for the chicken farmer. Paradoxically it keeps the show on the road for far longer than it deserves. The crash, if it does happen will be much worse because the imbalances just keep growing. Another banking crisis and we really will be in the soup.

I have a passion for mixed metaphors which I have now indulged to the full..

Saturday, 5 April 2014

When the threads in the safety net break

It's the end of my financial year and time to survey the wreckage. I have lost 6.4% while the FTSE made 7.1% and the Dow 12.7%. It could have been worse, at the end of October my losses were running at -11.2%. So between October and March I managed to make almost 5%. This was while the FTSE lost 1.5%. Message to self - you can do it when you try.

My average return, since I started trading in September 1998, is still almost 14% per year compared with the market's 3.7%. Things began to go wrong in 2009. From that year onwards I have underperformed the market every other year. Previously I outperformed the market in 9 out of 10 years.

I attribute my problems to misreading the market following the 2007/8 crash. I worked on the belief that the chickens created by the wholesale printing of money through QE, the massive government deficits run up in the USA and other wealthy economies, together with the problems faced by weak economies prematurely joining the Euro would come home to roost far sooner than they have. Governments have done a fabulous job of staving off the evil hour. (But read on to the end of this post for some chilling analysis of the global economy.)

Above all I failed to see that developing economies would fund the profligate governments of the developed world and that their cash transfers would result in grossly inflated stock markets. The result was that I was far too cautious in my investing and I was permanently on the wrong side of the market. Incredulously I watched the market rise while sitting on the sidelines. Then I would jump in too late and I would take a hit as the market pulled back.

I hope I have learned my lesson and I will now be able to make the most of whatever next year brings.

That's the past. I start the new year with a clean sheet. No accumulated profits no accumulated losses. It's up to me to make the best of what the market throws at me.

The condition of the market.

After my days of nervous waiting the market has finally pulled back sharply. At the same time gold rallied after its weeks of weakness. Interestingly no-one has stepped up to explain what is happening. Commentary focuses on  the fact that it is mostly momentum stocks, particularly those in biotech and technology that have led the losses. 

Friday's decline followed an initial rally responding to good employment figures. 

Is this the moment I have been waiting for? Too early to say. But here I sit, on the sidelines waiting in the hope that the market will do a big dive so I can pick up some bargains and start to return to my performances of old.

The Dollar Trap by Edwar S. Prasad

I continue to read the Dollar Trap. The chapter I have just completed analyses the phenomenon of currency reserves in developing countries. 

These countries desire to build a buffer that will enable them to weather future storms in international markets. They are willing to buy low yielding bonds  issued by rich countries (essentially the USA) and they see the sacrifice in yield as an insurance premium they have to pay to protect themselves.The bonds they buy are safe assets and as their savings grow their security grows. They plan to buy their way out of any problems by cashing in their accumulated savings. (Savings for a rainy day.)

Luckily for them they achieve a collateral benefit. The positive trade balance of these low cost countries, (especially China), puts upward pressure on the exchange rate of their own currencies. Higher FX rates erode their competitive advantage. The act of buying foreign bonds to augment reserves means that they sell their own currency. This keeps the exchange rate low and maintains the competitiveness of their exports.

There are two disadvantages. First buying low yield bonds has an opportunity cost. If they bought higher yielding assets their savings would generate better income. Some countries tackle this problem by creating sovereign wealth funds that buy better performing assets (e.g. equities, higher yielding bonds etc.) but their priority remains maintaining high levels of safe assets.

The other problem is the risk that, by their sheer volume, safe assets turn into toxic ones. All this security is concentrated in the bonds of one major country: the United States. In the event that all the developing countries need to cash in their securities at once, the effect on the price of US bonds would be catastrophic. Suddenly the security blanket would become a lot thinner. 

Added to this would be the dramatic shift in the supply/demand balance for funds that the US needs to fund its continuing deficit. At present the US finds willing lenders as it borrows more and as it replaces maturing bonds with new ones. In the event of a rush for the exit all that would change. The US would find it difficult to redeem maturing bonds and even to pay interest on existing ones because it would be unable to borrow more money The funding of the US deficit would be shown to have been a Ponzi scheme. 

To be fair, Prasad never says this in so many words, but I find it hard not to draw the conclusion. It has happened before. Investors in the sub prime mortgage  market attempted to protect themselves from disaster by buying swaps to protect their investments. When the mortgage market collapsed AIG, the insurance company that had written the bulk of those swaps almost collapsed and had to be rescued. Without the government's intervention there was a near certainty that  all the institutions that insured their sub prime investments through AIG would have gone to the wall. Who is there to bail out the US treasury if their bonds turn toxic? A chilling thought.

Tuesday, 1 April 2014

Capital flows uphill

The market continues to rise gently. Today the S&P is pulling back after making a new all time high . I continue to sit on the sidelines, but I admit to a little nervousness.

I have just started reading The Dollar Trap by Edwar S Prasad. I have barely started reading and already I have the idea that it will turn what I think and know about the markets on its head. I will fill you in fully when I have finished but already I have a sinking feeling. What I was taught no longer works.

The book makes a claim to explain why, when the US Government is pursuing a raft of policies that should be digging a grave for the Dollar, the currency goes from strength to strength. The answer is that there is nowhere else for nervous money to go. The worse things get, the more nervous investors get and the more
Dollars they want. Americans and their financial institutions are sitting on a gold mine. They're digging a hole and the deeper they dig the stronger their currency gets. Now they're in their hole their best strategy is to keep digging because the rest of the world will shore up the tunnels as they make them.

I've read a little deeper now. The argument in the book looks in depth at what it describes as "uphill capital flows".

Economic theory predicts that capital should flow from developed to developing countries. The data suggest that exactly the opposite is happening as shown in these two pie charts from the book .

According to theory capital should flow from better developed countries who lack the opportunity to increase productivity and to generate a better return on capital. Less developed countries have it in their nature to develop faster. They have large underemployed workforces ready to work and generate profits.

The equations that make these capital flows work  are simple. Savings >Investment equals capital outflow. Savings < Investment equals capital inflows.

Net result is that the high levels of savings generated in the poorer parts of he world are exported to richer countries. In the US , at any rate, these capital inflows do not go into investment but find their way into consumption. And when they do find "investment" destinations they fund asset bubbles such as the the sub prime housing market.

The paradox is explained in a variety of ways. They boil down to the argument that developing countries lack the capital and market infrastructures that provide a safe home for savings generated. Prasad summarises them as follows: "These problems include ramshackle infrastructure, unstable governments that could turn around and confiscate foreign-owned companies, high levels of corruption , and so on."

More of this later and in the mean time I will continue to sit nervously on the sidelines  as I watch the stock market inflate.