January 14, 2009
David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
What were formerly viewed as wild currency fluctuations are becoming more accepted in this post-Lehman failure period of the global financial crisis. Lately the strength has been in the yen. Many ask why?
We know that the economic situation in Japan is weak and the outlook is poor. We know that the Japanese exporters need a weaker yen not a stronger yen to help their business models. And we know that Japan has been mired in a deflationary recession for over a decade and the outlook for substantive reforms which would enable it to exit this quagmire seems to be elusive.
So why the yen and what will happen next?
We believe that the global mix of assets boils down to just four currencies. Most of the $85 trillion of bonded debt in the world is denominated in these four currencies: euro (30%), dollar (39%), pound (4%), and yen (13%). Most of the other currencies in the world (not all) are managed in one way or another or are tied directly to one of these four. Hong Kong, for example, runs its policy so that the Hong Kong dollar is fixed in a link to the US dollar. In Europe most of the non-euro countries in the European Union are managing their currencies in a narrow band so as to eventually gain entry into the euro system. Freer floating currencies like the Aussie, Kiwi, Krona or Loonie are important but are also relatively small portions of the globe’s total.
Let’s look at the big 4.
The dollar story is widely known. We have a huge developing federal deficit now measured in the trillions. And the Federal Reserve has rapidly expanded its balance sheet to more than triple the size of the pre-Lehman failure period. See www.cumber.com for a graphic illustration of the Fed’s balance sheet. Remember that when the Fed enlarges its holdings of assets (loans in the “lender-of-last-resort” role) it is also expanding the liability side of the balance sheet (printing money electronically) in order to pay for those loans. Many conclude this will lead to a disastrous decline in the value of the dollar and a fierce inflation explosion. We are not as sure about this outcome as are the detractors; readers will see why below.
The pound has been hammered as the Bank of England (BOE) cuts interest rates to record lows and is now following a balance sheet expansion policy similar to the Fed. Examination of the British central bank’s balance sheet shows a similar explosive form to that of the United States. BOE is now following the US policy prescription. We led the global move to easing and our currency weakened first. The others are playing catch-up and the BOE is now in second place. We expect the British pound to continue weak for some time.
The euro faces its harshest test since it was born a decade ago. The global economic slowdown and the fiscal crisis have combined to cause serious dislocations among the countries that are in the euro zone. The convergence of interest rates that underpinned the European currency miracle has reversed with a vengeance. Greece is probably the weakest country in the euro zone. Its sovereign debt is trading with a 250 basis point spread over the German benchmark bond. To put this in perspective, imagine if the debt of the State of Pennsylvania carried an interest rate of 5% while the debt of the State of New Jersey needed to pay 7.5% in order to clear the market. This gap in the cost of finance would have huge implications for state budgets, spending and taxation decisions. Pennsylvania would gain at New Jersey’s expense as citizens migrated their wealth across state lines.
In addition to Greece, Spain, Ireland and Portugal have been put on negative credit watch for a possible downgrade by Standard & Poor’s. Belgian debt is trading with a widening spread. Italy is, too. Wide credit spreads among euro zone sovereign debt issuers present a specific problem for the European Central Bank.
In the euro zone the monetary policy is centralized with European Central Bank (ECB). Fiscal policy is not centralized and is in the hands of each country. But the ECB must conduct its operations in only one currency, the euro. Therefore the ECB has to deal in the euro denominated debt of each of these countries. Think of what things would be like here if the Fed had to implement monetary policy the debt of the 50 states and not in the debt of the US Treasury or its agencies.
This wide spread among the ECB member countries adds to the pressure on the ECB. It wants to maintain a strong currency and has stricter rules regarding inflation than any other central bank. But it also doesn’t want to weaken the euro zone structure to the point where one the member countries will seek to leave the euro currency community. The explosion of the credit spreads between euro zone countries and the ongoing difficulty of policymaking have caused the euro to weaken. That seems likely for a while because the policy issues are quite difficult.
So the yen has emerged as the strongest of the big 4 by default. We believe that is about to change. The ECB is altering its tough policy slowly but it is altering it. Their balance sheet is starting to grow and may soon resemble the Fed’s and BOE. Meanwhile the Japanese are suffering. They are approaching the end of their fiscal year and their need for a strong yen to make currency translations positive will pass as the fiscal period closes. Japan has shown in the past that it can engage in massive quantitative easing in order to offset the yen strength. There is no reason to believe that this history will not be repeated.
We expect the surprise will be a return of robust dollar strength. The other central banks and governments are following the easing policy and the deficit prone fiscal policy; hence, all interest rates will converge to very low levels. The global recession has created a large negative output gap. That means the inflation risk that is foreseen by many will be deferred into the future.
When Japan’s policy accelerates into quantitative easing, all four of the large currencies will be in the same mode. The dollar led in the weakening because our Fed and our government moved first. The result is that we will come out of the recession first and that our economy will turn and commence growth ahead of the other large currency blocks. That means a stronger dollar. Currency strength goes to growth. And it is driven by real (inflation adjusted) interest rate differentials. As the world gets to a level playing field at very low interest rates, the dollar gains against the other choices. Remember this is a relative price game. All currencies are worthless except for what markets determine to be their expected values. In the relative price game, the US is likely to win this round. We are long dollar in our global; strategy.
Now to this: we note that there may be some difficulty in the new Obama administration with a tax scofflaw behavior of the Treasury Secretary designee. Dennis Gartman’s (www.thegartmenletter.com) letter from this morning is quoted below. Dennis is a keen observer of markets and politics and his comments need to be respected.
The Gartman letter wrote:
“ON THE POLITICAL FRONT, and to be
listed under the heading “You Really Cannot Make
This Stuff Up,” Obama’s nominee for the Treasury
Secretary’s Position… the position in government that
follows, in our opinion, just behind that of the Sec’y of
State,… Mr. Tim Geithner has created a very real
problem for President-elect Obama, for it appears that
he did not pay self-employment taxes that were owned
to the IRS for the years 2001-2004 when he was an
employee of the IMF. Apparently then, the IMF treated
all employees as “contractors,” and did not withhold
taxes. Geithner was responsible for his quarterly taxes
AND for self-employment withholding, which he
apparently failed to pay. He paid the taxes, but only on
the years ’03-’04, for which the statute of limitations
had not yet expired, and he paid them in late
November when it was clear that he might well be up
for a Cabinet position.
We shall not argue that the taxes in question were
sophisticated, and we shall not argue that the taxes he
had not paid were easily missed, and we shall not even
argue with the fact that Mr. Geithner paid the taxes as
late as he had and that he probably would not have
paid them at all had Obama not won and had he not
had some assurance he’d be a Cabinet rank official;
however, not paying the same taxes for ’01 and ’02
because the statute had run out is inexcusable.
Further, as we understand tax law, there is no statute
of limitations upon the non-payment of taxes due,
although perhaps there is some exemption that the
IMF was able to include in previous tax laws protecting
their “employees” from litigation. We shall leave this all
to the tax lawyers, spin doctors and Obama
Administration offices to wade through. All we know, or
think we know is that Mr. Geithner’s problems will
make those of Judge Kimba Wood and of Ms. Zoe
Baird of 16 years ago regarding payrolls taxes and
illegal household help seem really quite tame. Colour
Geithner gone! As they say, “Stick a fork in’im; he’s
done.” Obama has to be livid… and horrifyingly
We will not quibble with Dennis Gartman’s criticism. We agree with it. Dennis correctly asks if there is going to be a lesser standard for the Treasury Secretary than there is and was for federal judges.
Our postscript is to emphasize that in the post-Lehman, post-Madoff, post-SEC failure, post financial crisis period, confidence and transparency are now the two most important elements for the United States. Geithner would serve the new president and country best if he admitted error and immediately paid anything this is owed or suspect. Come clean and clear the air. If he does, the new leadership will be setting the standard for the new post-Madoff era. If he doesn’t, President-elect Obama must remove his nominee from consideration. Otherwise Obama’s “Audacity of Hope” will become dashed and replaced with despair. The world’s eyes are witching this one closely.
David R. Kotok, Chairman and Chief Investment Officer, email: email@example.com
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