Saturday, May 4, 2019

Fed's Chief Concern May Be Dollar Is Creating Instability

A Strong Dollar Carries Both Pros And Cons
The dollar holds a special place in the world currency market. Following Friday's strong job report it is surprising we are not hearing anyone talking about raising interest rates or how this may be inflationary. Instead, the focus has been steered in the direction of how we have obtained a "Goldilocks" situation and if anything Fed Chairman Powell may have room to cut rates even more. It appears many people have taken the position that Powell has totally capitulated to President Trump's calls for lower rates. When the stock market started to wobble at the end of 2018, President Trump increasingly ratcheted up his attacks on Fed Chairman Jerome Powell for"ruining the party." The idea that now is not the time to hike rates is of course very popular and solidly endorsed by those who have benefited by feeding at the trough of easy money. 

It is possible that rather than bending to pressure from Trump that Powell is trying to navigate a course that doesn't cause the dollar to strengthen to where it devastates emerging markets. It may be that the Fed's chief concern is that a stronger dollar would create massive instability. This underlines that not enough attention is being paid to the currency woes occurring in several emerging markets. A stronger dollar could cause massive defaults across the globe. Near the end of 2014, released minutes from the Federal Reserve meeting confirmed growing concern about the pressure a stronger dollar is putting on other currencies around the world. Bottom-line is other currencies are under assault because across the globe economies are weak and countries are buried in debt they can never repay at real market interest rates.

China's RMB Makes Up Around 1% Of Reserve
The power the dollar wields as the world's largest reserve currency makes it imperative that Powell does not disturb the delicate balance that currently exists. For years the major world currencies have traded in a narrow range as if held in limbo by some great force. It would be wise to consider the possibility that currencies are trading in a false paradigm due to the coordinated collusion of the major central banks. It is important to understand that wealth is contained within a rather closed system of fiat money, by laws and rules that discourage freedom of movement into tangible assets. This has sheltered currencies from a storm of volatility.

I contend that the central banks across the globe have made an effort to reinforce feelings of economic stability by keeping currencies trading in a "quiet" range. This is a central part of the narrative which has allowed people to think the global economy is on sound footing even as central banks continue to print and pump out money and credit. Remember the failure of any of the world's four major reserve currencies will destroy the myth that major currencies are immune to the same fate that has haunted so many currencies throughout history. When a nation proves unable to control its budgets and is crushed under the weight of debt its currency is swept away.

All this indicates that investors should get ready for the rude awakening that major changes in currency values would usher in. Because of generally weak demand for goods, companies have little reason to pump money into investments in buildings and equipment thus much of it has flowed into intangible investments. This is the reason inflation has not been a major problem and explains the surge of stock prices to all-time highs. Even companies are buying back their own stock rather than expanding into new markets. Yes, this is a bubble manipulated higher by those with money chasing returns, leveraging up, and taking on risk in a low interest rate environment. Have no doubt the seeds for inflation in the future have been planted everywhere.

When investors become unwilling to buy the bonds of heavily indebted nations causing their bond bubbles to burst the values of currencies in those countries tumble. John Maynard Keynes said, By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. As the central banks print like crazy to control interest rates on bonds they devalue the currency. While there are not many Bond Vigilantes there are a slew of  Currency Vigilantes and they are ready to make their presence known. History has repeatedly shown these vigilantes are acutely aware of when a currency is overvalued or ready to be re-pegged and pounce on the weak currency to tear it apart.

Today we live in an age when billions of dollars are traded in just the blink of an eye, imagine how fast things could go to hell in a situation where markets become unstable and chaotic. It is reasonable to assume even the batch of recently created money will be used against the Central Banks that created it. The euro and the yen remain the two major currencies most vulnerable to a devaluation. For years Japan has faced a wall of debt that can only be addressed by printing more money and debasing their currency.  Often because of its Japan's small size, people often forget that it is the worlds third largest economy making it a huge economic power with a big shadow. 

Japan's failure would be felt across the world. I believe the cross-border flow of money leaving Japan is one reason many of the worlds stock markets have remained so resilient. With the death of the Yen, the notion that advanced Democratic countries are immune to hyperinflation will be destroyed. Soon after that people will realize that the Euro, Pound, and even the Dollar are not safe from hyperinflation.  While Japan could be the first domino to fall, in such a scenario it would not be the last. This will bring much clarity to the debate of whether the next crisis will be of a deflationary or inflationary nature. The dollar is not immune to falling in value but I predict it will be the last to go.

More and more often we have seen Central Bankers forced to pull rabbits out of their hats knowing if people lose faith in the major currencies the system will come crashing down around our ears. Using history as a guide markets show no mercy when this shift occurs. As we stand on the abyss Central Bankers will be forced to print so much worthless paper the money it will act as a cushion to our fall, but not change the reality currencies are about to be debased. World Central Banks have been on this murky path for a long time. This is a path that paves the way towards a new "world currency" that will be controlled by the same forces currently in charge.

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Footnote; There is a solid reason why so little is being said about Japan and Korea when it comes to the talk of "Trade Wars." The article below delves into how Japan has exploited its close proximity to China over the years in an effort to remain relevant as a power. This also feeds into the value of the yen as a "proxy" currency.

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