This is a simple scenario building excercise for a Telecommunications & Information Technology which I thought of conducting online. This is just an experimnent and the results of this could lead us to opportunities and warn us about coming Threats. I invite one and all, related with it to participate in it. The book "The Art of Long View" by Peter Schwartz the master scenario-builder said that in such an excercise, it is important to learn the opinion of everyone related to the focus of the scenario...and so here we go....
Two weeks ago, Federal Reserve Chairman Alan Greenspan urged the Bush administration to reduce the budget deficit and encourage more personal saving here at home. He said foreign investors were not likely to finance America's huge and growing trade gap forever, and he implied that if current trends continued, the U.S. risked a currency crisis.
This is not the first time we've heard these warnings. But it is the first time we've heard them from Greenspan.
Concern over the fate of the dollar is hardly new. The following prophetic comments were made by Teruhiko Mano, writing for the Japan Times in November 2000, when the euro was trading at 0.85 to the dollar—28% below the level it was at when the euro launched in January 1999, and more importantly (at least to those like myself who are beating themselves up now for not buying piles of Euro bonds at the time) when the euro was at its low point:
"Since it would be too much to ask the U.S. dollar—the currency of a nation that has accumulated a gaping current account deficit—to cover the financial transactions of the entire world, we must realize that the euro, despite all its problems, is on its way toward becoming a world currency."
Fast forward four years. Now you find Simon Brewer, Chief Investment Officer of Morgan Stanley, telling his clients at the Emirates Bank International's Al Shaheen Club dinner last month that he likes oil, gold, and Asian equities. And he hates U.S. equities and the dollar.
What happened?
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First, a brief primer on currencies. According to commodities and money expert James Sinclair, a currency is valued by:
— The reputation and financial acumen of management. This is expressed in a currency by the actions of the central bank, the quality and actions of the people in charge of the treasury, and the financial direction given by the country's political administration. This has a bottom line in the position of the federal budget in terms of the flow towards deficit or surplus.
— Earnings, which are expressed in the Balance of Trade in terms of its deficit or surplus position.
— The amount of shares outstanding, which in a currency is expressed by the Current Account of the country in question and its deficit or surplus position.
— The "dividend" rate, which expresses itself in a currency in terms of the interest rate paid on six month money. Simply stated, if the interest rate paid on six month money exceeds the anticipated six month inflation rate, the impact is positive.
Various items on a company's balance sheet, such as debt versus income, influence a company's stock price. Similarly, the balance of trade, the federal budget deficit, and the current account all influence the dollar's value. These factors are currently negative for the dollar, and they have been for a while. We now have a massive budget deficit, a negative trade balance, and a negative current account—and it's getting worse.
Since Teruhiko Mano wrote his prophecy in November of 2000, the dollar has declined from 0.85 euros to 1.30 euros. As bad as that is, other countries certainly would have suffered considerably worse erosion of their currency value under the same conditions. So why has the dollar held up as well as it has?
The dollar has been supported by our trading partners, especially Japan and China, by their purchase of U.S. Treasuries for the past several years. Why do they do this? Because if the dollar declines, imports become more expensive and Americans buy fewer of them. At the same time, U.S. exports become cheaper and U.S. voters sell more of them. Neither is good for China and Japan.
But there's more to the unusual strength of the American dollar. Another factor that determines a currency's value is what I call "currency brand." Like any strongly branded item that's bought and sold, a currency's brand is built over a long period of time. Consistency and longevity of purchasing power build currency brand; inconsistency of purchasing power, or imbalances such as trade deficits, destroy it.
The dollar is the longevity king of currencies. Since its inception, the dollar—unlike any other currency in existence—has never been cancelled. All Asian currencies, and all of the European currencies that preceded the euro, have at one time or another lost most or all of their value and then been cancelled and replaced by a new and improved version. If you held securities prices in that currency, they either lost value (as you traded them in at a discount in exchange for the new currency) or became completely worthless. By contrast, you can buy a dollar's worth of gasoline today with a dollar printed in 1900.
But the dollar has seen some dark days. In the late 1970s and early 1980s, inflation ran over 10%, rapidly eroding purchasing power. The U.S. had to impose currency controls on its trading partners to slow the flight of capital. But trading partners forgave this as "management" (to use the analogy above), and eventually bit the bullet and adjusted policies so that the dollar returned to its previously stable state.
Despite these episodes, the dollar's popularity has long trounced that of its European and Asian counterparts, which begs the question: if the dollar is the world's second greatest monetary brand, which is the greatest?
As it turns out, Teruhiko Mano's November 2000 prophecy not only marked the best time to buy euro bonds, but also (not coincidentally) the best time to buy gold. A month before Mano's piece I wrote the following analysis, when gold was trading below $270 per ounce:
"One can buy physical gold now for around $270 and have gold provide the same 'fundamental strength' to one's personal balance sheet as it provides for the IMF's. But as a long-term investment I conclude that its value is far more doubtful. Long term, one is best off owning an index of stocks that will tend to grow in line with the world economy, an inevitability in spite of occasional setbacks.
Still, it's hard to go wrong with a small gold bullion position. Gold is now trading near 13% of its inflation-adjusted peak price of $1,937 (in year 2000 dollars) whereas U.S. stocks as a class are trading at a premium never before seen, even after recent declines. It's possible that the price of gold will fall the remaining 13% to zero and the DOW will explode to 36,000 in the next few years as some predict. But is the collapse of the price of gold the remaining 13% toward zero more or less likely than a return of stock prices to their mean P/E ratios and a counter-cyclical return of the price of gold toward a (DOW/gold) price ratio closer to one to one from the current ratio of 37 to one?"
Gold has risen by 66% since I first penned the above analysis, to $448.20.
A very old money brand, gold, and the new monetary brand, the euro, are getting stronger, as the dollar brand continues to weaken. This trend will not change unless politically painful choices are made by management to support the value of every dollar ever printed.
Ajay, no the world's not about to end. It's unrealistic to think that foreign central banks are not aware of the risks and are unhedged. A friend of mine writes to offer the following speculation.
"Suppose you're running a CB that holds tons of USD reserves. Believing in basic obvious economics, you assume that a major USD devaluation is imminent. At the same time, you don't want your domestic currency to rise too much, hurting your politically influential export sector. What to do?
You can't simply dump your USD portfolio because you'd tank the market you want to buy with your holdings. First, you take long futures positions in everything denominated in USD: commodities and other currencies. Things like oil and gold go up without immediately showing your hand to the USD FX markets. Second, with those hedges in place, start to unload our USD. The sheer volume of sales pushes the USD down. But you're OK; you're currency hedged. Even though the end game reduces USD purchasing power and will hurt your exports, you now hold lots of commodities and domestic currency which are worth more on the world markets than before. Third, push those assets into the local economy to compensate for the lost exports to the US.
Japan, in particular, would do very well by this strategy.
The USD decline has reached the shoe-shine boys. You can't swing a cat without hitting someone who's talking about it. Haven't seen much discussion of foreign CB hedge and trading strategy, however."
The US consumer is really doing the world a big favor by running this big trade deficit that keeps both a fairly inefficient Europe ( French & the Germans I believe work about half that much hours as Americans ) and a more efficient Asia ( specialty China & India ) grow their economy and continue to tackle potentially explosive issues like rural urban migration etc. with the new job opportunities that are coming up. US trading partners are accumulating huge mounds of $s in the process, which means are lending US the money to finance their growth. There can be three breaking points to the happy circle, the US consumer gets too far into debt, the trading partners get fed up of collecting $s or the US Government continues it's proliferate and warring ways and is unable to contain its budget deficits. This is an issue in India too, the national and state budget fiscal deficit is about 10% of GDP, one of the highest in the world, the cause, too small a tax base. To me it is obvious that in 2-3 decades years when China and India are thru with this phase of export lead growth and reach full employment levels, the $s will get eventually spent on US goods and services, like Indian tourists visiting USA. Meanwhile what will help US most is to get Europe, Japan and others to remove their huge agricultural subsidies, which will create a big market for American produce and also help create more rural opportunities in countries like India by raising farm incomes.
To me the $ is not dead , it is just finding a new role for it's self.
Let's not forget that while we watch the bubble shell game move from equities to real estate to bonds to equities to real estate, as debt (consumer debt: $2.0 trillion in credit cards, $9.0 trillion in home equity - federal debt: $7.5 trillion - cumulative trade deficit: $8.0 trillion - US GNP: $11.0 trillion) piles up and must someday be paid, either via wrenching inflation or catastrophic deflation - as the imbalance accumulates - the gilded class consolidates their wealth, increasing the percentage of Euros and gold in their portfolios. And all the while they mouth the ostensibly moral platitudes of laissez faire and free trade, while the rest of us forget we're making less than we've ever made because we get the extra cash by borrowing against our home equity.
Hey, Eric whatever rocks your boat...........but everyone really wants to know when this thing blows.........or the real machanics of a petro-dollar war..........which is missing here..............
China reduces holding of US treasury bonds
Mr. Zhong Wei, Director of Financial Research Center of Beijing Normal University states that such reaction reflects extreme disbelief to US dollars in the international market.
"From the perspective of financial psychology the market has entered Panic Transition Period," he says.
Jeff, you crack me up with the grant money funded market magic manifestos. Keep it up.
Thomas, re views... In October I wrote a piece on the housing bubble that's received 6481 views. Many visitors to AO are understandably anxious about these issues. It's hard to know what to think... complex topics and lots of contradictory views. The mainstream press didn't do a very good job of identifying the stock market bubble or preparing us for its aftermath, so there's a tendency to look to other sources. Consumer debt has been making historic highs for a while, not only as a proportion of GDP but more starkly relative to savings. A column on credit and debt is on my list.
2591 views.. does this make you king of the hill, Eric.
Congratulations !!
I have a MIM degree in Intl. Finance/Eco and still don't feel like touching this issue. It is starting to remind me of highly leveraged financial investments..
Eric, question. I was reading in Money magazine, possibly, that private consumer debt was at 85% of GDP ??????
Does this make any sense to you ? I do not understand this at all or what it could mean. Any help would be appreciated. Thank you.
Technical Analysis and Deviations from Random Walks
Starting from the characterization of the past time evolution of market prices in terms of two fundamental indicators, price velocity and price acceleration, we construct a general classification of the possible patterns characterizing the deviation or defects from the random walk market state and its time-translational invariant properties.
The classification relies on two dimensionless parameters, the Froude number characterizing the relative strength of the acceleration with respect to the velocity and the time horizon forecast dimensionalized to the training period. Trend-following and contrarian patterns are found to coexist and depend on the dimensionless time horizon. The classification is based on the symmetry requirements of invariance with respect to change of price units and of functional scale-invariance in the space of scenarii. This “renormalized scenario” approach is fundamentally probabilistic in nature and exemplifies the view that multiple competing scenarii have to be taken into account for the same past history.
Empirical tests are performed on about nine to thirty years of daily returns of twelve data sets comprising some major indices (Dow Jones, SP500, Nasdaq, DAX, FTSE, Nikkei), some major bonds (JGB, TYX) and some major currencies against the US dollar (GBP, CHF, DEM, JPY). Our “renormalized scenario” exhibits statistically significant predictive power in essentially all market phases. In contrast, a trend following strategy and trend + acceleration following strategy perform well only on different and specific market phases. The value of the “renormalized scenario” approach lies in the fact that it always finds the best of the two, based on a calculation of the stability of their predicted market trajectories.
Oil exporters have sharply reduced their exposure to the US dollar over the past three years, according to data from the Bank for International Settlements.
Members of the Organisation of Petroleum Exporting Countries have cut the proportion of deposits held in dollars from 75 per cent in the third quarter of 2001 to 61.5 per cent.
Middle Eastern central banks have reportedly switched reserves from dollars to euros and sterling to avoid incurring losses as the dollar has fallen and prepare for a shift away from pricing oil exports in dollars alone.
Japan threatens huge dollar sell-off
The Observer - December 5, 2004
Japan is warning the White House that there will be 'enormous capital flight' from the dollar if the Bush administration maintains its laissez-faire approach to the mounting currency crisis.
Related stories for further reading on this issue.
A Field Guide to the Falling Dollar
NYTimes - December 5, 2004
Just what will the plummeting value of the dollar mean for the American economy? The answer is not quite as simple as "less imports, more exports." Depending on how investors behave, the dollar's downward drift could cast anything from a benign breeze to a hurricane.
US dollar hegemony has got to go
Asia Times - April 11, 2002
There is an economics textbook myth that foreign-exchange rates are determined by supply and demand based on market fundamentals. Economics tends to dismiss socio-political factors that shape market fundamentals that affect supply and demand. World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy.
The avalanche is coming
Times Online November 22, 2004
It happened before; it might happen again. The dollar could pitch the world into financial catastrophe.
All that glisters
Economist - November 30, 2004
Is the rise in the price of gold merely the flipside of the dollar’s fall? Or does it point more broadly to a loss of faith in central bankers’ promises?
On the plus side of the dollar depreciation equation, just returned from a few days in NYC. Recently observed the same phenomenon in Boston and expect I'll see it in San Francisco when I'm there next week. It's a pleasure to finally see US cities filled with tourists from all over the world spending some of their new wealth here in the US. For all the years of the so-called strong dollar policy, American tourists swarmed over the planet with over-valued dollars and few could afford to return the favor with a visit the US. Now the US benefits from foreign visitors who find their visit to the US more affordable. This is more honest trade than artificial support of the dollar by foreign central banks and a positive development.
Ajay, indeed the need for diversified currency reserves has grown. The main problem for the dollar isn't that the US is doing badly but rather that the rest of the world is doing better than ever. Not only the usual suspects, China and India, but central and south America, eastern Europe, and many previously economically and politically unproductive Asian nations have over the past 20 years especially developed the economic and political institutions necessary to prosper, and prosper they have. In fact, the long term trend is toward increased trade among these nations vs counting on the US as the near sole engine of consumption to drive economic expansion via exports. In networking terms, imagine the evolution toward a mesh topology from the US and dollar centric star topology of trade in place since the end of WWII. As a result, over time, trade among each of these rising nations in aggregate increases relative to trade with the US as a proportion of total global trade. A lower proportion of trade with the US means diminishing demand for conversion of local currencies into dollars for those goods and services that are not priced in dollars, and thus less demand for dollars. The dollar based system, predicated on a US centric trade system, is under inexorable pressure by this positive development for the world. The US needs to adjust to this change by increasing domestic saving and reducing budget deficits, by taking the same steps that nations such as Argentina have been asked to take in order to qualify for World Bank loans.
Jeff, as the Yale study you post suggests, the adjustment of the dollar to the trends above may not be gradual. In fact, historical data suggest the high probability of a rapid adjustment. One reasonable interpretation of Greenspan's unusually direct public comments a few weeks back on a topic he usually leaves to the Treasury dept. is to tell foreign central banks that their efforts to maintain the status quo via massive buying of US treasuries is not only counter-productive but puts a gradual currency adjustment at risk by creating a greater pent-up demand for price adjustment than would happen without their extraordinary support of the dollar. When the treasury buying binge ends, the conditions for the necessary adjustments will be created; interest rates will rise, dollar depreciation will slow, lowering consumption and increasing the real return on savings.
The world to date never really had a choice other than $ as the second largest economy, Japan or Germany was a fraction of America's. Now we have an EU and the Euro, and given the time have China, Russia & India too will be on the currency stage too. There is no reason these currencies will not be bankable in a few decades like the $ and Euro now are . US is struggling on the economic front as there is completion like never before due to globalization and a WTO makes is more difficult to act unilaterally so $ must adjust to the new reality and the world must diversify its financial holdings. All we are seeing is the beginning world adjusting to a new monetary order, and having a few anchor currencies to me is not a bad idea at all.
The Hopelessness of the Gaussian Assumption in Financial Returns
The observed extremes deserve to be further documented. IBM saw its stock fall instantaneously by 10% early in 1996, and later in that year rise instantaneously by 13.2%. Concentration with or without discontinuity is striking even in the extensively averaged portfolio based on the Standard & Poor 500 index. Of this portfolio’s returns over the 1980s, fully 40% was earned during ten days (0.5% of the number of trading days in a decade.) This concentration contradicts a fundamental theorem about the ideal market, namely that even the most active day makes a negligible contribution.
Even if it were true (it is not) that an ideal market model represents data correctly 95% of the time, its fit would not be sufficient because the 5% remainder includes most major events. Indeed, it cannot be questioned that, irrespective of the measures chosen for the notion of ‘cumulative effect of events’, the partial effect of the 5% largest far exceeds 5% of the total effect. As a preview, my models predict that the effect of the largest 5% may dwarf the effect of the remaining 95%. That is, all told, the study of finance cannot be blind to extreme price changes.
A further criticism of the ideal market hypothesis is qualitative but deep. Financial dailies, weeklies and monthlies can thrive because every day in the market is unlike any other day, one week, month or year unlike any other. In an ideal market, in contrast, daily chapters of the history books might vary from one another, but all yearly chapters would seem effectively alike.
Over the past few years, first private then insitutional foreign buyers started to slow their purchases of dollar denominated assets, including US treasuries. Now only foreign central banks buy them in sufficient quantities to cover America's massive trade and fiscal deficits. An astounding 80% of the world's savings are needed to fund America's deficits every day, and more than 70% of these are from foreign governments vs private sources. Clearly, this can't go on forever. The question is, how will it end?
As a rule, todays' fiscal deficits are tomorrow's high interest rates or higher taxes, or both. But there's another possible outcome. A future column will explore my theory that a significant inflation has been in the offing for many years, and will function to help clear both internal and external debts. My belief is that the inflationary process has already started, but is obscured by the contradiction between the price of traded vs non-traded goods and services. The result of inflationary monetary policies are apparent in the price of non-traded goods and services -- especially transportation, education and health care -- while the price of traded goods and services, even priced in depreciating dollars, continue to decline in the face of global over-capacity. Commodities, the inputs to global goods production, continue to rise in price in dollars, but as they account for a fraction of the total cost of finished goods, traded goods prices are still declining. Sum the prices of a basket of traded and non-traded goods and services, eliminate "volatile" ones (e.g., energy), and you get prosaic inflation ala CPI. But will this continue if one of the central banks that's been buying US treasuries breaks ranks and sells and the others follow? No central bank wants to cause a dollar crisis, but then none one wants to be the last holding massive reserves of a depreciated currency, either.
Dantus if you doubt America you are obviously not a Californian. There is no trade deficit here in California, the weather is great, and the culture is advanced and advancing. California culture, giving America Nixon, Brown, Reagan and Schwarzenegger, will lead this mighty country once again, and America will a greater beacon than ever to the world.
I agree with 'Ed' - all what is 'high' in america like educated workforce, infrastructure, dams etc. etc. That is what is great about America.
But, the other 'high' which is there is the very 'high cost' of maintaining all those infrastructure, which is the problem. When the rule of the game changes... many of the advantages of one era actually becomes 'current liability'.
America is America because it attracts the best talents from across the globe, which drives the economy... When the attraction fades away, the talent also looks for other options and there are options available. That is the issue America will be dealing with very soon... coupled with the insecurity of the local job-seekers. So, it is a catch-22 situation.
Corrective economic cascades can collapse currencies and crush international trade. If this happens a country falls back on its natural endowment - in America's case that is a hard working, highly educated workforce, and an infrastructure of technology and higher education, of roads and power plants, vast farms and forests, dams and water delivery and treatment systems, industries and innovation second to none in the world. America will survive. How will America adapt politically is the question. Will America turn to humanitarian reforms, as she did in the 1930's? That was a laudable reaction, considering how many other developed countries coped with a global depression by embracing facism.
As a former Sr. Quant Froex trader in London for one of the worlds largest banks, I can say the falling dollar will probably be poor for equities and debt denominated in $' in the coming year. A lot large global investors pension funds, Insurance companies etc. use something called a Markowitz asset allocation method or at least use it as a guide. The 2 components are risk (annualize variance) and return. When return is looked at through the lens of a local currency the US equity market looks like it took a pretty good hit in 2004. Those who tilt portfolios and determine allocation guidelines for the coming year may thus "underweight" US equities as strong economic growth may not offset potential project forward currency losses.
What Kondratieff theory tells us is that the boom-bust cycle that inflationary monetary policy brings about creates prodigious amounts of debt that eventually overwhelm society. A period of liquidation then must follow in order for the economy to regain its health.
Hopefully the adjustments the dollar faces will echo in magnitude the adjustments of the 1970's. As for gold; it unique in that it's commodity and a currency. As a currency it is more stable than the Euro in today's environment, as a commodity it is (as you say) not a long-term growth investment.
If the dollar devaluation can be managed, in the long run the dollar will emerge a stronger currency "brand" than ever. The U.S. doesn't have the demographic crisis the Japanese and Europeans face, and the U.S. doesn't face the growing pains confronting China and other large emerging economies.
So people have seen this coming for a while as Bush has presided over enormous wartime spending and huge tax cuts. It seems his solution to any obstacle or criticism is just more tax cuts. Guess he didn't get the memo from the Reagan White House that trickle down economics doesn't really work. Add to this the looming catastrophes of spending that are Social Security and Medicare, and we've got a really big problem on our hands.
What solutions are out there? Let inflation help close the trade gap so that we can stop borrowing? But we couldn't repay much of the deficit with such a weak dollar. Raise interest rates to encourage saving? First, this would put the whole economy at risk; it could strengthen the dollar but could also cause inflation if the dividend rate doesn't react in kind.
This whole situation is so precarious and seems to have no clear answer. I'm afraid that one of the main things supporting the value of the dollar in many people's minds also might not be with us for much longer: Alan Greenspan. We need to take advantage of the confidence this man ensues and listen to him before its too late.
IT Facts
The Honorary Award for Peace and Prosperity goes to Symantec
Two weeks ago, Federal Reserve Chairman Alan Greenspan 
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