Mis-direction on Dollar Devaluation

It’s Monday. You know what that means. Another week of monomaniacal focus on the coming U.S dollar crash and what it means for everyone. See Pura Saxena’s note below for more gory details.

But truthfully, it’s hard to be overly gloomy when you’re in Australia in the spring. It’s a nice place. We’ve been here for almost five years now. There is something relentlessly, resiliently cheerful about the place and the people. No amount of bad news – no matter how probable or awful – changes the vibe. That’s probably good.

What is not good is that the U.S Treasury Secretary went on record as saying that the United States government had no intention of devaluing its currency to boost export competitiveness. Be suspicious. Very suspicious. Geithner is engaging in rhetorical mis-direction.

Speaking in California ahead of the G-20 blabfest in South Korea, Timothy Geithner said, “It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity, to (be) competitive…It is not a viable, feasible strategy and we will not engage in it.”

In an even more worrying sign, Geithner explicitly said, “It’s not going to happen in this country.” Geithner isn’t a politician. He’s even worse. He’s a former banker serving in the government. What he says and what the government is actually going to do are probably very different things.

But in a strict sense, he could be telling the truth when he says the U.S. is not going to devalue its currency to boost its export competitiveness. It’s going to devalue the dollar in a attempt to reflate the economy and especially the American real estate market. If it makes paying off American creditors cheaper via inflation, so much the better.

Really if you think about it, the 2008 GFC began as margin call on American banks that were collateralised with falling residential real estate assets. Instead of taking losses on those assets – which would have wiped out the equity capital of many banks and set in motion a chain reaction of falling asset values for all the securities related to housing – the Federal Reserve posted new collateral, in a manner of speaking. It whipped into creation out of nothing.

The Fed then allowed the big banks to swap their garbage mortgage assets for better credit quality U.S. Treasury paper. And then it pushed interest rates down to create profit loop for banks: borrow at near zero percent short term and loan money back to the U.S. government at anywhere from 2%-4% interest. Free money to boost bank earnings and cushion capital!

You wonder what U.S. creditors must have been thinking as they watched this win-win-win between Treasury, the Fed, and the Banks. Did they admire it? Were they appalled? Or are they so hostage to the dollar as the world’s reserve currency that they had no choice but to play along while planning to move at least some of their wealth in real things or higher yielding, more soundly managed currencies, or gold (real money)?

The Fed’s strategy hasn’t reflated the economy. But it has been good for assets prices and bank profits. Just as each dollar of new debt in the mid 2000s purchased less and less real GDP growth, so too is each new dollar of Fed quantitative easing money having a diminishing effect on boosting asset prices; so much so in fact that the markets have jumped way ahead of the Fed and seemingly priced in $1 trillion or so of QE money expected to be announced when the Fed meets on November 3rd.

The trouble is, we suspect, that it’s going to take a lot more money than just a $1 trillion or so for the Fed to reflate the American economy. In fact, it’s not possible. But that may not stop the Fed from trying. And the result should be a huge flood of money into asset prices.

One canary in this monetary coal mine of the QEII strategy is oil. If Fed QE money leaks into emerging markets and commodities, you know it’s going to drive up the price of oil. But oil is not just a monetary commodity like gold. The rising oil price hits real people in the pocket book every day.

Thus, if the Fed’s strategy accidentally leads to another oil price blow up, it will be self-defeating, at least in the sense that rising oil prices act as a consumer tax and act as a drag on economic growth. However, one noticeable difference between this commodity melt up (post March 2009) and the last one, is that oil has not percolated as much. Thus, it has been less noticeable at the petrol pump.

If you check out the chart below, you’ll see that in the last three years the leadership of the commodities complex changed hands in early 2009. Oil (the bottom line on the chart), having crashed, gave way to gold (the top line) and industrial metals (the middle line). To be fair, though, it’s only since June of this year that industrial metals (copper, aluminium, nickel, lead, and zinc) have “decoupled” from oil and tried to join gold back at the head of the race.

Industrial metals “decouple” from crude oil

Industrial metals
Click here to enlarge

This is a pretty interesting chart. But what does it really tell you? That’s the trader’s question. If oil is a barometer of activity in the real economy – and not, as it was in 2008, a speculative asset massively influenced by futures traders – it is telling you that there’s not much to get excited about in the global economy. Ho. Hum. Ho hum. Ho. Hummm.

If the “ho hum” case is correct, then gold and industrial metals would correct, all other things being equal. Commodities don’t melt up when the economy is in the doldrums. The wild card, of course, is the extent to which gold prices and industrial metals prices reflect investment flows into commodities as a “tangible asset” refuge against Fed money printing. If gold and metals are would-be hyperinflation fallout shelters, they could go much, much higher even if the real economy goes exactly nowhere.

The other tradeable proposition is that oil has some catching up to do with its buddies, especially if commodities are ‘pricing in’ rapid U.S. dollar devaluation. This gives share market investors a lot to choose from with a lot (and we meant A LOT) of risk. You can buy the junior diggers leveraged to higher metals prices (Alex’s current strategy in Diggers and Drillers).

Or you can take a punt on undervalued oil producers (if, in fact, they are any right now). This is also a punt on oil as the key and most hoardable strategic commodity of all (more important than oil and rare earths combined, if you want to run machines and drive cars). This is the story we’re chasing up for the October issue of Australian Wealth Gameplan, due out later this week.

In the meantime, let’s all pretend none of this is happening and get ready for next week’s Melbourne Cup. And, if you really must worry yourself over the effect of massive money printing on Australian share prices, stay tuned later this week for additional insight from our small-cap guru Kris Sayce. Until then….

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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