 The Case For and
Against the Dollar
Axel Merk
Merk Hard Currency
Fund
Aug 13, 2008
We have been cautioning for
some time that volatility in the currency markets may increase
further, even from the elevated levels of the past year. Nonetheless,
violent market action is nerve rattling, even to seasoned investors.
An uptick in volatility tends to be associated with an unwinding
of leveraged positions. This is also the case this time, but
the types of trades being unwound look very different from those
just a few months ago when the "carry trade" was the
talk of the day. To shed some light on recent activity, we will
focus on some key forces we believe act on the dollar and the
currency markets.
Ultimately, the U.S. dollar's
value is determined by supply and demand. And just as with anything
else that can be traded, the traders of the moment determine
the price. Many may opt to trade on short notice, but typically
most holders of the dollar or any security do not trade on a
daily basis. In our view, in making medium to long-term term
forecasts, it helps to look at possible cash flows scenarios
to gauge who may be buying and who may be selling in the future.
To be less abstract, referencing
the U.S. budget deficit in discussing risks to the U.S. dollar
is appropriate, but there is little correlation to short- or
medium term currency moves. The budget deficit is a balance sheet
item; of greater relevance to short-term currency moves would
be the trade deficit or its broader measure, the current account
deficit: foreigners must buy over US$ 2 billion in U.S. dollar
denominated assets every single day to finance excess domestic
spending and a lack of exports to compensate for imports. Even
so, as the U.S. economy slows down, the trade deficit may narrow
because of a drop in domestic economic activity; if that's the
case, it may not be a good omen for future investments in the
U.S. by foreigners.
The concept of differentiating
between balance sheet and cash flow items sounds simple enough,
but even experienced policy makers seem to get overwhelmed with
the rapid succession of bad news coming out of the financial
markets. In early July, solvency concerns of Fannie and Freddie,
the government sponsored mortgage entities (GSEs), made it to
the headlines after our senior economic advisor and former St.
Louis Federal Bank president William Poole stated what was publicly
known. The public discussion then focused on a government bailout;
unfortunately, a phasing out of the GSEs has not been center
of the discussion. One concern was whether guaranteeing the debt
of the GSEs would increase the U.S. government's debt by over
$5 trillion and, as a result, cause a meltdown in the U.S. dollar.
Without a doubt, such an escalation of government debt overnight
would be more than a balance sheet event. However, this argument
wrongly assumes that the debt of the GSEs was not government
guaranteed beforehand. While there was no explicit guarantee,
the public had always assumed these entities were too big to
fail and would be bailed out. If one assumes that there was a
95% probability that the government would guarantee the debt,
then making the guarantee explicit would "only" add
5% US$ 5 trillion to the public debt or about $250 billion. On
the scheme of about $10 trillion in government debt, an increase
by $250 billion is not a positive, but unlikely to cause a meltdown.
We do not suggest that the giant debt loads of the GSEs are desirable,
but we believe the market is smart enough to realize that this
debt did not come out of nowhere in recent months.
Accounting schemes, be they
by the government or private institutions, are unlikely to be
hidden from the markets forever. Conversely, when mortgage insurer
MBIA recently announced it would reduce the value of its own
debt because the market trades it at a discount, such a smokescreen
is unlikely to convince investors that MBIA is suddenly healthier.
MBIA then trumped its arrogance by not taking any further reserves,
again telling the markets more about its own desperation than
its financial strength.
The far healthier approach
would be to phase out the GSEs. Fannie Mae is a relic
from the Great Depression, a socialist Ponzi scheme that makes
housing not more affordable, but more expensive to potential
new home buyers. If private enterprise were allowed
to take their place, the mortgages would truly be in private
hands and not on the government's balance sheet; indeed, a few
years ago, there was a period when Fannie and Freddie had a very
low market share of new mortgage acquisitions as a result of
limitations imposed by Congress at the urging of the Federal
Reserve. Such a transition cannot happen overnight without disruptions,
but, in our assessment, are urgently necessary for the long-term
health of the U.S. dollar. The problems we have with Fannie and
Freddie now are because of inaction of Congress for too long
to clip their wings.
Given a sharp drop in euro
holdings in the U.S. Treasury's Exchange Stabilization Fund,
it seems that the U.S. Treasury may have intervened in the currency
markets, possibly out of fear that a more significant run on
the dollar could have resulted while Congress was pondering about
its GSE bailout. While taking out insurance against such a scenario
may be understandable, we would argue that the recent surge in
volatility may well be the side effect of such intervention.
Without having proof, we would not be surprised if other countries,
notably Asian governments, also interfered in the markets, although
with very different motivations.
Asian countries have been suffering
from a slowdown in the U.S. However, because of surging commodity
prices and inflation, they have been reluctant to keep their
currencies weak to spur exports. With commodity prices off from
their highs, Asian governments may be blinded into thinking that
inflation is less of a problem; that would allow them to weaken
their currencies yet again. Taking advantage of historically
low trading volume during August seems to be a tempting opportunity.
The positive of the surge in
volatility is that it teaches hedge funds a lesson - too many
of them pile into the same trades. In recent months, we believe
these funds may have shorted financials to buy commodities and
sell the dollar. The global deleveraging must continue; for that
to happen, hedge funds must have their access to credit be tightened
as well. We hear that brokers close out positions of speculators
if margin calls are not met promptly; such a development causes
more severe pain in the short-term, but may be necessary.
In the meantime, a lot of technical
damage has been done to precious metals prices and hard currencies
versus the U.S. dollar. Just as everyone was piling into the
same trade, now it seems the speculators all either wanted to
exit or received margin calls and had to exit their trades. Pundits
were eager to call a major shift in the market, declare the end
of inflation, the rebirth of goldilocks.
It is on this perceived drop
in inflationary pressures that has contributed to the dollar's
recent rally. As European growth may be coming to a halt under
a strong euro and high commodity prices, the idea is that the
European central bank will focus more on growth, thus possibly
lowering rates; that the Fed may be able to raise rates; and
that Asia may be able to keep their currencies weak. Indeed,
these are good arguments for a dollar rally.
We are concerned that pundits
and policymakers alike may be pining their arguments more on
hope than reality. The potential for interest rate hikes in the
U.S. with drops in Europe may be the most compelling one to support
the dollar, but will it happen anytime soon? In Europe, we expect
the European Central Bank to take their time before they are
convinced that the commodity boom is indeed over. The reason
to be skeptical is that, of all things, the Fed may see falling
commodity prices as a warning sign of a downward spiral in economic
activity. Given the large number of homeowners that owe more
on their homes than they are worth, the Federal Reserve may actually
want inflation: a recent survey shows that one third of those
who bought a home in the past five years now owe more on their
home than it is worth. The Fed would never say it wants inflation,
but what is needed is a relative adjustment of the cost of home
ownership versus other goods and services. This can happen through
a decrease in the value of homes - something most undesirable
due to the negative implications on consumer spending - or through
an increase in the cost of other goods and services relative
to housing. It's the latter that the Fed may be banking on. In
our assessment, the Federal Reserve will try to push growth until
inflation can no longer be ignored. For the Fed, this threshold
is likely to be the TIPS spread over Treasuries; that's the premium
paid for inflation-protected securities (TIPS) over bonds. Note
that these TIPS reflect core inflation as measured by the government.
By then, real wages may not
have picked up and if the Fed indeed decides to tighten monetary
policy then to try to bring inflation under control, it may cause
a rather severe recession. To wait until inflation is apparent
even in the TIPS market may be waiting for too long as it may
be extremely painful to get inflation back under control. However,
the Fed may think it does not have another choice as the consumer
and financial sectors are too fragile to tighten monetary policy.
Will inflation bring the dollar
lower? It is possible that we will enter an inflationary growth
period, but that may not be enough to cause a sustainable rally.
In our assessment, the risk of a lower dollar is alive and well.
We don't have a crystal ball, either, but investors agreeing
that this risk is real may want to consider diversifying to take
that risk into account.
Aug 13, 2008
Axel Merk
Contact
Merk
©2005-2012 Merk Investments
LLC. All Rights Reserved.
The views in
this article were those of Axel Merk as of the article's publication
date and may not reflect his views at any time thereafter. These
views and opinions should not be construed as investment advice
nor considered as an offer to sell or a solicitation of an offer
to buy shares of any securities mentioned herein. Mr. Merk is
the founder and president of Merk Investments LLC and is
the portfolio manager for the Merk Hard and Asian Currency Funds.
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The Merk
Asian Currency Fund invests in a basket of Asian currencies.
Asian currencies the Fund may invest in include, but are not limited
to, the currencies of China, Hong Kong, Japan, India, Indonesia,
Malaysia, the Philippines, Singapore, South Korea, Taiwan and
Thailand.
The Merk
Hard Currency Fund invests in a basket of hard currencies.
Hard currencies are currencies backed by sound monetary policy;
sound monetary policy focuses on price stability.
The Funds may
be appropriate for you if you are pursuing a long-term goal with
a hard or Asian currency component to your portfolio; are willing
to tolerate the risks associated with investments in foreign currencies;
or are looking for a way to potentially mitigate downside risk
in or profit from a secular bear market. For more information
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is in the prospectus, a copy of which may be obtained by visiting
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Please read the prospectus carefully before you invest.
The Funds primarily
invest in foreign currencies and as such, changes in currency
exchange rates will affect the value of what the Funds own and
the price of the Funds' shares. Investing in foreign instruments
bears a greater risk than investing in domestic instruments for
reasons such as volatility of currency exchange rates and, in
some cases, limited geographic focus, political and economic instability,
and relatively illiquid markets. The Funds are subject to interest
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