Friday, June 18, 2004

Rock and Hard Spot: Dollarized Inflation or Recession

If you take a look at this chart of the change in the past two years from Yahoo-Finance of the S&P500 versus the Dollar-Euro exchange rate you can see everything you need to know about Alan Greenspan's monetary policy.

The S&P500 has moved upward while the dollar has fallen over 20% in the past two years. Why? Money supply extravagence.

However don't take my word for it. Listen to Big Picture blog.

Money Supply Hits Post 9/11 Record
Since making a new low on May 17th, the markets have moved appreciably higher. In less than a month, the Nasdaq gained 8.5%, while the S&P500 and Dow each netted nearly 6%. This fast run led us to note one week ago that the markets were “rapidly approaching - but not quite at yet - an overbought short term condition.”

Since then, the markets have achieved that dubious distinction of being dramatically overbought state. That suggests to us that some selling and/or sideways action would be healthy, allowing the market to work off its “condition.” That i’s what must happen when markets get ahead of themselves.

To work off this overbought condition, we would like like expect to see a few more days of orderly selling – or simply sideways action. This could will bring equities down to a level that may be too tempting for buyers to ignore. We like that selling hasnot begat more selling. What few “disasters” we’ haveve seen have been admirably contained to individual names, and are not painting entire sectors red. We continue to be relatively constructive on the markets, and are willing to be patient in looking for more advantageous entry points.

But we keep coming back to the issue of Money Supply (see chart nearby). As mentioned previously, the Federal Reserve has been pumping cash into the system at a fantastic rate. Indeed, the Money Supply increase for May was the highest injection of liquidity the Fed has put into the system since the post 9/11 period.

That grabs our attention. Recall the two most recent periods of high Money Supply increases: Pre-Y2K, and post 9/11. The Markets greeted each of these M2 spike intervals like an injection of nitrous oxide into a racing engine.: They took off, soaring further and faster than anyone expected. The recent fuel injection is a significant increase: It has led to some speculation (amongst the cynics) that the Fed – the ultimate insiders – are bracing us for ‘something bad.’

We find this argument unconvincing. The Fed has shown little in the way of prescience (i.e., Y2K) and gets the same intel – for better or worse – as does the White House, Pentagon, and USAG. We continue to advocate patience in waiting for appropriate levels: Dow 10,200-300, Nasdaq 1950-60, and SPX 1115-25 are where investors youcan start scaling into the markets adding as they pull back further.

If you want a historical peek at the money supply versus recessions and year over year percentage change, look here courtesy of Economagic.

The reason why this is bad however is that money supply is badly out of line with the fundamentals. As The Financial Times is reporting the current accounts deficit has risen to a revised all time high.

US current account gap widens to record
WASHINGTON, June 18 (Reuters) - 8:59 AM ET
Published: June 18 2004 14:24 | Last Updated: June 18 2004 14:44

The US current account deficit widened more than expected in the first three months of 2004 to a new record, pushed by the growing gap between imports and exports, government data showed on Friday.

The larger-than-expected gap renewed downward pressure on the dollar in early trading against the euro, and boosted gold prices as investors turned to the metal as a safe haven.

The gap in the current account balance, the broadest measure of the nation's trade with the rest of the world, increased to $144.9 billion in the first quarter from a revised $127.0 billion in the last three months of 2003, the Commerce Department said.

"It is a very large number, another record ... most of the deepening in this did come from the deterioration of the goods and services balance," said Jason Bonanca, foreign exchange analyst with Credit Suisse First Boston in New York.

"The dollar is weakening a little bit, which would be in line with the notion that a (wider) deficit would raise concerns about the U.S.'s capacity to fund that deficit," he said.

Economists polled by Reuters had expected the funding gap to widen to $141.0 billion in the first quarter. Fourth quarter 2003 was initially reported at $127.5 billion.

The gap between goods imports and exports widened to $150.8 billion in the first quarter, from $139.4 billion in the fourth quarter as the U.S. economy picked up steam, increasing demand for both foreign and domestic goods.

The current account deficit has been blamed for weakening the dollar against other currencies, as Americans import more than they export and borrow from the rest of the world to make up for the shortfall in their domestic savings.

Much of this gap has been filled by official foreign purchases of U.S. government bonds, as countries like China and Japan snapped up dollar-denominated assets during massive intervention campaigns to weaken their currencies against the U.S. currency.

Official foreign purchases of U.S. assets rose $125.2 billion in the first quarter following an increase of $83.7 billion in the fourth. Total foreign-owned assets jumped $447.6 billion in the first quarter, after a $230.3 billion rise in the fourth.

U.S.-owned assets abroad climbed $289.3 billion, after a $61.6 gain in the previous quarter, the report showed.

The U.S. dollar fell 3 percent in the first quarter on a trade-weighted basis against a group of 7 major currencies, the Commerce Department said, compared to previously reported decline of 12 percent for all of 2003.

If you read between the lines, the US is about to experience another year of the falling dollar. The only way this could be avoided would be to restrict money supply and tighten interest rates. However Greenspan is unlikely to do this as it would put us back into recession for sure. For political reasons this is unlikely.

The large amounts of imported goods and services will result in larger price increases. A weaker dollar means that the prices of everything from oil to other goods will continue to increase. Where they do not it will be because in exchange for not charging us higher prices, countries like China and Japan will be buying our debt instead. Despite this prodigous wealth transfer of our assets to foreign hands, the total intervention in the currency market will be insufficient to prevent an increase in across the board inflation from pure currency movements.

This is the flipside of the situation we have been experiencing for so many years. We have been able to expand our trading sphere through the use of dollar hegemony and "free trade". This has resulted in us being able to print money supply at ridiculous rates and have the rest of the world absorb this difference by exchanging their goods and services in exchange for liquidity. They needed our dollars to carry out other transactions and traded goods/services to obtain those necessary dollars for other purchases and financial dealings.

However we have reached a saturation point. Because we have reached a saturation point further excess printing of dollars results in one of two courses. Either to prevent a weakening of the dollar interest rates must rise and therefore end the time of easy money. The alternative to the resulting recession would be to suffer increased price inflation driven by the fact that the dollar is going to fall because supply exceeds demand.

It seems that Greenspan has opted for the inflationary route and to destroy the legacy of the Volocker in return for short term sociopolitical and socioeconomic stability. Welcome to rising commodity as well as energy prices and inflation. With flat wages real incomes will decline and the purchasing power of American family budgets will edge year over year into insolvency. When this becomes apparent a recession should rear its head and the full stagflation scenario - stangant growth and inflation both - should show its full face. At that point it will take years of retrenchment and strong monetary medicine - interest rates north of 10% I'd guess - to bring things back into alignment. Ugly. Ugly. Ugly. This will make it practically impossible politically to fix America's ailing social insurance programs and pension arrangements.

Nasty. Makes me want to do something like take over the helm of United or something. Turning around a hopeless and basketcase airline would cheer me up and trying to do so would keep my mind off the hideous future that Greenspan is laying out for all of us.

The alternative would be to do the right thing and apply the interest rates now. Yes there would be short term pain but it would provide the impetus for political change. I'm not talking about Democrat vs Republican. I'm talking about the return of fiscal discipline and the political will to make social insurance policy changes. Without that short term pain we will be condemned to another lost decade.


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