Weaker Dollar, Higher Precious Metal Prices Ahead

There are numerous signs that we are not in a normal economic recovery. Instead, the US is headed towards an outcome which results in a much weaker dollar, and much higher prices for precious metals (first) and then commodities. Alternatively, if our government changes composition, which would favor fiscal conservatism, then beware of a quick resumption of the deflationary depression, and then we will see how useless the Fed will be. 


* To me, watching the markets today, is like watching an earthquake or tornado in slow motion. While the press and government officials declare that we have averted a depression, due to the heroics of Bush/Obama stimulus, and outside the box tactics by the Federal Reserve, the reality is that ordinary measures of financial system stability, is flashing warning signs. Some prognosticators declare that the recovery is back on stream, and that the lagging economy and employment situation is normal by a variety of metrics, and that we need to be patient. Among the list of disconcerting warning signs in my opinion, we have the following:


1> Gold is at an all time high, and silver is at a 30 year high;


2> Interest rates are as low as they have been in 60 years;


3> Unemployment is chronically stuck near 10% and the U6 reading is almost at 17%, effectively, the worst readings in 70 years. And these numbers do not show any movement towards improvement;


4> The dollar is on a secular trend towards lower levels, yet our trading partners continue to accumulate all the dollar deficits we are able to run, and seem content (for now) to hold their surpluses in dollars. The bottom line is that trade surplus countries would like to own resources and other commodities instead of their dollars, but they cannot spend these dollars as fast as they are accumulating them;


5> The world leading economies are in the early stages of a trade war. This is being fought by beggar thy neighbor foreign exchange policies, in a race to devalue their currencies. The next phase of this trade war is going to escalate with the enactment of tariffs and trade restrictions.


In short, all is not well, despite what our trusted leaders tell us. To summarize my thesis on the cause of the current dilemma, I trace this back to a topping process in the secular credit expansion cycle, which topped out in 2005. The miracle of credit expansion up until this time, is that it created money for people to spend, which in turn fueled economic growth and expansion. Credit cycles usually end when the borrowers of the newly created credit can no longer afford to service this debt. The top of the credit expansion process came with the top of the subprime mortgage boom in 2005. As private credit in the US turned south, the US government has stepped in to be the borrower and spender of last resort. A similar situation has occurred in Japan over the last 20 years, with its government debt to GDP ratio now at an astonishing 200%. As private borrowers shy away from credit and private credit contracts, governments are picking up the slack, and this is where it gets interesting, and inter-twines with the sphere of global trade. 


Global trade and credit demands of the government has not been such a catastrophe for Japan because they are a trade surplus country, and inflows of capital to Japan has offset the governments demand for credit. The roots of economic stagnation in Japan was their credit and property bubble in the 1980s, and the contraction which has followed, shows the force of such a situation. Government deficits since 1990 have put the Japanese government’s fiscal situation in a precarious place, yet the inflow of capital into Japan, due to their persistent trade surplus, has allowed to Japanese government to fund themselves at the lowest interest rates on the planet. The jury is out on how this will resolve itself for the Japanese, but the thing Japan has going for it is that they have been de-leveraging for the last 20 years and the country does have inflows of capital to immunize it from the adverse consequences of the persistent fiscal deficits by the government.


The situation is not going to end so easily in the US, predominately because:


1> the process of de-leveraging has just gotten started, and for many reasons, our government has been slowing down the pace of real estate liquidations;


2> the US is a chronic trade deficit country, is running deficits at a pace of $600 billion a year, and has a cumulative deficit of approximately $8 trillion over the last 25 years. Up until now, this has not been a problem as countries around the world have been collecting dollars as a reserve currency. But with $8 trillion scattered around the globe, it appears that there just might be enough dollars out there to satisfy this demand;


3> Our government is running persistent budget deficits, estimated to be around $1 trillion as far as the eye can see. Any attempt to pull back on this spending will tip the economy into a resumption of the depression. This could happen if the Republicans have their way in the upcoming elections;


4> If the government continues to run deficits, the concern is that our creditors will run away from the treasury debt and the dollar. I expect this to be a false concern, and fully expect the Fed to support the US bond markets, and monetize the fiscal deficits if necessary, as they did for a decade from the early 1940s to 1951.


This scenario leaves the dollar as the only instrument left to give way as the plethora of dollars which the Fed is willing to print, and the US government is willing to spend, finds its way into the coffers of trade surplus countries. And I have been harping on over the past few days, every export/surplus oriented country does not want the export party to end, because if it does, it is quite unlikely that the domestic consumers in these countries will spend their way to economic prosperity, to make up for the loss of economic activity which the trade deficit countries contribute. So for the time being, these deficit countries continue to accumulate dollars, and hope these dollars are worth something when they want to redeem them for something else.


And this is where the scramble to do something with the dollars in the world will come onto center stage. This is evident by the strength of the precious metals markets, which is starting to gather momentum as an alternative currency. And despite the fact that global economies are meandering forward, commodity prices are on average going higher in dollar terms. When I compare the dollar to other stable currencies, notably the Swiss Franc, Japanese Yen, the commodity currencies (CAD, AUD and NZD) and the Norweigin Krona, the dollar is in a secular bear market, and I expect this to continue. The game of hot potato is just beginning.


Going back to point #3 above, if we do cut back on spending, that could easily throw the economy into a recesssion/depression, and as that happens, it will cause our trading partners to run smaller surpluses, and perhaps they will unilaterally pick up the slack and spend their trade surpluses. Of course, in the US, we would need to just let the economy slide into this recession without any more government heroics, in order to force the trade surplus countries to pick up the slack. This is not a certain thing, and based on the way our government has responded up until now, I question how much chutzpah our politicians have to let a depression occur, without spending more money. The Fed has said that they will not let such an event happen. My prediction is that if the government cuts back on deficits and spending, and the economy sinks, that the Fed will be powerless to stop this depression, despite their best intentions. 


* This is all unfolding in slow motion, so there is time to get your financial house in order. And for professional money managers who have to operate in this environment, what’s important so far is that the “risk on/duration” trade is still working. Watch the elections and see what our government is likely to do, to take your cues about the future.