A Little Further Down the Road

/0 Comments/in , /by

Download PDF

The most overused expression that has come about since governments in Europe and the US have been unable to compromise on budget negotiations is “kicking-the-can down the road.” Unfortunately, it remains appropriate following Thursday’s last minute deal to avert the Treasury imposed (or perhaps supposed) budget ceiling deadline. The implication of revisiting these political issues in another 90 days in the future creates uncertainties for investors. By chance, Washington could put together that fantasized grand bargain budget deal, but if history can provide any indication and considering there have been eight budget commissions since 2010, chances seem slim.

This prompted Chinese rating agency Dagong to once again downgrade US credit. The firm revised their A status down one notch to A- as concerns with an increasing US debt burden seem to outpace potential growth in fiscal income and economic growth. Following the selloff in the gold market last week, this news alone gave the metal enough support to re-enter the trading range we’ve seemed to be stuck in since mid-September. And while failing to advance fiscally has not been supportive of gold, the fact that gold did not selloff following a finalized budget deal and actually held its rally through the end of the week seems to have eliminated the bearish undertone of the market for the time being.

The other big factor driving demand in the gold market has been the increased demand for the physical metal, particularly from the usual suspects India and China. Reports of increasing premiums on the Shanghai Gold Exchange over the London market support the notion that Asian buyers are again willing to pay a premium for the physical metal. This was also the case in July as inventories replenished following the precious metals breakdown in April and June.

It’s important to differentiate the outlook for the gold price in the sense of a short term and medium term perspective. The biggest distraction to all asset classes since the beginning of September has been fiscal negotiations in Washington. As Robert Schiller was one of three recipients awarded the Nobel Prize in Economics this week, his contribution can remind us that the irrationality of investors may avert asset prices away from their fundamental values in the short term. I am not attempting to imply that gold is overvalued or undervalued; moreover, gold (and all asset markets) have been over consumed by a budget process with an easily predictable outcome.

Tuesday (October 22) of next week the Bureau of Labour Statistics will report the September payrolls report. Jobs data is the single greatest factor that influences the US Federal Reserve’s decision to taper their asset purchases, and that’s where gold’s focus will return. Regardless of Tuesday’s payroll report, however, the inevitable taper will not come anytime soon.

Despite the independence and the operational structure of the US Federal Reserve, Bernanke will not begin the taper. He is now a lame duck. Part of the legacy Bernanke leaves at the US Federal Reserve is the transparency he has created in terms of the role the Fed plays in financial markets. As his credibility has been questioned by some market participants, current economic conditions aside, the reigns have been handed over to Janet Yellen, and anticipation of the inevitable Fed Taper goes with the upcoming budget deal, just a little bit further down the road.

The Almighty US Dollar

/0 Comments/in , /by

Download PDF

The Triffin Dilemma, named after economist Robert Triffin, speaks to the balancing act required on the part of the government that stands behind the world’s reserve currency. On the one hand, foreign nations wish to hold the reserve currency either to conduct international transactions, or as diversification for their foreign exchange reserves to ensure stability in their exchange rate vis-à-vis their price level. This requires the issuer of the reserve currency to run trade deficits as their currency must be in surplus. In the case of the United States reserve status, there must be excess dollars in the world in order for other countries to hold their currency. Thus, nations that hold the US dollar look to the issuer for stability. The dilemma for the States, however, is that any short term policy or shocks can have long term implications on the currency’s value. This is especially true if the shocks are manufactured by their government.

The Triffin Dilemma was specifically used to explain the role of the United States during the period of Bretton Woods. The world operated on a gold exchange standard, as 35 US dollars was fixed to an ounce of gold. Eventually, continuously expanding fiscal policy in the United States caused investors’ perceptions to devalue the US dollar relative to an ounce of gold. This resulted in countries, led by France, to call on the US to redeem their dollars for gold. Ultimately, the Bretton Woods regime collapsed. In 1971 the price of an ounce of gold again began to float against the dollar. Similarities though, from the Triffin Dilemma can be drawn to the international monetary regime we are in today.

The US dollar is still by and large the world’s reserve currency, and there’s no escaping it. About 85% of international transactions are done in US dollars, and of the world’s central banks 62.2% of their Foreign Exchange Reserves are US dollars verses the second most held currency, the Euro, which accounts for 23.7% of reserves. What this has meant for the US though, is that this demand for US dollars and US debt created by their currency’s reserve status has allowed them to borrow at relatively cheaper levels, and this also doesn’t account for the US Federal Reserve’s easy money policies supressing what would be a natural level for interest rates. Moreover, it becomes clear that events in Washington over these last few weeks illustrate how US policy makers abuse the privilege of the role of the US Treasury in international financial markets.

There is no question, and never was a question surrounding whether or not the US was going to default on their debt. The idea of a manufactured default orchestrated by the President and Congress’s inability to negotiate a deal to raise the debt ceiling, however, is what led investors to interpret the situation like it were probable. The discussion itself though was enough to damage the credibility of the US dollar. Large institutions like Fidelity and JPMorgan sold near dated Treasury’s as the idea of the US going past the debt ceiling deadline was not worth flirting with.

No other currency can handle the inflows of capital like the US dollar. There is no alternative. However, investors more than ever require that hedge to their US dollar assets. We saw an IMF report last week that showed the Canadian dollar, after a long time in the making, is now the fifth widest held Forex Reserve, and it’s not just because of our strong commodity export sector. There’s also an increasing demand for reserve assets uncorrelated with, or negatively correlated with the US dollar. Policy makers today exemplify the importance of diversifying away from or hedging against the US dollar.

Showdown to Shutdown

/0 Comments/in , /by

Download PDF

What is going on in Washington is more of a political charade than real budget negotiations; albeit, it is a distraction from the real structural problems created from a two decade period of credit-fuelled surges in consumption. That being said, with financial markets taking a very immediate focus on the outlook of the US economy, investors are looking past this political uncertainty and for a deal to arise because they know, that inevitably, this will be resolved. That is why, despite equities only falling off marginally, the financial markets have underreacted to the developments of a government shutdown.

A lot of fear and focus is going into what will happen if the US were to actually default on its debt, but investors are seeing past this commentary because as of this point it is far too premature. The Obama Administration, through Jack Lew and the US Treasury, has done a good job fear mongering investors of the devastating effects of US default. It is also fair to say that the financial media has played a role in perpetrating this message. This, however, is only a bargaining chip at the Obama Administration’s disposal to lead voters to associate blame for this whole debacle on the Republicans and their members in Congress. And while they very well might be able to play this game of politics with the general public, it is evident over the last week that investors are yet to react.

Equities markets slipped at the beginning of the week, which was prompted by the government shutdown. This reflects some 800,000 government employees that were furloughed or temporarily laid off because their respective government agencies are not in operations. IHS Global Insight, a consulting firm, estimates the cost to be 300 million dollars a week in lost productivity to the US economy. Other analysts calculate it to shaving a tenth of a percentage point off Q4 GDP growth for every week that the government is shutdown. Obviously, in the near term, that number is of little significance, but it could very well have an impact depending on how long this shutdown is sustained.

What this means, though, is that US economy will suffer in the fourth quarter because of the brutality of their government, and that is the single greatest consequence of this government shutdown. Any market reaction to a US default will be short lived, because at this point their Treasury will not default. The US Treasury sees annual revenues between 16 and 20 percent of GDP, and interest payments on their debt amount to about 2.5 percent of their GDP annually. In the extreme scenarios where Congress fails to implement measures to raise the debt ceiling, the Treasury, for a short period of time, would still be able to make interest payments to their creditors.

The problem with this debate goes beyond the logistics of whether or not the US will satisfy debt payments; moreover, it should be focused on how the biggest impediment to the US economic recovery has been the US Government. It is inevitable we are entering a transition of deleveraging as a result of how much debt has been incurred by the world’s economic superpowers. And with that deleveraging means moderation and repression both individually and from the provisions of government. What it should not mean is halt to economic activity when governments lack the ability to show leadership and implement constructive policy.