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What Trillion Dollar Deficits Mean for the US Dollar
The New York Times has an article this week reporting on US President-elect Barack Obama's warning that there will be trillion-dollar deficits for years to come." What's that mean for the markets? The first line of recourse will be the issuance of Treasury bonds; in other words, the US government will look to borrow money, offering to pay it back with interest. The key question, though, is to what extent buyers of Treasuries will be easily found. As we have discussed previously, the very low yield on bonds coupled with the fact that the economic pains are being felt all around the world suggest one of two possibilities: bond rates will have to go up or the Federal Reserve will have to "monetize the debt" -- meaning it will simply have to print more money. I have stated and continue to believe that the result of increased deficit spending, due largely to government bailouts, in this environment will be debt monetization (even if there is a rate hike, that will only increase the future debt, and thus will only delay and exacerbate debt monetization). I believe this will prove to be inflationary, that it will devalue the US dollar, and that this is the real way the bailouts will be paid for; not via a direct tax, but rather a tax through inflation. Economist Mike Shedlock, however, offers a counter viewpoint: [I]The Fed at some point will resort to out and out monetization, and that will have the inflationists screaming at the top of their lungs. However, banks will still be reluctant to lend, and consumers and businesses will be reluctant to borrow. In addition, I expect the velocity of money printed to be close to zero and for the savings rate to rise. In aggregate, these are not hyperinflationary things. Heck, they are not even inflationary things. [/I] Admittedly, I am one of those inflationists who will be screaming at the top of my lungs. :) There are two reasons I believe debt monetization will be inflationary: 1. I disagree with the notion that banks won't lend and consumers won't borrow. As I recently noted, we are seeing a declining TED spread as well as an increase in many money supply metrics (M1, M2, MZM). And even in this environment, we have seen companies like Verizon be able to secure a massive $17 billion loan. 2. Even if lending is reduced due to the economic climate, debt monetization increases the likelihood that foreigners will not only stop buying Treasuries, but that they will sell the ones they have, and will dump US dollar holdings out of a concern of dollar devaluation by the part of the Federal Reserve. This suggests there will be a "run on the currency," similar to what was seen in Argentina in 2001. [B]How to Trade This Scenario[/B] Timing is the key issue for trading this; we are currently seeing a rally in the market, though I expect that at some point in the second half of 2009 we will see the concerns about the Treasury market begin to manifest. As a trend-following trader I look for momentum that corresponds to my fundamental viewpoint, with the exception of precious metals, which I treat as buy and hold type investments. With that in mind, here are the conclusions I am making based on the trillion dollar deficit scenario: 1. US dollar will fall in value. The Japanese Yen and Australian dollar are likely to appreciate relative to the US dollar in such a scenario. 2. Dollar hedges like gold and silver will rise. GLD and SLV are corresponding ETFs. 3. Both monetization of debt as well as a hike in interest rates will send bond prices falling, as a rate hike devalues all bonds previously issued at a lower rate while monetization of debt introduces inflation concerns and the possiblity of the bond being paid back with a currency that is worth less. 4. A rate hike, which I think is increasingly unlikely given the Fed's behavior though still possible, will be bearish for US stocks. DOG and SH are inverse ETFs worth considering in such a scenario. Disclosure: Long gold and silver; currently short US dollar against Australian dollar.
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