Trading the Cable

"Cockamamie. That's a word you generation hasn't embraced yet. You ought to use it once in a while to keep it alive."
--Frank Horrigan (In the Line of Fire)

They say you learn something new every day. Saw this headline this am and couldn't figure what 'cable' meant in the context.

Turns out it refers to exchanges between the British pound and the USD. 

When transatlantic cable was stretched across the ocean floor in the mid 1800s to connect telegraph services between the England and the US, transactions between the two currencies became known as 'trading the cable.'

Obviously, this is no longer popular slang as it took me several decades before I heard it.

Interesting nonetheless. And I hope to put my newly discovered lingo to work soon.

Euro Energy Bailout

Here I am in silence
It's a game I have to play
You and I in silence
With nothing else to say
--Information Society

On the back of yesterday's post, headlines this morning find euro bureaucrats committing to massive bailouts of consumers and producers as they face virtual margin calls as energy prices spiral higher.

These bailouts are forms of stimulus--subsidies that work against efforts to reign in higher prices.

Still wrapping my head around how this spills over to the US. The obvious consequence is an even strong USD vs the euro.

Cause for Pause

How can you just leave me standing
Along in a world that's so cold?
--Prince

Our working hypothesis is that the Fed will pivot from its hawkish track when 'something breaks' in the market. That's been the historical pattern and there's no reason to believe this time will be any different.

But where will the breakage occur this time around? One possibility is something in the credit markets. The greater the systemic leverage, the more susceptible the system is to higher interest rates. And systemic leverage has never been higher.

After the Fed's historic tightening over the past six months (on a relative basis), some folks are on the lookout for cracks in credit. We recently noted, for example, that low rated debt spreads are widening toward alarm levels.

Another possibility, one stressed here, is that a funding crisis arises in Washington. Higher rates mean more interest expense on ever-escalating federal debt levels. We're currently on a run rate to spend over $1 annually on Treasury bond interest. How much longer before politicians exert enough pressure on the Fed before it breaks?

Finally, one possibility that I frankly had not entertained concerns the strong dollar. The dollar index (DXY) currently stands at its highest level since 2002. The broader Bloomberg dollar index has spiked above the pandemic highs.

There is growing suspicion that this is sparking margin calls in emerging markets stemming from short dollar positions. 

If so, then systemic contagion could provide another possible cause for Fed pause.

Dollar Dominance

We're talking 'bout the dollar bill
And that old man that's over the hill
--Simply Red

The US dollar has been touching multi-year highs as 'risk off' traders flee to what is perceived as the best house in a bad neighborhood. The below graph is telling in that regard.

At some point, the USD may be a meaty short candidate--particularly if you subscribe to the notion that the USD is in the process of losing its reserve currency status.

Art of Hybrid War

"War is a continuation of politics by other means--von Clausewitz."
--Captain Frank Ramsey (Crimson Tide)

Interesting post that fades mainstream media claims that things are going poorly for Russia in Ukraine. The central claim is that Russia is slowly and deliberately tightening the vise around territory that is strategically meaningful. 

Moreover, by keeping the pace deliberate, Russia puts more pressure on Western economic systems that have essentially sanctioned themselves into positions of peril. That peril includes long-term damage to a dollar-denominated financial system.

Russia may be honing the art of hybrid war.

Status Quo Changing

"The status quo has changed, son."
--Patrick Gates (National Treasure)

Interesting piece by Louis Gave on the possible impact of the Ukraine conflict and associated sanctions on the USD's reserve currency status. He suggests that, in an age of fiat currencies, military superiority strengthens a nation's currency and has gone a long way toward solidifying the dollar's reserve currency status.

However, cheap military technologies such as the drones that have been deployed en force in Ukraine are changing the game of warfare--to the extent that they might substantially reduce the impact of conventional weaponry that the US holds a lock on. Should this come to pass, then Big Defense loses value alongside the US dollar's status.

In addition to the impact of the war on the ground, Gave suggests that the weaponization of finance as reflected by the blitzkrieg of war-related sanctions is tutoring the world about the risks of depending on the USD. Developed country bonds have been getting pounded while developing country bonds have been strong--quite the turn from the lessons of the Asian Contagion in the late 1990s. Lesson: Why hold US/EU bonds in this environment?

Moreover, sanctions have demonstrated that the US and its allies can run roughshod over property rights at their discretion. If the wealth of Russian oligarchs can be confiscated so abruptly, then why not the assets of any entity deemed to be an adversary of the US? Lesson: Why depend so highly on a financial system controlled by the US?

The status quo may indeed be changing.

Petrodollars to Petroyuan

When situations never change
Tomorrow looks unsure
Don't leave your destiny to chance
What are you waiting for?
--Swing Out Sister

Courtesy of the 1944 Bretton Woods Agreement, the US dollar has enjoyed reserve currency status for the better part of a century. A reserve currency is a money that circulates extensively internationally. It is deemed the standard used to price and execute financial transactions. As such, it is constantly in demand. Banks worldwide must keep piles of reserve currency on hand.

Strong international demand for the USD has been a boon for the federal government. Money can be printed and debt can be issued without having to worry about destroying the value of the currency. 

It is safe to say that the financial position of the United States would be in a much different place were it not for the USD's reserve currency status.

No market demonstrates USD reserve currency privilege more than the international oil market. For decades, Saudi Arabia has priced barrels of crude in USD. Any non-US entity seeking to buy crude from the Sauds has to pay in USD, which lights a fire under dollar demand in forex markets.

Plus, the US gets an extra kicker. Because it can print gobs of USD with little penalty, the US can do so to buy oil on the international market. Let's see...paper dollars printed out of thin air versus a barrel of crude. 

Who gets the better deal? 

The USD's use in oil trade has led to the term 'petrodollar.' The US has reaped huge gains from the petrodollar.

However, the age of the petrodollar may be coming to an end. Financial system warfare currently being waged as part of the Ukraine conflict is awakening countries to their vulnerability, and prompting them to investigate ways to reduce dependence on the USD. By doing so, these nations could sidestep crushing sanctions that might be hurled toward them in the event that they cross the US in some manner.

Seeking alternatives to petrodollars in oil markets would constitute  a significant step in that direction. 

It should not be surprising, then, to learn that countries are experimenting with pricing oil in yuan rather than in USD. In an uncertain world, it makes sense to diversify--even more so when some of that uncertainty involves a country that might decide to weaponize its currency against you.

By engaging in financial warfare the United States appears to be looking the proverbial gift horse in the mouth. The gift of reserve currency status may be rescinded as countries scramble to increase their sovereignty in a sanction-heavy world.

Movement from petrodollars toward petroyuan demonstrates.

Inflation and Stocks

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

Some believe that if Big Inflation cometh, stocks will get creamed. Surging prices will drive folks to spend less. Simple ECON 101.

Lower demand for goods and services should be bad for stocks.

A counterargument is that Big Inflation occurs when people get nervous about the value of their dollars sitting idle, so they put them to work today assuming that they can buy more today (i.e., goods, services, AND stocks) than tomorrow. The psychology feeds on itself, creating, in its ugliest form a reinforcing cycle of higher prices and money printing that feeds it.

Although producers are hurt on the input side with higher costs, they can offset them at least partially by raising prices, thereby preserving profit margins to some degree. To the extent that producers own tangible assets, these are also likely to appreciate in value as inflationary pressures rise--giving a boost to book value at least in nominal terms.

In this scenario, stocks are likely to rise. Perhaps not to a degree that completely compensates for purchasing power decline, but at least to serve as a partial hedge that preserves wealth (note Kyle Bass estimates perhaps 85% coverage).

Historical analysis supports this thesis. Weimar Germany, Venezuela, Zimbabwe. Equities tended to rocket in the local currency--even if they didn't keep pace with exchange against more stable currencies (and gold).

One thing seems increasingly clear. In Big Inflation environments, stocks are likely to be a better place to be than cash.

It also seems that, in the current market environment where the CPI is starting to print some big numbers, stocks seem unfazed--like they want to go higher.

position in gold

Dollars to Dust

It slips away
And all your money won't another minute buy
--Kansas

The Coinage Act of 1792 established the US dollar as the the standard unit of money in the United States. For nearly a century and a half, the value of the US dollar remained relatively constant.

1800 $1 PCGS F12 CAC

That all changed in 1913 with the passage of the Federal Reserve Act. The act instituted the Federal Reserve as the central bank of the United States. Since the Fed was created, the value of the dollar has consistently declined.

From the above graph, observe that the USD has been so debased that it is impossible to detect just where on the purchasing power scale we are vs 1913. 

Cause and effect. The Fed and inflation. Dollars to dust.  

Heating Up

You can make or break
You can win or lose
That's a chance you take
When the heat's on you
And the heat is on
--Glenn Frey

The May consumer price number printed at a 5% year over year rate of increase. That's the fastest annual growth in prices since 2008.

Glass half full folks contend that this is just a transitory situation, reflecting an economy on a post CV19 rebound. One problem with this claim is that policymakers have signaled that they don't intend to reverse the trillion$ of stimulus meant to motivate the recovery. 

With millions of people out of work and sitting on their couches subsidized by money printed out of thin air by Uncle Sam, spreading enough new incremental output to sop up all those new dollars that policymakers plan to keep in the system seems a tall order.

Here's what I mean. Suppose in Period 1 there are 5 million dollars in circulation and 1 million units of production for consumer to buy. The average price = $5 million/1 million units = $5 per unit.

Now, suppose in Period 2, money in circulation increases to $10 million and production expands to 1.5 million units. The average price = $10 million/1.5 million units = $6.67 per unit.

The 'consumer price index' in this case increases by (6.67 - 5) * 100 = 33% from Period 1 to Period 2.

When the production of goods does not keep up with increases in money supply, prices heat up.

And the heat is on.

Letting It Fly

Time keeps on slippin,' slippin,' slippin'
Into the future
--Steve Miller

The always insightful Stan Druckenmiller zooms with the USC student investment fund group. In the first 20 minutes he offers prepared remarks, primarily concerning his current macro view, while the remainder is Q&A.

Druck lets it fly in part one. After unprecedented monetary and fiscal intervention in response to CV19 last spring, he contends that both the federal government and the Fed are being reckless on a historic scale by continuing to pump stimulus into the system after indicators show that the economy no longer needs assistance. Debt has exploded and prices are rising. He is preparing his family trust fund (a few $billion large) for Big Inflation with bets against the US dollar and on commodities. 

Although he remains long stocks, Druck says that he'll be surprised if he isn't out of equities before year end. I'm not sure whether he thinks inflation will hurt stocks or whether he believes prices are too high (he mentioned that he sees bubbles in nearly all assets classes).

Several interesting notes from the Q&A. On lessons learned from his mentors, Druck highlighted the advice he received about envisioning what things will look like in 1-2 years rather than where things are today. Today has already been priced in. Also enjoyed the Soros story about sizing positionss accordingly. Attractive opportunities should be well funded.

Re digital currencies, he suspects that the dollar et al will be headed electronic. However, he isn't keen on Bitcoin or its brethren being the chosen one.

On unequal wealth distribution, Druck suggests there has been no greater facilitator than central banks--a point these pages has made before.

In prepping for inflation, was surprised there were no questions or comments on gold. I'll take that as a bullish contrarian indicator...

His remarks on shorting also surprised me. While the last 10-12 years have been 'miserable' on the short side, Druck said that recently his shorts have been doing better than his longs. Moreover, given the historic macro situation, he suspects that upcoming years may be very friendly to shorting assets that are wildly overpriced. 

This inspired me to start thinking about setting aside modest short side space in my taxable account for some put projects. Also set up a short candidate watch list. 

position in gold 

Back in the High Life

And we'll dance and drink with one hand free
And have the world so easily
And oh we'll be a sight to see
--Steve Winwood

On the back of yesterday's eye-popping job report, the NASDAQ Composite Index hit an all time high.

The action finds many bears howling. I get it, believe me. Many seemingly insurmountable issues lie ahead.

However, I don't think the Lockdown Depression is what brings the house down. Further, stocks may not be a good indicator of real economic angst when markets begin to forecast the end game. If the future involves Big Inflation, stock prices may go higher, perhaps much higher, to adjust for depreciating currencies and the supply of dollars in the system.

Money

Money, get away
Get a good job with good pay
And you're ok
--Pink Floyd

When civilization began, it did not take individuals long to determine that they would be more prosperous if people specialized when producing output. Gains in productivity obtained from specialization enabled all to be better off as long as producers could trade their output amongst themselves to obtain the diversity of goods and services necessary for better standard of living.

Early trade involved exchanging goods for goods. Today, this type of exchange is known as barter. People who chopped wood traded a portion of their incomes (i.e., logs) with people who baked bread. When they traded their specialized production, both lumberjacks and bakers became better off.

The direct trading of goods for goods presented some problems, however. Sometimes it was difficult to trade goods evenly. Perhaps one house was deemed to be worth 3.25 boats on the market, and it was difficult to trade a fractional house or boat. Spoilage was another problem. Many food producers were limited in trading capacity because their output had a limited shelf-life. That put them at a disadvantage on the market.

To address such problems, people created money to improve the fluidity of exchange. Money in this sense serves as a medium of exchange. The idea is intuitive enough: convert the value of goods into quantities of money and trade should flow easier.

Commodities became intuitive forms of money. Livestock, salt, eggs, and wheat functioned as mediums of exchange in some societies. In colonial America, tobacco was used as money.

Because commodities are products themselves, many of these early forms of money suffered from problems familiar to goods-for-goods trade. Some commodity monies were not readily divisible. Others were hard to recognize or subject to decay. Lack of portability made some commodity monies difficult to carry around.

Most commodity monies also lacked this important quality: scarcity. If a money is abundant and can be created easily, then prices--a key element of market structure--are unstable and difficult to predict as the supply of money changes. When money is easy to create, it is also subject to mischief--particularly mischief of a political nature.

Over time, the search for an effective commodity money has led many societies toward a particular solution: gold. Gold possesses all of the qualities of good money. It is divisible, portable, durable, recognizable, and scarce. It is difficult to produce legitimately and to counterfeit illegimately.

Although many gold-backed 'hard money' designs have existed throughout history, gold rarely serves as money today. In fact, there is not a single monetary system in the world that is currently backed by gold. The backstory as to why gold-as-money has fallen out of favor is a subject for another day.

In contemporary monetary systems, gold has been replaced by currencies that can be created out of thin air by government fiat. On the plus side, contemporary monies, such as the paper form of the US Dollar officially known as Federal Reserve Notes, facilitate huge volumes of trade on a daily basis. On the negative side, fiat monies are subject to politically-motivated manipulation that serves to debase monetary value. This is the other function of money, btw--it serves as a store of value. Debasement of money distorts markets in the short run and creates potential for enormous socio-economic problems in the long run.

Because of the centrality of money to trade, investors benefit from solid understanding monetary of history and of the pros and cons associated with contemporary monetary systems. We will surely focus more on monetary issues in future posts.

Inflation and the Gold Standard

Revvin' up your engine
Listen to her howlin' roar
Metal under tension
Beggin' you to touch and go
--Kenny Loggins

While absorbing the Phillips et al. (1937) study, I was struck how much money can be created inside a banking system (governed by a central bank) despite the purported 'limitations' of the gold standard. During the 1920s, the USD was still backed by gold to the extent that people could still trade dollars for gold.

Yet central banking policies facilitated the inflation of total quantity of money (particularly credit money) by orders of magnitude while the Twenties 'roared.'

Yes, several factors were working on the monetary system at the time, including some outside the US, that served to confound (and perhaps obscure) the dollar:gold relationship.

But the point is that a gold standard, by itself, does not prevent inflation of the money supply into the danger zone.

position in gold

Price Stability

Face to face
Each classic case
We shadow box and double cross
Yet need the chase
--Sade

Phillips et al. (1937) present compelling evidence that the primary objective behind the Federal Reserve's fateful financial market interventions during the 1920s was to stabilize general prices at some level that the institution thought appropriate. Included are several statements from Fed officials during the period that reflect a price stability motive.

But why should these researchers expend such effort to present the obvious, I wondered? Everyone knows that one of the Fed's charters, as poorly executed as it as been, is price stability.

It turns out, however, that the central bank was assigned no such mission in the original Federal Reserve Act of 1913. Developed largely in reaction to the Panic of 1907, the original Act created the Federal Reserve primarily to govern national banking operations and to serve as the 'lender of last resort' in times of market stress.

No explicit monetary policy objectives appeared in the original Act. They were added later as an amendment in 1977. These policy objectives empower the Fed "to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates." [emphasis mine]

The price stability motive, then, has been a consequence of mission creep at the Fed.

Of course, most people have been conditioned to think that price stability is a good thing. After all, who should oppose consistent, predictable prices in the marketplace?

You and I, if we were smart.

In unhampered markets, the natural direction of prices is down. As Phillips et al. (1937) point out several times in their analysis, productivity improvements funded by investment capital create more goods over time. More goods spread over a constant amount of money means lower unit prices.

As productivity improves, prices go down and purchasing goes up.

People pounding the table for stable prices (much less the 2% price increase currently promoted by the Fed) effectively seek to rob you of purchasing power. They want to raise your cost of living.

Who would want to do this? Who would want prices to be higher than they otherwise have to be? We'll consider this question in a future post.

Government Workers

"Nice house on government pay."
--Mace Ryan (Rapid Fire)

As the current 'government shutdown,' which in reality affects only a small fraction of total federal government services and employees, continues, statists are predictably trotting out stories of furloughed workers who are missing paychecks and struggling to make ends meet. An underlying message is that these people are dependent on and entitled to these wages--as if they were working under contracts or similar employment agreements like those commonly made in the private sector.

However, the legitimacy of any wage agreement made by the federal government to transfer taxpayer funds--whether it be to workers or to suppliers--is questionable. Taxpayers surrender economic resources to the government under penalty of force. They are not willing principals using federal government agents to contract for them. Because the sources of the funds have not consented, contracts to pay government workers can be seen as invalid and breakable at any time.

Compounding the problem is the 'promise' to provide furloughed government workers back pay for all days missed once the shutdown ends. One can be confident that few taxpayers are on board with paying workers for services not rendered.

Politicians try to stave off taxpayer revolts by keeping tax rates below a politically expedient threshold--which historically appears to be about 20% at the federal level. But taxes collected at the politically expedient level are not enough to fund the federal payroll. As such, government borrows the difference to make payroll.

Thus, even if taxpayers do not revolt, the bogus federal employment agreements will ultimately be broken by economic forces. The debt and deficits necessary to fund the existing federal payroll, not to mention future spending increases, are not sustainable. Either the government defaults on its debt and payments cease, or the currency gets inflated away and debt (and government workers wages) get paid back in real pennies on the dollar.

Printing Press Preference

The deception, with tact
Just what are you trying to say?
--The Fixx

Chris Rossini explains why politicians prefer the monetary printing press for extracting wealth from the populace. It is confiscation by stealth.

Direct taxation, on the other hand, is overt confiscation. People can readily see how much of their wealth is being taken. There is a limit to direct taxation beyond which politicians are reluctant to venture because the people will push back.

Wealth confiscation via inflation is much more difficult for people to discern in the near term. They cannot easily recognize how much of their wealth is being taken when the government prints dollars and spends them while they still have value. Only later do people figure out that the purchasing power of the dollars in their pockets has been eroded.

Inflation is the invisible tax. Using the monetary printing press to confiscate wealth could very well constitute the ultimate in political expedience

Why Don't People Care About Inflation?

It ain't no use
We're headed for disaster
Our minds said no
But our hearts were talking faster
--Donnie Iris

In response to an Ask Fleck post yesterday, Fleck admits to wondering about this question often: Why don't people seem to care about inflation? It is perplexing. Because it reduces the purchasing power of money in people's wallets, inflation amounts to theft. One would think that people would be outraged about their property being ripped off.

But it doesn't generally work that way for several reasons. One is that low-to-moderate inflation rates can be difficult to notice in daily transactions. Only over large periods of time where the cumulative effects can be seen, or until the inflation rate really picks up, do people begin to notice. This is why inflation is sometimes called the 'invisible tax.'

Another reason is that government measures generally under-report inflation, which makes people think that their purchasing power is not being lost at rates as high as they actually are. Moreover, we are told that a 'little' inflation is generally good. People tend to believe this and forget how the compounding effect of even a 'little' inflation can erode purchasing power and wealth over time.

Most people are also debtors. Debtors generally welcome inflation because it allows them to pay back loans with money that is less valuable than the funds that they originally borrowed. For instance,  borrowing $100 dollars that can initially buy, say, 50 cans of soup can be paid back with $100 (plus interest) that can buy only 30 cans of soup.

Unfortunately inflation rates must often begin to go vertical before people wake up to the dangers wrought by their permissiveness. By that time the toothpaste is out of the tube.

Virtual Saving Vehicle

So true
Funny how it seems
Always in time
But never in line for dreams
--Spandau Ballet

Ron Paul poses the following hypothetical. Suppose you were gifted $10,000 and were required to keep it for 10 years without touching it. If you had to choose between dollars, gold, bitcoin, and T-notes, which saving vehicle would you choose?

A wealthy person gifts you $10,000. You get to choose in which form you’ll accept the gift. But there’s a catch: You must keep the gift in the form that you choose for 10 years without touching it. In which form would you accept the gift?

— Ron Paul (@RonPaul) November 15, 2018

The most preferred choice among almost 95,000 survey respondents was bitcoin.

Sign of the times, I suppose, that the top preference was for a virtual saving vehicle. Also helps explain the muted action in gold despite rising inflation signs.

position in gold

1850

"You see, grandfather scratched the Scott mills to life with nothing much but his bare hands."
--Paul Scott (Valley of Decision)

In 1850 the US was in the midst of a productivity-led expansion. The country's population had more than quadrupled since the turn of the century. Innovations were driving spectacular increases in productivity. Agricultural output more than doubled from 1840 to 1860 while the value of manufacturing and mining industries nearly tripled during this period.

1850 $20 PCGS XF40 CAC

A bottle of port cost about 10 cents while a pound of coffee cost about 80 cents. Pianos could be purchased for less than $200 and a routine doctor's visit cost $2. A new home in Brooklyn cost $2,500.

With a sound money and improving productivity backdrop, prices would generally remain stable or decline during the second half of the 19th century.