February 28, 2011
There’s major shift occurring right now in financial markets.
Sure, the food and freedom riots that are spreading across the globe are a major indicator that civil unrest follows very closely behind resource shortages and economic turmoil… but there’s something else that I’ve noticed recently– it’s a sea change in the financial system.
In the past, major crises normally caused investors to seek safe haven assets, and everything else equal, the dollar would rise. They call it a ‘flight to safety’, and investors would flock towards the perceived stability of US Treasury securities.
In 2008, for example, the Lehman collapse spurred the market to go rushing into the dollar. The pound, euro, S&P, oil, and gold all went into freefall, and the dollar surged. Anyone holding cash felt pretty smart, and the market paid tribute to the US dollar as the world’s safe haven currency.
There were a lot of reasons for why this happened. The US government likes to claim that it has never failed to pay on its debts. Of course, even the most cursory analysis would lead one to conclude that they trade debt for inflation… and more debt.
Regardless, when financial markets were collapsing in 2008, investors made a rational decision to accept negative real rates in the dollar (effectively paying a fee to hold short-term treasuries) over other currencies and asset classes.
It was the lesser of all evils at that particular moment and should not be conflated with ‘confidence’.
The other big reason for the dollar’s 2008 surge was that many of the world’s financial markets were leveraged to the hilt… in dollars. When Greenspan started slashing rates in 2001, investors around the world had been able to borrow cheap US dollars and park them in higher yielding assets abroad.
This global carry trade helped produce huge returns in emerging financial markets as investors borrowed four to six times their dollar equity at 2% to 8% and invested in China at 20%+.
When those markets began to melt down, however, the dollar loans needed to be repaid, and investors went rushing back into the dollar.
The dollar sat atop its altar for about six-months from September 2008 through March 2009, at which point risk tolerance reversed and the dollar began steadily losing ground again.
When European sovereign debt woes surfaced later that year (and in earnest in early 2010), the dollar surged once again… but that time it was a little different.
Sure, the dollar rallied against the euro and other European currencies… but gold rose as well. I remember writing about this last year, suggesting that the simultaneous rise in both the dollar and gold indicated the market’s changing attitude towards what it considered a ‘safe haven.’
Clearly the dollar was beginning to fall out of favor.
Fast forward to today. Mubarak. Gaddafi. Khalifa. Al Said. Ben Ali. Etc. There is no shortage of turmoil right now… yet we are seeing the dollar get clobbered while gold, silver, and smaller currencies like the Swiss franc rise. This represents a major shift in the way that the market views risk.
It’s true that nothing goes up or down in a straight line… but long term, the market is telling us that investors are washing their hands of the dollar as a safe haven asset.
So what happens from here?
In the long run, the law of one price will prevail; the US dollar cannot become so cheap relative to other currencies that a multimillion dollar home in Malibu only costs the equivalent of six month’s wages in Switzerland… or that a new Corvette equals the price of an electric bicycle in Singapore.
Foreigners will swoop in and mop up US inventory long before that happens, not to mention foreign governments will manipulate their own currencies in order to avoid missing out on a 300 million-strong consumer market.
We’re already seeing this now as the ridiculous game of international capital controls tries to masquerade as a free market. I suspect the regulatory environment will only worsen as the political lemmings follow one another off the cliffside.
(Yes, I know it’s a myth, but so is the notion of fiat currency as sound money…)
What about commodities? Investors looking for safe haven assets may opt for things like oil and wheat which have functional value… but I suspect that governments will step in long before we see $200 oil to set a ceiling price, or begin attacking speculators once again.
Ironically, this makes precious metals among the most attractive safe haven alternatives– the fact that they have no real functional value is a net positive.
As a caveat, I am not a gold bug, but the regular lamentations by the PM bears (gold is just a paper weight that has no function, you cannot eat gold, you cannot fill your gas tank with gold, there is no way to value gold, etc.) may turn out to be beneficial.
It is simply BECAUSE you cannot eat gold, cannot fill your gas tank with gold, etc. that governments will be more concerned about regulating high oil, wheat, and soy prices. If gold has no real benefit to the masses, the political consequences of high gold prices are less significant.
In other words, $20 wheat means blood in the streets. $2,000 gold only makes for pithy headlines, and its significance is easily dismissed when highly regarded sages like Warren Buffet dispute the notion of holding precious metals (nevermind he bought oodles of silver in the late 90s).
We’ll talk about this much more on this later, especially why the euro will likely fall first, and how the renimbi will continue to rise as an alternative reserve currency.