As The Us Dollar Falls, Stagflation Becomes A Reality

``Much has been written about panics and mania…. But one thing is certain; that at particular times a great deal of stupid people have a great deal of stupid money. At intervals… the money of these people — the blind capital, as we call it, of the country — is particularly large and craving: it seeks for someone to devour it and there is a 'plethora'; it finds someone and there is a 'speculation'; it is devoured and there is a panic." – Walter Bagehot, "Essay on Edward Gibbon"

In our previous outlooks we mentioned that given the mixed signals delivered by the markets, some of these would be resolved after the Fed’s action.

Well as Bernanke and Company waved the magic wand, indications became clearer, Bond Yields over the long end climbed, Gold surpassed its previous highs, the Baltic Freight index soared to record levels alongside ALL TIME HIGH Crude Oil prices, a crumbling US dollar index—all of which points towards the resurgence of inflationary pressures.

Figure 5: stockcharts.com: US Treasuries yield bolt higher

Figure 5 shows how the 30 year and 10 year treasury yields have surged following the FED’s actions while 3 month yields remains soft. The Yield spread of the 2 year and 10 year treasuries is at the highest level since May 2005.

A further steepening of the yield curve implies more inflation pressures. This should be confirmed by a motile rise in commodities as well as a drop in the US dollar, hence places the Bernanke in a box. Question is, could this lead the FED to a ONE and DONE move?

Since we are predisposed towards the view that the US monetary policies have been anchored to the developments in the financial markets particularly the equities market, its direction going forward would likely determine the FED’s next moves.

For instance, a continued surge in the equity market, or a Dow Jones breakout from the 14,000 levels could effectively put a tether on the future rate hikes, which is unexpected by the markets. On the other hand, a slippage of the Dow Jones Industrials back to the 10% loss levels could likely impel the FED to continue with its present phase of liquidity expansion.

While we see the more likelihood of a second scenario, we simply cannot discount the first. As we earlier said, markets can go either way from this point. Mr. Bernanke can further revise or rewrite lending rules, as they recently had--to accommodate more eligible collateral and they could print money and bonds to buy all those affected or “freezed-up” assets which could send US markets higher at the expense of the US dollar.

Moreover, a rising market may not imply diminished risks; not when GOVERNMENTS INSTEAD OF MARKET PARTICIPANTS THEMSELVES DRIVE THE MARKETS. Remember, markets today are heavily stacked towards the expectations of a “socialization” of the financial economy, where government interventions are greatly expected to deliver the elixir to the recent crisis. The argument for rate cuts has been synonymous to the arguments for political subsidies.

To consider, the threshold levels and record levels of gold, oil and the US dollar index is in itself a source of concern (figure 6). As we previously said, while mainstream analysis heavily discounts a US dollar crisis, we don’t see this as unlikely. The fact that the US dollar trades a few PIPS (price interest points) away from its LIFE time lows could trigger a massive and violent reaction either way. And violent reactions suggests of amplified volatility.

For instance, the US dollar fell heavily on rumors that the Saudi government would junk the US dollar peg and diversify AWAY from US dollar assets. This was apparently triggered by the Saudi Arabia’s government’s refusal to adjust rates alongside the recent US monetary actions, where since 1986 Saudi’s currency has been pegged to the US dollar at 3.75 riyals for every dollar, hence are required follow the interest rate policies of the US.

Quoting Ambrose Evans Pritchard of the Telegraph (highlight mine), ``This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

``Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

``The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.”

With surging inflation as consequence to a US dollar peg, the oil rich Kingdom could finally break from its linkage as Kuwait last May.

Notwithstanding, in July according to the US Treasury International Capital System, net foreign purchases of long-term securities dramatically slowed to $19.2 billion from June’s $120.9 billon. This reflected the net foreign purchases by foreign official which declined to $4.4 billion in July from $53.8 billion in June.

In short, these could represent troubling evidences of the US dollar losing support as the de facto world’s foreign currency reserve. The denouement of which could reveal itself when prime commodities like oil get to be traded in ex-US dollar currencies.

For now, it is likely that as the US dollar swoons, the risks grows where pressure is felt by foreign holders of US dollar assets to slacken from adding more positions or to even become net sellers.

This is why as we have said last week we find gold and commodities and their proxies in the Philippine markets in the form of equities as possible HEDGES against risks from any financial crisis that could transpire.

Figure 6: stockcharts.com: Inflationary Landscape?

Yet, we remain UNCERTAIN of how a potential selloff in the US markets (assuming a recession comes to play) could affect Asian or Emerging Market or Philippine assets, although a soft US dollar has in the past provided important support to them.

We believe that Philippine mines should continue to outperform as the inflationary setting accelerates.

One should not forget that while governments’ control the money tap, the leakage from such actions will percolate unevenly, hence inflation may appear in any asset class from anywhere across the globe where such transmission permits. So while global economies downshifts, such inflationary scenario translates to a stagflationary outlook, an almost similar landscape that took place during the 1970s to the 1980s.

We also believe that Asia will be the strongest link if a negative correlation or a prospective decoupling occurs. Until evidences suggest of such dynamics becomes apparent, we will position only in small amounts to reflect on the risks we can afford to take as conditions warrant.