Bush Abandons Strong Dollar
16 March 2002
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The Bush administration has been undermining the pillars of dollar policy under the management of his associates - Mr. O'Neill and Mr. Greenspan - even long before adopting the phrase 'free markets determine foreign exchange rates' (paraphrase).
Since last March as the Treasury and Fed were engaged in a policy that was aimed at slowing down the rise in commodity prices, and the fall in asset values, the President had already been allowing the Unified Budget Surplus to dwindle.
Greenspan and O'Neill's strategy, we surmised, was that while the Fed pushed down on interest rates, Mr. O'Neill would continue to talk up the dollar's potential, thereby creating price pressures in key commodity markets, or it could have been the other way around - by pressuring commodity prices, the dollar could stay strong, and monetary policy could work to inflate the investment premium on dollar denominated assets.
We argued that O'Neill was the perfect pick for the job because this way they had the element of surprise in their favor. The entire world expected Mr. O'Neill to pursue a weak dollar policy because he was Chairman of Alcoa you see.
But as self-correcting mechanisms go since monetary policy still failed to reverse the shock to the economy from sliding stock prices and business capital expenditures, for most of 2001, fiscal policy kicked in to pick up the slack. The result was a dwindling budget surplus that even until today the Treasury insists is a brief phenomenon.
In reality, Bush's economic policy has been at odds with the Treasury/Fed's strategy from day one, which means it has been at odds with dollar policy since day one.
Thus, March resulted in the left shoulder of the 12 month topping formation (in the Treasury bond) technical analysts refer to as a head and shoulders formation (see chart below).
Note in the chart also that by June last year, bond prices turned back up. That was coincident with a downturn in equity prices, which were to begin their next bear leg that ended 3000 points lower for the Dow and 300 points lower for the S&P500.
What bond market wouldn't rally on that, particularly as commodity prices slide, and as the Fed lowers short-term interest rates by 75% on a firm dollar?
Still, the budget surplus did not return, and Larry Summer's promise a year earlier, of a buy back scheme targeting the long bond, was becoming less believable to the bond market. Now this was the real problem revealed to the Treasury after the bombing of the WTC towers on September 11th, 2001, because even while the Fed slashed the Fed Funds rate another 50% after that (to 1.75%), and commodity prices as well as government price indexes sunk to their 1998 lows, Treasury yields continued to stay stuck (high).
This in turn is partly why credit spreads didn't really grow through 2001 even though the secondary bond markets had to contend with growing default rates.
So concurrent with Enron's belated bankruptcy disclosure, on October 31, 2001 the undersecretary of the Treasury Peter Fisher announced a scheme that would involve suspending the issuance of the 30-year government long bond. This was the advice given to the President as being the best way to keep borrowing costs low.
The combination of that implication along with the sudden perception of scarcity that was engendered in the 30 year drove yields down sharply. In the above chart, this was the HEAD of the pattern we referred to earlier, and it was the method by which the Treasury was temporarily able to unstick the sticky bond yield.
What a coup for dollar policy! The reason Fisher claimed borrowing costs would stay low is due to the affect this announcement would have on long-term interest rates.
He further argued that when the surplus returns to displace the temporary deficit he would be vindicated of any interim errors resulting from that judgment. But he probably didn't count on how crowded the medium to short term debt markets could become, and he probably didn't see the stimulus to commodity prices resulting from the then current decline in yields.
After all, November was the precise bottom in the CRB and other commodity indexes as well. Finally, he probably didn't see how much credibility the scheme would cost.
What you're reading about is the battle by the Fed and Treasury to keep yields low, while the economy has time to heal itself. You're reading about market manipulation at its highest level, where the masters of the universe are above the laws preventing the rest of us from swindling our neighbor.
The lower interest rates helped fuel consumption, but at the cost of credit quality and further dislocations in capital structure, all of last year. Meanwhile, none of these maneuvers helped profits come back, and the value of stock prices surged as much as another 50% in the case of the S&P 500.
That's right, the simple PE ratio went from 27 times earnings to better than 40 times trailing earnings today. This valuation spike was the direct result of lowering interest rates below the level at which savings and consumption were in equilibrium, thereby superficially inflating investment expectations while concurrently deflating inflation expectations, and thus sustaining the low equity risk premium.
I bet you couldn't say that ten times real fast.
However, lower interest rates also brought on bond supply. Within a month, Fisher's strategy had backfired. Greenspan's own argument for dwindling long-term Treasury supplies became a warning to Congress and the President, commodity prices surged, and yields continued to rise until late December when stock prices weakened again.
The December/January capitulation in stock prices kept yields from rising further, but now, stock bulls have been working themselves up about confidence surveys, housing activity, and the interim manufacturing data. For the moment their eye is off the valuation ball.
Equity bear market parameters are largely still in place, technically speaking, but there is tremendous excitement that the Fed's stimulus has finally begun to work.
However, the dollar has been troubling to us all along because it is supported largely by an inflated set of expectations about future dollar denominated returns. What's more is that while the dollar was still up against most currencies last year, it was the first year in its six-year bull market where it was outperformed by gold prices.
The most recent peak in the dollar index occurred at the end of January, roughly as the Dow's cyclical leadership began to develop into the current mini-mania, as if the market was privy to the Bush administration's coming steel import tariff news.
In fact, even during early February I had a sense that the cyclicals were discounting a weak dollar policy.
Regardless how terrific the economic data looks today (it really doesn't by the way) stock prices themselves are considered to be a leading indicator. And their valuation could be an obstacle to full fledged economic recovery. Should something happen to reassert the bear market's stranglehold on stock market confidence these very same indicators will not look as good.
Of course, nothing helps the bear come out of hibernation like the smell of fresh fear, or concern about valuations.
And nothing focuses investors on the problem of valuation like changing relationships between interest rates, currencies, and commodity prices.
This week, global bond markets all fell out of major topping patterns. The long term Gilts, the Euro bunds, US Municipal bonds, as well as the thirty-year Treasury bond (though the break is clearer in all the others besides the US long bond) all followed the Japanese government bond in reversing their 2-year intermediate bull markets.
The catalyst? A shift in US trade policy that threatens to ignite a global trade war. A rising tide of protectionism is bearish for the dollar and bond since the US leadership position on trade is one of the key pillars of dollar policy.
The willingness of foreign investors to fund the ongoing US current account deficit is in jeopardy as their biggest incentives (the ability to engage in competitive currency devaluations for the benefit of trade, and accumulate appreciating dollar reserves) have been markedly altered. It doesn't matter whether the US has the right under a world trade agreement because of a surge in imports. If the owners of US bonds feel as if they've been slighted, they set the rules, not the WTO.
The world trading and banking community is in an uproar over the US steel tariffs.
We'll just have to wait and see if those cyclicals can continue to lead equities higher, amidst a collapsing dollar, and bond prices. I suspect that by Tuesday of this week, when the EU and US meet, we'll have an idea of whether foreign exchange markets are going to adjust the chronic current account deficit, and how quickly.
But I have a feeling too that President Bush was serious when he said that the free markets determine foreign exchange rates. I have a feeling that despite Greenspan and O'Neill's wishes to the contrary, Bush has already abandoned the strong dollar policy.
I believe this is what concerns Treasury markets today. But I think it will concern equity markets tomorrow.
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