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“I fear those big words which make us so unhappy.”

James Joyce

Commentary & Analysis

The Dollar is Doomed? A new currency order. The Chinese yuan replaces the buck. A new Black Swan currency service.

Given the incredible irresponsibility of our government in handling its finances, the dollar deserves to be doomed. And an alternative to the US dollar – its role as the world reserve currency – would likely be a much better alternative for the global economy. Usually when we see headlines on Drudge talking about the dollar being doomed and the Chinese currency supplanting the buck, it is a sign the dollar is near a significant bottom.  Hmmm …

Let’s briefly examine dollar-doomed alternatives which usually include the IMF Special Drawing Rights (SDRs) at the center of a new system. The concept of an SDR reserve currency is not a bad one (it was a concept I think Keynes got right in his outline of the bancor; which was rejected by the US commie spy Harry Dexter White who shaped the Bretton Woods monetary system. White did all he could to support his commie friends in Russia as Roosevelt’s Treasury Secretary (I suggest Ben Steil’s excellent new book, The Battle of Bretton WoodsJohn Maynard Keynes, Harry Dexter White, and the making of a New World Order, if you are interested in learning more about this topic).

In theory, a supranational currency would lead to a more balanced global economy and force the US from running a chronic current account deficit (as Triffin warned about) and in turn force the developing world currencies to stop running chronic current account surpluses (remember in the macro global capital flow world one side is always the flip-side of the other.)

But what would it take to create some type of SDR alternative? Answer: a high degree of global cooperation among the major powers that be, including the US, China, Germany, Japan, UK, Brazil, and Russia.

Now think about that for a moment?

  • Players in the US government can’t even agree amongst themselves on fiscal matters.  I was sent this recently, and I think it sums it up well:

  • Angela Merkel of Germany is still seeking a coalition partner even after her “stunning victory” in recent elections. She is also still wondering how to stabilize the Eurozone banking system without taking on the risk of legacy debt of periphery Eurozone banks onto the back of German taxpayers (France’s fiscal and political situation is deteriorating rapidly, but that’s a story for another day).
  • Japan is mired in the midst of a three-arrow strategy that is extremely tenuous and could lead to a major global bond conflagration if it fails.
  • China is facing the unenviable reality it must make a potentially painful transition away from export-cum-investment-driven growth to domestic demand-driven growth given the secular trend in the global economy (not to mention in the meantime building up its military to challenge the US in the Pacific and establish its “ownership” of resources and control of shipping lanes well beyond the usual international limits; and of course that pesky little country Japan is attempting to thwart this at every turn).
  • Brazil is faced with the reality credit is no longer free; its economy is inefficient and over-regulated, global demand will not likely drive resource growth to any degree it did in the past cycle, and social unrest is soaring—that’s all.
  • The UK is still deciding whether it wants to be part of the Eurozone and whether it cares if Scotland secedes or not.
  • Russia, incredibly, seems the most stable amongst the crowd.  But Putin and friends have to be worried if global commodities prices continue to fall because they have nothing else to fill the gap.

The point is this: Those that can do something about re-shaping the global monetary system for the better are mired deep in their own problems that could last years. And this reality has been reflected in the latest set of G-20 meetings; global cooperation on many big issues is in tatters.  So, it seems we are stuck with the US dollar for a while despite the newsletter writer scare tactic of sucking you into an editorial with the headline: The Dollar is Doomed.  J

The other theme that rears its head when US dollar sentiment gets bad is the idea that soon the dollar will be replaced by the Chinese yuan as the global reserve currency.

Even though China would love to have the buck displaced by its own currency as part of their grand strategy competition with the United States, I don’t think it’s going to happen for a very long time–decades.  First and foremost, China has to decide to open its economy and allow international investors to accumulate Chinese assets at will if its plans for internationalizing the yuan as a US dollar replacement have a chance to succeed. But in the real world of power relationships, it seems Chinese leaders are turning more inward as their relationship with the US seems to be deteriorating and the probability of conflict with the US grows.

It is true that China and the United States are not currently adversaries — certainly not in the way that the Soviet Union and the United States were during the Cold War. But the risk of a U.S.-Chinese crisis might actually be greater than it would be if Beijing and Washington were locked in a zero-sum, life-and-death struggle. As armed adversaries on hair-trigger alert, the Soviet Union and the United States understood that their fundamentally opposed interests might bring about a war. After going through several nerve-racking confrontations over Berlin and Cuba, they gained an understanding of each other’s vital interests — not to be challenged without risking a crisis — and developed mechanisms to avoid escalation. China and the United States have yet to reach a similar shared understanding about vital interests or to develop reliable means for crisis management.

Neither China nor the United States has clearly defined its vital interests across broad areas of the western Pacific. In recent years, China has issued various unofficial statements about its “core interests” that have sometimes gone beyond simply ensuring the territorial and political integrity of the mainland and its claim to sovereignty over Taiwan. Beijing has suggested, for example, that it might consider the disputed areas of the East China and South China seas to be core interests.

Washington has also been vague about what it sees as its vital interests in the region. The United States hedges on the question of whether Taiwan falls under a U.S. security umbrella. And the United States’ stance on the maritime disputes involving China and its neighbors is somewhat confusing: Washington has remained neutral on the rival sovereignty claims and insisted that the disputes be resolved peacefully but has also reaffirmed its commitment to stand by its allies in the event that a conflict erupts. Such Chinese and U.S. ambiguity about the “redlines” that cannot be crossed without risking conflict increases the chances that either side could take steps that it believes are safe but that turn out to be unexpectedly provocative.

Uncertainty about what could lead either Beijing or Washington to risk war makes a crisis far more likely, since neither side knows when, where, or just how hard it can push without the other side pushing back. This situation bears some resemblance to that of the early Cold War, when it took a number of serious crises for the two sides to feel each other out and learn the rules of the road. But today’s environment might be even more dangerous.

 Foreign Affairs magazineChina’s Real and Present Danger: Now Is the Time for Washington to Worry

My view on the Chinese yuan replacing the dollar is different from the idea the yuan will increasingly become a global reserve currency. China is making lots of progress here, using Hong Kong as its laboratory—dim sum bonds, etc. And this process could move faster than analysts expect. But this progress is very different from the idea of a “flip the switch” replacement of the dollar as world reserve currency, as many scare mongering newsletter writers would like you to believe.  (I, of course, attempt to scare you with other topics.)

When Matt Drudge starts running headlines such as “the dollar is doomed” and the Chinese want a new global reserve currency, as he did today, it should be a flashing yellow light to suggest the dollar is likely near an important bottom. This is not to say it IS the bottom (or THE bottom.) But it means sentiment is becoming very negative. Andsentiment in currency markets is everything and the only thing we need to know in order to make longer-term bets.

From the currency trading bible—The Way of the Dollar, by John Percival, The Tao of the Market:

The key to trading financial markets successfully is to be on the right side of the “big moves”, which are often measured in years. That’s easily said, but to do that we have to be able to locate the start of the big move and also its end. In the currency markets, as with all financial markets, the extremes of the big moves are invariably attended by certain psychological characteristics, reflecting degrees of hope and fear among the players. But the big moves -or underlying trends -are composed of smaller multi- week or multi-month moves. And the extremes of these moves too are marked by the same psychological characteristics or behaviour patterns. So there may be no way of knowing whether a turning point marks a change in the major underlying trend or just a correction which leaves the main trend intact. Moreover, these minor moves are usually made up of smaller multi-week or multi-day moves with similar attributes. And you can go on. Within a single day, you find the same pattern of alternating fluctuation between bullishness* and bearishness* measures in hours and minutes and even seconds.

The mathematician Benoit Mandelbrot coined the word ‘fractal” for this phenomenon of patterns that contain similar patterns within them, some- times ad infinitum. It has also been called “scaling”, because of the way such patterns recur on different scales, up and down the dimension spectrum. The fractal phenomenon seems to lie at the very heart of nature-within the genetic process itself -though one of the first places Mandelbrot saw it was in series of soybean prices.

In all markets, price extremes are usually attended by a consensus that the trend, be it up or down, will continue; and by a peak of speculation in line with the trend. Hence the excruciating paradox of financial markets,that sentiment is most bullish at the peaks when prices have only one way to go which is down; and most bearish at troughs  vice versa: at the top there’s no- one left to buy, and at the bottom n0-0ne left to sell. This paradox is absolutely central to the working of all financial markets and we need all the help we can get to understand it so thoroughly that it becomes part of our nature. The more bullish things are, the more bearish they are.

Bullishness is born as hope in the midst of despair. Hope swells to confidence and confidence swells to euphoria, and the process contains the seed of its own destruction and the birth of its opposite, fear. Fear is nurtured by falling prices and the two feed on themselves until they swell to despair. And so the cycle is completed -and ready to begin again with the birth of hope. This is both the way things are and the way they have to be. We haven’t understood the process until we have grasped that. The despair creates the price trough: the price trough creates the despair. The  price extreme is the definition of the extreme of despair, which is in turn, by definition the moment when hope comes to prevail; hope feeds and is fed by  rising prices until the peak of price and euphoria leave prices with only one way to go, which is down. This circular process underlies every price fluctuation in free markets from the smallest one measured in seconds or minutes to the largest measured in years or decades. So it has always been and so it will always be, because it must be.

The ancient Chinese symbol called T’ai-chi  T’u or “symbol of the ultimate reality”, more commonly known as the  yin yang  symbol, is delightfully appropriate to the way markets are – and uncannily appropriate to the way currency markets are. It is up to each of us to see anything in it we find helpful. This exquisite symbol of the Tao* works at many different levels, in many dimensions.  You choose your own levels and dimensions. We can see the light and the shade as representing opposites like bullishness and bearishness, hope and fear, sympathy and antipathy, consensus  and dissension,  speculation  and prudence,  euphoria  and despair, illumination and benightedness,  yi* and yang*.We can see the thin and thick ends of each tadpole as representing the beginning and end of something; the wax and wane; the birth and death. The light is born out of the pitch of the dark, and the dark out of the fullness of the light: the small circles within each half represent the seed of the other half. The whole is a circle, with no time scale. It can be accomplished in seconds or in years. It goes on and on, round and round, scaling. This is precisely the way of markets and market sentiment. It is the Tao* of markets.

Any time you should find yourself assailed by extreme confidence or despair, remember the T’ai-chi T’u symbol. Or take a look at CB’s [Currency Bulletin] logo, in which the dollar sign becomes the interface between the light and dark.

In securities and commodity markets, you have a cycle of bullishness and bearishness as prices rise and fall; and speculation (and activity) is notably greater at price peaks than at troughs. But in the currency markets, there’s no difference between peaks and troughs. A peak in the dollar is a trough for the pound, DM or whatever, and vice versa. Hope for the dollar equals fear for the other currencies. They are two aspects of the same thing – just as the yin and the yang are two aspects of the same thing (see Glossary).  So, as one would expect, speculation in the currencies tends to be similarly extreme at both peaks and troughs in the dollar.

Expected total return is the value benchmark for currencies. This includes yield differential and appreciation in the currency itself. Recently, the yield spreads across the major pairs have been moving against the US dollar, especially as US rates fall on the “deal” in Washington.

I realize many bank analysts are saying it all makes sense because the slowdown caused by the disagreement in Washington means Fed tapering will be delayed until next year some time.  And of course we all know new Fed Chairman Yellen will be a dove compared to Bernanke. The point is that this IS what we know, or think we know. Therefore, it is likely in the price. But what we don’t know is if the Fed will wait to taper or if Yellen will turn out to be the dove the consensus expects.

And something I find hard to believe is this: going forward benchmark yields in the Eurozone will outpace those in the United States. I think the yield divergence grows in favor of the US, in other words.  And if total return is the currency benchmark, over time the dollar will reassert itself in a big way against the euro.  Will that happen tomorrow?  Who knows—there is a full moon and lunar eclipse tonight; loonier things have happened.

So what is the perfect way to play the dollar in here if you are a speculator, i.e. not short-term trader or long-term investor, and are shooting for high-leveraged gains and believe, as I do, sentiment is turning decidedly dollar negative and the dollar has entered a bull market that will be measured in years?