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“Now Main Street’s whitewashed windows and vacant stores
Seems like there ain’t nobody wants to come down here no more
They’re closing down the textile mill across the railroad tracks
Foreman says these jobs are going boys and they ain’t coming back to your hometown.”

                          Bruce Springsteen

FX Trading – No buyer of last resort is a deflationary train wreck

I was reading George Soros’ criticisms of Germany this morning. If the euro experiment fails, it will be all Germany’s fault, according to Mr. Soros (yeah, okay, sure). It seems Mr. Soros wants Germany to start raising wages and do all it can to boost domestic spending. The old ideas of thrift and hard work be damned—the basic virtues that have led to economic success through the ages should be jettisoned now for all things to be okay. Of course there is a deeper message than just saying party on, but at times it gets lost in translation.

[Note: Mr. Soros can be loony tunes on a lot of issues, as most eccentric billionaires are prone to be because people rarely tell them to open a can of shut-the-hell-up; but Mr. Soros is good on global macro, probably the best there ever was.]

Though I disagree more spending and less thrift is good for what ails us, I do think Soros is right about the consequences of current imbalances in the global economy. It is something the G-20 seems to understand. But there is an increasing probability we are watching one of those slow motion train wrecks, we all know the outcome is bad, but the momentum set in motion is so great there may be no chance of stopping it.

We see three major interrelated drivers—the US consumer is the most concerning now:

1) Everyone wants to export and no one seems to want to import. This is why Mr. Soros is urging Germany to start importing. The reality is, Germany competing with China, and Japan, for the same piece of American pie has inherent flaws — any attempt to change China’s model now will likely lead to less global demand. The US was supposed to play the role of buyer of last resort, as it always has, but I don’t think that will happen this time.

The US consumer will consume less instead of more in the near future because he is losing confidence in his government’s handling of the economy, and just about every darn thing you can imagine, and his own ability to produce wealth; thanks in large part to the incredible ineptitude of his government. [Does anyone see a pattern here besides me?] Therefore Mr. Consumer does exactly what he should under these circumstances—save more and spend less (why private deleveraging will continue and monetary velocity, already in the tank, will likely start falling yet again as the deflationary spiral gains more traction).

Fear Factor Extraordinaire: Monetary Velocity

Yo, Larry! Larry! Keynesian money pumping isn’t working! [Unfortunately given the pathetic state of politics here and everywhere, we will never get a real test of just “letting the market cleanse itself” which requires government getting out of the way.]

And Mr. Soros wants more of this? Sir Karl Popper is rolling in his grave.

Sooner or later the market must cleanse itself for healthy growth to take hold. Money pumping leads to bad sovereign credits and stagnant under-capacity growth. In response, governments tax the private sector more to sustain sovereign credits turned bad because of their spending. You couldn’t make this stuff up if you tried.

2) China: Wrong we have been. But as night follows day, sooner or later China will have to pay the price of suppressing both its interest rates and currency at the same time. By forcing capital into capacity and infrastructure building it has avoided inflation, i.e. robbed its domestic consumer of the money that normally would flow to them and push up domestic prices (forced savings by another name). But without a buyer of last resort, this game is increasingly transparent and all those bad loans will sooner or later bite.

As I said to a friend the other day: we knew the bubble in the Nasdaq would end badly, we just didn’t know when it would end. The same bubble mentality still exists for fund managers and analysts about China. They see the buildings, they see the cranes, and they see the insatiable demand, so therefore it MUST continue to go up. If it were all predicated on healthy market growth, instead of massively intervening to keep the music playing, we would agree; but it isn’t.

You can control your currency, you can control your interest rate, and you can control you inflation rate, but you can’t control all three at the same time, as Mr. Milton Friedman once told us. Yes, the same Mr. Friedman who told us very early on in the game that the euro was yet another train wreck in the making.

3) European monetary system: Domestic German forces in play, I think, will ultimately trump seemingly happy-face Kodak moments the “leaders” of the eurozone have together. This is part and parcel to Mr. Soros’ criticism of Germany. If Mr. US consumer does not take more German goods we will wake one day to the sound of the euro as a single currency being dumped into the ash heap of history, as Germany says no more. It’s incentives to stay in this game are vanishing fast. A real fall in German exports will most likely mean game over!

Hence, here are my guesses under this scenario for the key asset classes we know and love …

Upshot 1: US Stock Market Takes a Major Dirt Nap – I think I see a head-and-shoulders pattern!

Upshot 2: US Long Bonds Continue to Rally – Deflation the driver!

Upshot 3: Crude Oil Tanks: It is a supply/demand thing!

Upshot #4: Gold follows bond prices higher. (A bone thrown to #1 father-in-law!)

Upshot #5: Last but not least—the US dollar goes higher!

Well, that’s it for today ladies and gentlemen. Please realign your portfolios accordingly.