Investment Roadmap: Currencies

With all this turmoil, maybe we buy gold?  Oh boy.  Gold is said to be a safe haven, and it is during inflation.  It went from $35/oz in 1968 to $800/oz in 1980.  But it is not at other times, and it is unlikely to be right to buy, yet. So how to play currencies?

In every past credit bubble, what followed was a deflationary depression.  Deflation is the opposite of inflation. In deflation, fewer Dollars chase too many goods, and the value of the Dollar rises (prices fall, and the Dollar buys more).  In inflation, too many Dollars chase too few goods, and the Dollar drops (prices rise, and the Dollar buys less).   Despite all the efforts of first Greenspan and now Bernanke to reflate the currency and prevent deflation, it has arrived.  A clear drop in prices has hit the UK, the US, and even China.  (China reported a 6% growth rate in Q1, but much of that was due to deflation; nominal growth was only 3.5%.  In inflation, you subtract the inflation rate to get to real growth rates; in deflation, you add the deflation rate to get to real growth.) 

A depression is not just different in degree to a recession, it is different in kind.  It comes after a credit bubble, where credit or debt was used to borrow from the future, and in effect "pull forward" future demand.  In our case, we used houses as ATM machines, withdrew money and bought goodies like SUVs and HDTVs.  The credit bubble fools the market.  Too many houses get built; too many retail stores; too many auto plants; too many HDTV factories.  The bigger the bubble, the farther out the demand has been pulled forward.  When the bubble bursts, it is simply not possible to make up the future demand in one fell swoop with government stimulus or more credit.  Those extra houses and stores and car plants should not have built until years forward in the future.  They end up being bulldozed, abandoned and shuttered. 

The size of this bubble is shocking.  We added $24T in debt in 5 years for a meager $10T in cumulative GDP growth.  Our total debt, private and public, is $52T, and is supported by around $2T of "money" for a 26:1 leverage ratio.  That $52T will be heavily written off, and will be written off faster than Bernanke or Obama can replace.  The collapse of that debt causes deflation.

A simple comparison. 

• In a normal circumstance, people borrow against rising earnings.  Much of the growth of an economy comes from 20somethings entering the workforce and buying their "firsts": first car, first house, first furniture, first appliances.  They lack savings but anticipate growing wages, so they borrow against future earnings.  When a recession hits, they cut back on discretionary spending but continue to cover their debt payments. 
• In a credit bubble, people instead borrow against rising assets (stocks, houses).  They buy more than their firsts; they buy second cars, new HDTVs, and so forth.  When the credit bubble bursts, they are caught, since they borrowed ahead of their earnings.  They have to liquidate assets (again, stocks and houses) to cover the debt.  Often the assets drop below debt, and do not cover the debt.  The delta has to be written off.

When debt is repaid out of earnings, money changes hands.  When debt is written off due to assets dropping, it disappears.  In 1929, people were able to buy stocks with 10% down and 90% margin.  When the stock dropped more than 10%, the margin could be called.  As the stock market collapsed, rather than pay down the margin people abandoned stocks.  When they got sold at 50% lower, the 10% equity was lost and the margin of 40% was lost.  It didn't change hands; it disappeared.

This is why a deflationary period follows a credit bubble, and why a depression is different in kind than a recession.  In a depression, debt is written off, and money (in the form of credit) simply evaporates from the system.  The destruction of credit money can dwarf the money supply; in our case, a writeoff of a mere $2T of the $52T debt is more than the whole extant supply of money in the form of currency and checking accounts. 

The destruction of credit has already started - the so-called 'deleveraging' in the economy.  It will accelerate as the real housing crisis hits - the potential $2.5T in the next wave of losses.  It includes the huge losses GM and Chrysler bondholders are soon to suffer, and the even larger losses that will follow a major money center bank cratering. 

The Fed will be proven unable to stop deflation.  Bernanke has tried so many ways to push credit on the market, and to push money out there, but it is not moving.  The credit markets remain largely frozen.  All I can say is Bernanke is a fool and the people are smart.  They know they have to cut back and save again; they can no longer live beyond their means.  They won't take the credit.  Hedge funds won't lever up.  Companies will cut their debt levels.  And so forth all across the food chain.  The Fed is pushing on a wet noodle.

Bottom line: the bet to make right now is deflation, which will drive UP the value of the Dollar.  As deflation ebbs, the excesses of Bernanke and Obama may come back to bite, especially if he continues his new Operation Twist and prints money, helicoptering it into the economy.  There is a risk of a bout of hyper-inflation after deflation. That is the time to dump the US Peso and buy gold, as well as certain other currencies, especially those that do well when commodities do well (Australian Dollar, Canadian Dollar, NZ Dollar are examples).

Comments

[da bear]

the key question here is when to load up on gold. i think it is a good idea to have some on hand now, as the dollar might buckle soon, and you have it and don't have to worry about how to get it later.

i would say that after the Big Wave 3 down that EWI is talking about is completed then it would be the time to go heavily into gold.

da bear