RCM Editorial: The Ramifications of Increasing US$ Weakness

RCM Comment: The US$ is breaking down again today and has taken out key support. I continue to write about this weakness because the ramifications of the continued demise of the US$ are far reaching. Allow me to list a few thoughts to keep in mind while we watch the US$ developments:

Weakness in the US$ goes hand in hand with an eventual rise in rates/fall in prices of US treasury bonds. A rise in rates is contrary to what the Fed wants and detrimental to the recovery process.

The Fed has pledged to buy $300 billion of US treasury debt. Since this announcement the US$ has weakened substantially as we predicted. The purpose of this buying spree is to keep rates down. However, printing the fresh $300 billion weakens the US$ in turn pushing up rates. I fear the Fed is caught in a vicious cycle.

This cycle has accelerated the desire of our key trading partners to diversify out of the US$ as discussed in the Brazil/China story below. This diversification is like a body of warm water that fuels a hurricane. Stories of diversification take the vicious cycle and turn it into a named storm.

In a strange twist, often weakening currency leads to rallying equity prices for a time as the investing public realizes that holding cash is counter productive. This equity rally does not mean "green shoots" are forming and is not sustainable long term. Trade the rally? Yes. Buy and hold it? No.

This behavior also leads to a rally in commodity prices, which results in a blowout of inflation. This is the sector to establish longer term holdings for a more significant move. Pay no attention to the talking heads who blather on about impending deflation. They are simply missing the big picture and are stuck in a quagmire of minutia. Inflation is a currency event not an economic event. Example: For weeks now these self-proclaimed "pundits" pound the table screaming that the world is awash with oil. They point to "huge" inventory numbers each week and argue that oil should be trading in the low $40s. However, much to their chagrin, oil continues to roll ahead and trades today over $61. Are they wrong about the inventory numbers? No, but it is oil's relationship with the US$ that is driving prices and this fact they either can't see or choose to ignore.

We need to watch for signs that this named storm, let's call it Ben, is picking up speed and act accordingly to protect our assets. The Privateer reports: "As of May 7, US Treasury 30-year bonds had lost investors 20.9 percent in 2009 according to Merrill Lynch & Co indexes, as the Treasury increases security sales to help fund a swelling budget deficit. The world is now paying more on US Treasury credit default swaps than McDonald’s does on its borrowings." This fact raises the level from tropical storm strength to category 1. The best weapon to protect our assets - the storm shutter to the window of our portfolio - is gold. Please hold on to the bar.

Brazil and China eye plan to axe dollar - Financial Times
Financial Times reports Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil's central bank and aides to Luiz Inacio Lula da Silva, Brazil's president. The move follows recent Chinese challenges to the status of the dollar as the world's leading international currency. An official at Brazil's central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil. "Currency swaps are not necessarily trade related," the official said. "The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi." Henrique Meirelles and Zhou Xiaochuan, governors of the two countries' central banks, were expected to meet soon to discuss the matter, the official said.

Fleckenstein on China / Brazil development:

For Silva and Hu, an FX "I Do"
The dollar declined about 0.75% -- though even more trouble is brewing for our green paper. For those who don't know, Presidents Luiz Inacio Lula da Silva of Brazil and Hu Jintao of China are meeting this week in Beijing. According to several news accounts, unnamed sources stated that the talks are not about currency swaps (as we've seen between China and other central banks). Supposedly, China and Brazil are in the early stages of considering an arrangement whereby China would be able to buy Brazilian goods with renminbi (yuan) and Brazil would be able to buy Chinese goods with the real.

If that comes about, it would be the first move towards a floating renminbi -- and thus, a very big "small" step indeed. Because if China is ready to float the renminbi in any way, shape or form, that will further confirm that the Chinese are in the process of turning their back on the dollar, despite their official protestations to the contrary. But in fact, China needs to have it both ways -- i.e., jawbone us to not do anything foolish (which everyone knows we're doing and will continue to do), while attempting to figure a way out for themselves. So, this is a development worth keeping our eye on.