Hope is Not a Strategy

The January 19^th, 2009, Barron’s weekly magazine had two lead articles that are must reads for traders and strategists. They had the second installment of their Roundtable and their cover story is an article with their recommendations to the incoming president titled Spend Wisely. The economics editor, Gene Epstein, says in that article “Let us hope, however; that advocates of Obama’s plan prove right, and that the short- and long-term dangers linked to the nation’s debt prove to be manageable.” In a sentence Epstein summed the risks to traders, investors, and strategists for the coming year. Smart money already has framed the risk themes for 2009 and the underlying data points. So how have they framed it and what might this mean to U.S. strategy and to your money?

Data Points

2009 begins with variations on the themes from 2008. Those themes are energy, debt, and the dollar. I pick those as the bottom lines because that is where the current data points drive us. Last year we saw an inverse relationship between oil and the dollar as some people used oil as an asset class to itself. When the oil bubble unwound the dollar rose against most every currency except the Yen. The Yen and Treasuries seemed to be the only places investors could flee to sit out the de-leveraging of corporate and bank debt. Yet the dollar’s survival as the reserve currency still leaves us uncertain of its future and the future of United States’ financial health because of the rickety structure upon which it sets. Let’s look at the dollar first.

If Barron’s numbers are right there is cause for concern. In Spend Wisely Epstein says of U.S. Government debt, “The main concern: Much of the soaring debt is owned by foreigners. The share of outstanding U.S. Treasury paper held by foreigners jumped to 49.3% last year, from 31% in 2000, and appears to be heading higher. What happens if investors outside the U.S. stop buying our debt and instead start dumping some of their holdings?” This is that rickety structure for the dollar, and anybody with skin in the game should take note.

The specific risk here is most likely inflation. Bill Gross is the founder and co-chief investment officer of Pimco, a company known for their expertise in bonds. Pimco manages a great deal of money and they know the risks of inflation. In the Barron’s Roundtable Mr. Gross sums the risks to the dollar and Treasuries by explaining how governments default on their debt. “They default by inflation. They default by devaluation, and, yes sometimes they default and don’t pay their coupons.” Mr. Gross doesn’t believe the U.S. will default by failing to pay their creditors hence the strength of the dollar and inflation are the threats. Moreover the dollar is increasingly under the influence of its creditors and now almost half of those are foreigners. Mr. Gross also believes that the U.S. cannot abuse its advantage of being the reserve currency much longer. He says “If asset reflation works and the real U.S. economy kicks back into gear, the dollar can hang on. If it doesn’t work it’s a new ball game.” Sic. I take Mr. Gross’s opinion on this more seriously than I do, let’s say, German ministers because Mr. Gross is managing the risks of billions of dollars each day, and his company has a daily and quarterly deliverable to its clients. The rest of the Panel’s take on the dollar is that it survives as the reserve currency only because no other currency is strong enough to challenge it. The primary reason for this is because European banks have less equity capital than U.S. banks, and the Chinese and Japanese also are not financially fit enought to challenge the greenback.

Why should you care? Because U.S. policy is now increasingly beholden to foreigners. In 1956-57 Great Brittan and the U.S. were at odds over policy concerning the Suez Canal. In fact British military forces were engaged in military operations in the Suez region and political pressure from the U.S. via the United Nations had failed to obtain concessions from the British. It was Eisenhower's threat to sell U.S. holdings of British Sterling and British bonds that ultimately forced the British to concede. It is simply the Golden Rule in action. He who holds the gold makes the rules.

Tomorrow we continue with the debt theme and we will work our way towards what this all means to U.S. policy and your money.