August 28, 2003

Dollar Overcapacity

In the Setpember issue of Strategic Investment (which by the way you'll be able to get online today) I write about "Dollar Disinvestment." It's the idea that sooner or later, there will be so many dollars in the world, and so much government, corporate, and consumer debt, that ivnestors, especially foreigners, will no longer want to own dollars. Exhibit A: here, in black and white terms: "Treasury prices extended early losses on Wednesday after an auction of new two-year paper drew only tepid demand at a time when the supply of government debt is ballooning." Supply doesn't always create its own demand. This is debt/dollar overcapacity. And it's going to affect the ability of the U.S. government to finance its debt and its wars. Reueters reports that "The $25 billion of notes fetched a yield of 2.04 percent having steadily climbed from 1.97 percent in when-issued trading this morning. The sale drew bids for only 1.73 times the amount on offer, just below the 1.80 average of the last three auctions." And there's this revealing quote from Michael Cloherty at CSFB, "It looks like foreign central banks were reluctant to show up for this sale." There will be a lot more reluctance in the future if the the Congressional Budget Office figures on the Federal deficit are right. CBO now projects a $400 billion for this year. That's $150 billion more than before the war in Iraq. CBO says over the next 10-years the deficit could reach $1.4 trillion. And this does not include the $400 billion required to pay for the new Medicare prescription drug benefit. Nor does it include the billions more the President is about to ask Congress for to help rebuild Iraq. The President's own man in Iraq, Paul Bremer, says the Iraqi reconstruction could cost as much as $100 billion by the time it's all done. (not bad news if your'e Bechtel, which had its contract for Iraqi reconsruction almost doubled yesterday by $350 million dollars.) But how are bonds and the dollar reacting to the higher deficits and the lukewarm treasury auction? Take a look at a 3-month chart, courtesy of, that shows falling bond prices on the two indexes that I use to trade government bonds. IEF is Lehman's 7-10 year bond index. TLT is its 20-year bond index. Obviously, bond prices are falling. I WAS looking for a rally. But once real dollar disinvestment begins, there's no telling how far prices could fall, or how high yields could rise. What about the dollar? The dollar is up to about $1.08 against the euro in early trading this morning in London. U.S. GDP numbers come out today. And the market expects them to be better than previous estimates. This is just how the bulls envision it: superior economic growth in the U.S. supports the dollar and the stock market. And it's true, the dollar is up about 9% from its May 27 low of $1.19 against the euro. Yet two obvious facts are ignored in the press reports. First, a stronger dollar makes the current account deficit worse. It makes American goods more expensive...and cuts any expansion off at the knees. Over time, this is bad for the dollar, not good. Second, and more importantly, it would take a much higher level of economic growth to escape the drag of a growing Federal deficit. What we have here is a giant game of risk assessment. I'll write more on this later today. If you choose to own dollars now (buy U.S. bonds or stocks), you're betting that higher U.S. growth will make the dollar more appealing than the euro, the yen, or gold. But your risk is that the growth isn't real economic growth. Your risk is that today's higher GDP numbers are caused by the tax cuts and government spending. Will this "stimulus" be enough to actually create new economic growth, to pare the unemployment roles, to reverse the outsourcing of blue and white collar jobs, and erase the $32 trillion in aggreage U.S. debt? I think not. IMMEDIATE INVESTMENT IMPLICATION: LOOK FOR FALLING BOND PRICES TODAY, A MODEST RISE IN STOCKS, BUT WEAKNESS IN THE DOLLAR AND STRENGTH IN GOLD. TRADERS COULD BUY PUTS ON TLT AND IEF.


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