The Anatomy of an International Monetary Regime

August 23, 1999

It was not a whole lot of fun but we are, nonetheless, happy to have another option expiration week behind us. For the week, the Dow gained 127 points, or just over 1%. The S&P500 also rose 1% this week, with the Morgan Stanley Consumer index and the Utilities adding 2%. The Morgan Stanley Cyclical index was largely unchanged and the Transports actually posted a small decline for the week. The small caps were unimpressive, with the Russell 2000 unchanged this week. Trading was particularly sporadic in the technology area with some losers and some big gainers. The NASDAQ 100 ended the week with about a ½% decline, while the Morgan Stanley High Tech index was unchanged and the Semiconductors, despite today's strong gains, dropped almost 4% this week. The Internets had a strong week with The Internet index gaining 5%, raising 1999 gains to 37%. The financials also gained with the S&P Bank index rising 2% and the Bloomberg Wall Street index posting a 4% advance. The financial sector was certainly boosted by a resilient bond market that was able to brush off some particularly unbullish news. Spreads generally widened, particularly late in the week with the weakness in the dollar.

Actually, it was another very interesting week for macroeconomic analysis. Early in the week, July housing starts posted an increase of 5.7% from June, a much stronger than expected number and convincing evidence that the nation's housing market remains red-hot. Single family starts actually rose 22.7% in the key Western region. The president of the National Association of Home Builders was quoted as saying that builders are expecting some slackening of demand down the road, but "for now, however, builders may still be catching up on projects delayed by shortages of key materials and skilled labor." Additionally, this week two surveys of retail sales, one from Mitsubishi and the other from LJR Redbook, reported stronger than expected retail sales. Also, the four-week average of first-time jobless claims declined to the lowest level in more than 25 years and yesterday's Philadelphia Business Outlook Survey was stronger than expected. Notably, the new orders index increased sharply to 19.8 versus 5.2 in June. Shipments rose to 18.8 from 11.9. These reports all reflect an economy racing along on overheated demand. Yet, they pale in importance compared to yesterday's gargantuan trade deficit.

With the consensus estimating about $20.5 billion, June's actual trade deficit widened to a record $24.6 billion. For comparison, the deficit was $13.84 billion last June and $7.53 billion in June of 1997. Imports rose by 3.9% from May to $102.992 billion. For the first half of the year, imports have totaled $585 billion. Over this same period the accumulated deficit totaled $118 billion, 57% greater than last year's first half. And following yet another in a series of much worse than expected trade reports, there was what has become a monthly ritual of explanations from the bull camp as to why the trade deficit is not important. Commentators who should know better continue to claim that the deficit is related to the strong desire by foreigners to invest in US securities markets. Well, this is pretty silly analysis as the overriding explanation for the alarming deterioration in the US trade position is massive imports to satisfy the historic American consumption binge.

This binge becomes glaringly obvious if one digs a bit into the data. Looking at year-over-year US imports by country, we increased purchases from our two largest trading partners, Canada and Mexico, by a stunning 19.2% and 19.9%. Imports from Western Europe increased almost 12%. Stoked by strong luxury auto shipments, imports from Germany rose 19%. Imports increased more than 10% from many European countries, including our major trading partners, Italy and the UK. Year-over-year imports also increased about 12% from both the Pacific Rim and Latin America, while skyrocketing 29% from Korea. There is also an increasingly ugly trend developing in our trade position with OPEC. Here imports increased almost 24% from last year, as the price of crude increased more than $3 per barrel and volume rose 8%. Yet, prices in June were less than $15 per barrel, considerably below current prices.

Our country's quietly deteriorating oil import situation highlights what we believe to be an unappreciated structural problem for our economy and, inevitably, our financial markets. Now dependent on imports for more than 50% of oil consumption, we will have little alternative going forward than to pay whatever price the oil market commands. And if the dollar continues to weaken and import prices rise, there is considerable potential for this to develop into an intractable trade deficit problem with devastating ramifications for the dollar. This is particularly the case now that our country's manufacturing base has been so gutted over the past decade. As such, we have unfortunately in many ways lost control of our own destiny, as we rely heavily both on imports to sustain our standard of living and foreign security purchases to support our financial markets. The bullish perspective simply does not appreciate this profound and disheartening development.

Over the past few years, in this most extraordinary global financial and economic environment, many growing structural deficiencies here at home have been masked by the considerable benefits that accrued from a strong dollar and collapsing global prices for a vast array of goods and commodities. And, importantly, this was the driving force behind a favorable inflationary environment in the face of unprecedented domestic inflationary credit excesses. As such, we see all the praise afforded the Federal Reserve as incredibly misplaced. Now, however, the environment is changing with prices no longer declining generally and bullish perceptions of the dollar waning quickly. In our view, the sharply rising prices of oil and many other commodities is not unrelated to the increasing flood of dollars internationally. Moreover, with the dollar's recent weakness, it will only take more dollars to pay for the monthly mountain of imports we consume. Keep in mind, our imports this year will total about $1.2 trillion, a simply staggering number. So, any reversal in the general pricing environment for imports would inarguably play a significant role in pricing pressures for our economy as a whole, whether government statisticians see it this way or not. And, of course, if higher inflation leads to higher interest rates, faltering financial asset prices and a weaker dollar, it does not take much of an imagination to see how this could develop into a "vicious spiral." And while we still lean towards a bursting of the US bubble as a major impending deflationary event, we will keep an open mind as we watch this all unfold. All the same, we just don't think one can overstate the key role the dollar will play for both our financial markets and economy. One thing to keep in mind, while the bulls hold a view that the Fed can fix any problem that develops by simply adding liquidity and "printing money," we see the dollar as being the spoiler. Future dollar instability will discipline our out of control credit system.

Importantly, after months of ignoring the deteriorating trade situation, markets now care about trade deficits and the dollar. This is a crucial development. Yesterday, after the release of the disappointing trade report the dollar was hit hard, particularly against the Euro and Swiss Franc. The dollar/yen also traded below 111, down 12% from its high in May. As we have explained before, the leveraged speculating community has been hurt playing the "yen carry trade." Foreign investors have suffered significant losses as well. Japanese investors, in particular, have been stung with a major decline in the dollar together with a substantial fall in US fixed-income securities prices. Apparently, they had become major buyers of agency securities, particularly the big liquid issues from Fannie Mae and Freddie Mac. Supposedly, they reacted to the break in the dollar by becoming sellers of these securities over the past month. This certainly helps to explain the close correlation between the dollar/yen and swap spreads. As foreigners have rushed to sell agency debt instruments, securities firms were apparently major buyers. But as the dollar continued to weaken and liquidity began to falter in US credit markets, it appears that many holders of agency paper were forced to hedge exposure in the swaps market. This, however, only exacerbated the unfolding derivative problem and led to the widest swap spreads in years. We mention this as we believe it makes an important point as to the now very tight link between the dollar and the stability of our financial system.

We have mentioned before our analysis that questions the ease with which future dollar surpluses, emanating from our massive trade deficits, will be "recycled" back to US financial markets. Earlier this decade our large trade deficits were absorbed largely by Asian central banks that then bought Treasuries. This was part of the SE Asian boom and bust and now foreign central bankers are no longer significant buyers of US Treasuries. The leveraged speculating community also became a major force "recycling" our growing trade deficits back to US security markets, particularly through "yen carry trade" operations. Well, we think last fall's crisis was a key inflection point that largely ended this mechanism for getting surplus dollars back home to our financial markets. And then last year, Fannie Mae and Freddie Mac began borrowing aggressively from foreign investors, particularly in Asia. This was key as it accomplished two important factors, it recycled dollars back to fuel US markets while also allowing Fannie and Freddie to aggressively expand their mortgage portfolios and fuel the US bubble. We sense now, however, that this "recycling" mechanism is also faltering. With the substantial losses suffered with higher US interest rates, a weak dollar, and widening spreads for agency securities, we see foreign investors now much less willing buyers of these securities. They will likely buy fewer securities and, at the same time, demand higher interest rates to compensate for higher perceived risk. This, importantly, could prove a major inflection point for Fannie Mae and Freddie Mac, key players in the US bubble. Remember, last year they increased their holdings of mortgages and other assets by $220 billion, buying securities particularly aggressively during last fall's financial turmoil. As we have said before, Fannie and Freddie's aggressive measures played a profound role in providing liquidity to our financial markets which fueled an incredible stock market advance and today's overheated economy.

Interestingly, we see that Fannie and Freddie, in combination, cut back their purchases of mortgages sharply in July. We can only speculate that with interest rates rising and the spreads on their debt issues widening sharply, they saw it as prudent to temper their aggressiveness. We will also presume that this pullback in purchases by these powerful agencies was not unrelated to the dramatic widening of mortgage-backed security spreads during July. Furthermore, the faltering mortgage securities market then likely caused widening swap spreads as the leveraged players moved to hedge their exposure to mortgage paper and other debt instruments. So, our analysis is that a faltering dollar was the key for precipitating higher rates, wider spreads and general dislocation in the interest rate derivative arena. And, importantly, we believe that this episode has been a catalyst in turning perceptions against the dollar, and quite likely US financial assets generally, as it has exposed the acute frailty of the dollar and US credit system, generally.

Going forward, the dollar is key. If the dollar continues to weaken, we expect only further pressure on the credit markets and greater dislocation in the derivative area. Tuesday we have the Fed meeting and they are likely to raise rates. At the same time, we have little doubt that officials are watching developments closely and are certainly in "crisis management mode." With this in mind, we expect a particularly volatile week. The bulls did successfully get through another option period, but come Monday it could be a new ballgame. Certainly, with the way fundamentals are developing we don't see how the stock market can continue to ignore what is clearly a dramatic turn against the bull case, especially if the dollar continues to weaken.

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.

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