Please, click here to read this article in pdf format: december-10-2010

This wasn’t a good week for us. We began it in bed, sick, trying at the same time to figure out what was happening in the markets, caught in the midst of a sell-off in Treasuries and stronger US dollar. But, could we be heading towards a stronger USD?

To begin, let’s say that the USD action was triggered by the possibility of seeing the Bush tax cuts extended. There are no details yet but some have ventured to quantify the cost of this by US$200-300bn in increased fiscal deficit in 2011 (refer: “New US fiscal plan rattles the bond market”, Bank of America’s Rates Research, December 8th, 2010) . Loyal to our Austrian school approach, we have no idea nor are interested in venturing what the actual cost will be either in absolute or relative (i.e. % of GDP) terms. As good Austrians, we don’t care about the determination of balances, but about coordination, speculation, also known as human action.

On that note, we understand that all else equal, there will be a higher need by the US government to access the capital markets to finance the revenue that could be collected, if the tax cuts are not extended. We will assume, to be in line with the market’s expectation, that the tax cuts will finally be extended.

Over the past days we have heard and read all sorts of comments on the implications of this. Vox populi dixit that this fiscal move will generate “growth” (Note to the readers: The word “growth” here is used with the meaning assigned by the masses, when they refer to consumption. But growth, indeed, is nothing else than higher productivity). Given this higher “growth”,  the propensity by Helicopter Ben to print more money will decrease, on the margin, strengthening the US dollar. The other popular variation to this reasoning is that Helicopter Ben may not need to print less money but he may start rising rates earlier than what had been priced by the bond market. Hence, the sell off in the long end of the Treasuries’ curve that we witnessed this week (i.e. higher rates, lower prices).

In our view, this reasoning is flawed at best, and idiotic at worst. Not only that: We are angered to hear it coming from people that we know are smart enough not to believe in it. Why? Because it assumes that the US will continue to run a growing fiscal deficit undisturbed, without the need for the Fed to monetize the increased debt levels. Yes, we believe that lower tax rates generate higher fiscal revenue, but only when accompanied by other good policies. However, note that by extending the tax cuts there would be no lower tax rates. There would only be a continuation of the existing ones, in cohabitation with a growing fiscal deficit. If at current deficit levels Helicopter Ben had to pull out QE2…what do you think will be his reaction if the deficit increases? How can the US dollar be stronger then? Because Treasuries’ yields increase?

US yields no longer, in our view, reflect anything. They are being completely manipulated, curve wide, by the Fed. So, when Treasuries sell off, we don’t seek to explain them in terms of changes in expectations vis-à-vis future FOMC’s decisions. We are simple: If the market sells, all we care is that it disagrees with the Fed’s manipulation. If it buys, it agrees. We think we don’t need to look any further than that, given the obscene level of manipulation, which begins with the Fed’s purchases and ends with the absurd regulation called Basel III and its risk weightings scale, which assigns zero risk to sovereign debt.

To be fair, the only time we witnessed a stronger currency and a sovereign bond sell off was in 1995, in Argentina, at the time of the Tequila’s shock (i.e. the Mexican’s debt crisis). However, back then Argentina’s rates jumped under a convertibility system, which meant that the Argentine peso was 100% backed by FX reserves, being totally isolated from the fiscal side of the equation. The situation in the USA is hardly similar to that one. Those who bought the peso back then were wise to do so.

Lastly, a potential source of US dollar strength (or gold weakness) may be provided by the appointment of Congressman Ron Paul, to chair the House Domestic Monetary Policy Subcommittee, overseeing the Fed. We read yesterday’s Bloomberg’s report on a survey that found most American’s wanting to rein in or abolish the Fed. We wish Mr. Paul well on his new role and believe he fully deserves that place. But we also fear that his actions may end up being counterproductive. Mr. Paul or the Tea Party may wish to end the Fed, but they have no alternative plan, let alone clarity on how to unwind it. We will elaborate further on this in future letters.

Martin Sibileau