Editor's Note: This is the 11th Installment of an Ongoing Series Highlighting the Global Investing Outlook for 2008.
By Martin Hutchinson Contributing Editor
The dollar has dropped a long way since 2002 - by about 45% from its peak against the euro, for example. Yet even though holidays in Paris have been priced out of reach for all those without a Wall Street MBA or residual dot-com fortune, the U.S. trade deficit remains huge, at more than $700 billion annually, and is shrinking ever so slowly. For investors, which way the dollar travels this year is the crucial question in determining how to invest, and whether we'll end the year richer or poorer.
Predicting how currencies will perform is pretty much a mug's game: They're volatile, fluctuate all over the place, and the moment you finally believe a solid trend is under way, it reverses itself and eviscerates your investment portfolio.
Conversely, the moment when you believe that economic conditions have changed - so that a surging or tumbling currency will finally move back into equilibrium - is the moment when the original trend resumes with a renewed ferocity.
In short, you can make money on currency fluctuations - but only if you're Citigroup Inc. (C) or Goldman Sachs Group Inc. (GS), and have the decided advantage of watching a substantial portion of the world's currency transactions flow across your desk.
Every now and then, however, one of the world's central banks does something so spectacularly stupid that it enables you to predict the future with some degree of certainty. And that may have happened the week before Christmas.
The perpetrator was the European Central Bank. Worried about the major international banks' continued lack of confidence in one another - as reflected in the premium between the London Interbank Offered Rate (LIBOR) and the yield on short-term Treasury bills - the ECB decided to throw money at the problem.
Once it decided to do this, the ECB didn't mess around; within 24 hours it had lent no less than $500 billion to the major international banks, utilizing maturities that generally ranged into the middle of this month. Not to miss out on this fabulous opportunity to mess up the worldwide financial system, the U.S. Federal Reserve chipped in $40 billion of its own. In the short term, this worked well: The LIBOR benchmark dropped by more than half a percentage point - a huge move in that market - and everybody went home for the holidays happy. No chance of a year-end financial squeeze, so no emergency phone-calls for ECB Chairman Jean-Claude Trichet, waking him from his post-Christmas-goose snooze, or interrupting his light Noel supper of Pâté de foie gras, washed down with a little Chateau d'Yquem!
If we knew the world was going to end before Jan. 15 [ostensibly, next Tuesday], this would have been a brilliant move to make. Unfortunately, the reality is that thanks to those moves, the ECB and the Fed have returned from the holidays with a major problem on their hands. With $500 billion of short-term loans to the banking system maturing in the middle part of this month, the banks will touch off a massive liquidity squeeze if they try to repay these liabilities all at once. Hence, the two central banks will roll the loans over. European taxpayers will ultimately find themselves on the hook for $500 billion worth of questionable bank paper. What's more, the banks will use that paper to finance some even-more-questionable securitization vehicles, most of which hold U.S. subprime mortgages that have very little real value at all.
Since the primary aim of the ECB - like other central banks - is to keep from having to face parliamentary committees interrogations, during which the central bankers are asked rude questions about how they were able to lose half a billion dollars of taxpayer funds, Europe's central bank has itself a problem.
The only solution to that problem will be inflation. Lots of inflation. Indeed, if inflation could reach 10% by the end of this year, it would increase the value of housing and other "real" assets, propping up the value of housing-related debt and rescuing the ECB's funding to the world banking system.
Fortunately for the ECB, the $500 billion it has just injected into the banking system is more than half a year's growth in the Eurozone M2 money supply, even though that measure of the money supply is already advancing at better than 11% a year - about twice the growth rate of the Eurozone's Gross Domestic Product (GDP). So supporting a higher inflation rate won't be a problem.
Normally, you'd expect the inflation to be concentrated chiefly in the Eurozone, because that's where the money creation came from. That wouldn't do the ECB a lot of good, because it's not Eurozone housing that's the problem. It would also mean you could expect the euro to fall and the dollar to rise.
However, here's where it gets clever [don't ever forget that a key ancillary aim of a supremely educated French banker like the ECB's Trichet is to make the English-speaking countries look silly, while boosting the position of La Belle France]. Both the United States and Britain are running huge balance-of-payments deficits. These have to be financed by foreign money inflows - in the U.S. market, mostly by having foreign investors buy U.S. Treasury bonds. However, in monetary terms, having foreigners buy T-bonds has exactly the same effect as the central bank buying T-bonds; it inflates the money supply even as it leads to higher economic output and rising inflation.
Hence, most of the ECB's $500 billion won't stay in Europe. It will flow into U.S. T-bonds and British gilts. Even though the ECB has caused the inflation, Britain and the United States will be the primary recipients, and will therefore endure most of the suffering. The inflation will cause the British pound and the U.S. dollar to drop in value against the euro - and increase British and U.S. housing prices, the decline of which represents the main danger to the ECB's $500 billion.
Damn clever, these Frenchmen. Trichet's real joy will come about near the conclusion of this year, when he'll be able to give pained lectures about the irresponsibility of the British and U.S. central banks, while at the same time detailing the superior management strategies of his own institution. Clever indeed.
So what's the bottom line for the U.S. dollar? Over the next 12 months, expect for the greenback to continue its decline. Along with that, expect lots more inflation in the U.S. economy. Energy and commodity prices will go on rising, but at least U.S. housing prices may not fall as far as they otherwise might have.
Of course, none of this happens in a vacuum. Partly as a result of what investors will see inside U.S. borders, expect that China and India will also see worsening inflation, because it's already rising quickly in both those developing markets, and because both nations have primitive monetary systems without the tools they need to quell it easily.
What to buy? Well, it's obvious, isn't it? Don't buy foreign currencies; they're all going to hell - it's just that the dollar will get there first. Here are the moves to consider:
Editor's Note: Money Morning's "Outlook 2008" series last covered Latin America. Next up: Housing.
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