Monday, August 17, 2009 0 comments ++[ CLICK TO COMMENT ]++

Deflation & How safe is it make a contrarian bullish bet on the US$?

I don't usually quote, or indeed follow, Robert Prechter. For those not familiar, he runs a trading advisory firm, Elliott Wave International, which, as the name implies, uses technical analysis based on Elliott Waves. His strategies have little to do with anything I do. However, if I see him in a newspaper article or a video interview on the Internet, I pay attention. The reason is not so much because he is good—he supposedly called the 1987 crash but seems to have a debatable record, with good calls between 2000 and 2002 and poor strategy from 2003 to 2007—but because he is one of the few deflationists out there. He has been considered a perma-bear but, given how he is a trader, he may be trading both ways (without following his trading strategies, I have no idea.)

Other than Robert Prechter, Gary Shilling, and possibly Hugh Hendry, I don't see too many deflationists out there (there are also a few bloggers such as Mike Shedlock.) In the last few months, I had been looking for as many sources on deflation as possible and found an excellent deflation guide by Robert Prechter, largely excerpted from his book, Conquer the Crash. You can read up on his thoughts on deflation at the EWI website, which also contains the 62-page deflation guide (it's free but requires that you sign up with your e-mail.) If you are interested in the deflation case, do check it out. I haven't read his guide fully yet but, if there is one criticism I have, it's how he relies way too much on a comparison to the 30's (I'm in the camp that believes a Japan-style deflation is more likely.)

In an interview on Bloomberg (need to wait 10 or 15 minutes into this video) he speculated that the US$ is starting to get attractive. I had been thinking about the US$ for a while and wondered if it is worth betting on it. I think a US$ investment is more relevant for foreign investors. If you are American, you probably have most of your net worth in US$-denominated assets so you are implicitly long the US$.

Investments Under Deflation

One of the problems with deflation is that your investment options are very limited. This is one of the reasons I haven't really read either Prechter's or Gary Shilling's books yet. I kind of know what they recommend. It basically amounts to owning long-term government bonds or going long the US$ (and possibly the Yen). Short selling is also another viable strategy but I don't think I'm cut out for that.

There is no evidence that deflation is imminent but if my confidence does go up, I had been wondering about a macro bet on deflation. The cleanest bet is the long bond but that may be in bubbly territory if deflation doesn't take hold. But how about just going long the US$. In my case, I was just thinking about converting a lot of money into US$.

Why Do Deflationists Favour the US$?

Some amateur investors don't seem to get why deflationists are bullish on the US$. Well, it's a complicated issue. There are certainly many economic reasons that imply the US$ should actually weaken significantly. For instance, the unsustainably large current account deficit implies that the US$ needs to weaken to make the country more competitive (note that if one thought the current account deficit was sustainable then this isn't an issue; I believe it is unsustainable.)

To cut to the point, deflationists favour the US$ because the world is implicitly short the US$. Yes, it may be hard to believe but most of the world has taken a short position against the US$. What am I talking about?

If I turn really bullish on the US$ and invest in it, I might write about this in detail (need to do more research too), but to put it simply, a lot of the debt in the world is US$-denominated. When the debt needs to be repaid, the debtor needs to find US dollars. Usually this isn't a problem but when there is wealth destruction under deflation (i.e. assets used to back the debt fall), there will be a shortage of US$.

This sounds theoretical but it's not. It is exactly what happened late last year! There was a shortage of US$ because debtors, whose assets were falling, were scrambling to pay off the debt. It was so bad that the Federal Reserve even had to make US$ available to foreign central banks (I'm not a central bank expert but I believe these swaps were undertaken due to a shortage of US$.) If you are interested in this topic, read up on what happened to South Korea, which had a lot of US$-based debt, late last year. I suspect that if the FedRes didn't intervene, South Korea would have imploded.

Another way to think of this is as follows. Let's say you borrow $100 from me and go and buy $100 of land. Under normal conditions, the US$ doesn't enter into the discussion. You have $100 of land that you will liquidate to pay me back in the worst case. Let's say we face deflation and you land price permanently drops to $50. Now what? You still owe me $100 but you can only pay back $50 by liquidating the land. You will basically need $50 from somewhere. Imagine that there are hundreads of thousands like you. If all else were equal, demand for US$ will rise and push up its value.

If your income goes up by $50 (this is equivalent to the GDP growing) then there is no issue. But most, except the really optimistic ones, do not forecast GDP (or incomes) rising. Even those that are optimistc may concede that the incomes are growing for the savers and not the debtors. If my income goes up $50 it doesn't mean much because the problem is with your shortage of $50. So we can rule out the strong GDP saving the debtors scenario, I think.

The only other hope is if the central bank prints $50 and gives it to you. A lot of those who believe in high inflation think this is what will happen. I haven't made up my mind yet but I don't find this scenario very credible. Marc Faber has suggested that the FedRes will continuously intervene at any signs of deflation. I'm not sure about that. The problem with that view is that the "helicopter drop" uses the helicopter the lender.

Consensus Clearly Against the US$

Going long the US$ is clearly against the consensus. The consensus, including the opinion of many value investors such as Warren Buffett, Seth Klarman and David Einhorn, and macro investors such as Jim Rogers and Marc Faber, has been that high inflation is almost certain. I don't think value investors are very good at making macro calls—after all, Buffett may have wrote puts on major stock indexes near potential multi-decade peak—and would listen to macro-oriented investors any day of the week. Jim Rogers has been bearish on the US$ for what seems like an eternity and he is basically a perma-US$-bear. Marc Faber, who I am heavily influenced by, is in the inflation camp and one better have a good idea why he is wrong.

Bullish Bet on US$?

Currencies are almost impossible to call and I don't think I have any skill in judging them. However, there is one tactic one can follow, which is also how I think about currencies.

For a country like the US—developed economy, very low political risk, etc—I am of the opinion that the currency will stay within a range. Currencies can trend down if it is declining but I don't believe USA, contrary to some people's opinion, is in that state yet. The situation also looks bleak near the bottom so one shouldn't let the present influence their views too much.

Also note that I am talking about the US$ index (i.e. US$ against a basket of other currencies.) It is quite possible for the US$ to continuously decline or appreciate against a single currency for a long time. Similarly, the US$ can decline against some hard assets in the long run (since modern economics calls for currency to be printed close to the GDP growth rate.)

I think the US$ is sort of like how the Canadian dollar was in the 90's. The C$ declined in the 90's due to rising government debt, lack of interest by foreign investors, and so on. Many thought the C$ would continually decline against the US$. Yet they were all wrong. Due to various reasons, including a boom in commodities (Canada exports a lot of commodities) and better fiscal management by the federal government (Canada eliminated the deficit although the debt is still high), the C$ has rallied in the last decade. I think the US$ will behave like that. That is, the country will get itself in order, the currency will decline against rising economic powers (Latin America and Asia) but will probably strengthen against most of the world (including Europe).

Very Contrarian
The fact that so many people are bearish on the US$ (i.e. are in the high inflation camp) likely means that the US$ is "cheap"—note that this is a subjective opinion (you can prove it.) This doesn't mean that you can't lose money—anyone that invested in a value trap that was "clearly cheap" knows how you can lose a fortune. But it does mean that the downside is probably quite low.

Indeed, if you look at the 25 year US$ index chart, you'll note that it is at a 25-year (and possibly 40 or 50 year low):

Now, the whole notion of a "low" only matters if you believe in reversion to the mean (which I believe in.) If you didn't believe in reversion of any sort, then there is no such thing as a low. The US$ index value can keep falling forever.

That chart looks attractive to me. Is it time to bet on it? Something I'm thinking about. A sizeable chunk of my portfolio is in US$ but wonder if I should convert more. Note that, even if I bet heavily on the US$ with my portfolio, it isn't very concentrated because my income is in C$.

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