Tragedy or Mystery or Both?

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The story in the financial markets had changed from a tragedy to a mystery. The collapsing dollar should have brought down prices of the assets it measures — most notably, the prices of U.S. bonds, which are extremely sensitive to changes in interest rates or currency movement. There are about $10 trillion of U.S. dollar assets in foreign hands. Yet, bonds have not gone down — at least in dollar terms, which leads us to pose the Ten Trillion Dollar Question: Why not?

We will not remind you of poor Mr. Asakawa. You’ve already heard enough about him. But how many times have people like him — with, collectively, trillions of dollars’ worth of assets — almost reached for the phone? How many strangers overseas have wondered if they shouldn’t say “SELL EVERYTHING” before losing more money on the currency exchange markets?

And yet, they have not picked up the phone. They have not sold. Bonds, which would be the first things to be sold, have held their value…or actually risen. Meanwhile, on the very same page, where the health of the bond market is reported, is an article assuring us that almost every sentient analyst and expert anywhere in the solar system now expects the dollar to fall more! “Prospects are grim for the dollar,” says the International Herald Tribune headline.

The scene might be from an Italian movie from the ’60s; “surreal” might reviewers describe it: Dollar holders see the train coming. (They have subscriptions to the IHT too!) But they continue enjoying their picnic — right in the middle of the tracks

• And so the plot thickens….

“I read your book,” said an attractive woman at a New Year’s Eve party. “But you seem to be wrong; the world doesn’t seem to be headed towards a Japanese-style slide. U.S. stocks rose, slightly, in 2004.”

“Well,” we replied, trying to sound as if we had figured something out, “U.S. stocks rose in dollar terms. But the dollar fell so much that, when measured by foreign currencies or gold, the Dow actually went down.”

The tale we told in our book was that the U.S. economy seemed to be tracking Japan — with a 10-year lag. We couldn’t think of any particular reason why this should be so, except that the Japanese story itself was a classic. Markets boomed…and then bubbled up to absurd levels. When the crack came, people didn’t believe it was possible that the Japanese miracle economy could go down. And for several years, it looked as though Japan, Inc. had suffered only a setback. But by the mid-’90s Japan was sinking. Asset prices were collapsing. Consumer prices fell. The credit expansion that had made Japan such an extraordinary success story in the ’80s turned into a credit contraction, which made Japan into an extraordinary failure story in the ’90s.

If America were to follow the same pattern, its stocks and real estate would have to fall too. Note, we do not include bonds. Because a credit contraction typically wipes out poor quality bonds, but it favors credits of good quality, such as government issues. Interest rates typically fall during a contraction, which tends to hold up prices of Treasury bonds. Stocks, real estate and other assets usually go down, as people’s cheerful expectations from the bubble period give way to dark foreboding.

The mysterious element is the dollar. Japan was deeply in debt at the beginning of the ’90s — but to its own citizens. The country had a positive trade balance and trillions in savings. There was no need to devalue the yen.

The dollar, by contrast, is vulnerable. Americans save little. They depend on foreign lenders in order to maintain current living standards. Each day, the pressure on the dollar grows by $2 billion; it almost has to go down. And since it has to go down, it provides an opportunity for deceit; Americans can now grow poorer without realizing it. Last year, U.S. asset holders — principally Americans — lost between $4 trillion and $8 trillion, when their assets were measured in euros.

So, there we have a soupcon of how the Great Mystery might resolve itself. Why has the bond market not sold off with the dollar? The answer, we think, is because we ARE still tracking Japan…not perfectly…but appropriately. The U.S. economy is sinking into a long, slow, soft slump — where long-term interest rates will not go up…and good-quality bonds will not go down, at least, not in dollar terms

If we are right, the great U.S.-dollar credit boom must be followed not by inflation…not by growth…not by a new boom…but by a great U.S. dollar credit bust. Marginal credits — such as junk bonds, expensive stocks and leveraged real estate — are likely to be marked down. Some of the markdown can be realized by a cheaper dollar. But the dollar is already too low on a purchasing power parity basis. Things are already too cheap in the United States and too expensive in Europe. And, though Europe has a current account surplus, the euro itself is paper too — just like the dollar, and not much better. What’s more, if the dollar were to fall too much — that is, enough to fully deflate America’s credit bubble — there would be Hell to pay. Mr. Asakawa and other foreigners are already sitting on the edge of their chairs…barely restraining themselves from picking up the phone; they could sell at any moment. If they were to sell, it would quickly take down the value of U.S. dollar assets…and push the U.S. economy into recession.

In other words, we do not doubt that the dollar will fall, but we doubt that that will be the end of the story. For the year ahead, we expect U.S. dollars assets to fall — stocks and real estate, primarily. The price of credit is likely to rise — especially short-term rates. But quality bonds are likely to be supported by the credit contraction itself — people will covet secure income streams.

And gold? People want a lower dollar. They think it will make U.S. exports more attractive…while writing down the value of U.S. overseas debts at the same time. But people do not get what they want and expect from markets; they get what the need and deserve. What better way to deflate the American credit bubble than to deflate it in terms of real money? Just look at a chart of the Dow in terms of gold. You will see that the bear market that began in January, 5 years ago, is well advanced…and continues.

Our guess is that the dollar falls against other currencies in 2005…but even more about gold and commodities. A rise in the price of oil, along with an increase in short-term lending rates, will help give American consumers the shock they need. They will, most likely, stop buying as though they expected to drop dead next week…and begin preparing for the future. They must start saving money sometime; 2005 seems as good a time as any. This shift in consumer spending would tip the U.S. into the long, slow, soft slump we have been expecting.

Five years ago, we announced our “Trade of the Decade.” Just sell the Dow and buy gold, we said. We are now halfway into the decade. Our trade is up comfortably…but not spectacularly. We see no reason to change.

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21st Century.

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