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Wednesday, December 31, 2008

Hussman Article

Below is an exerpt from John P. Hussman's article "The Dollar Crisis Begins." I have been sharing this view for some time. Either the dollar will fall or the yield on the long-bond will rise. The retail way to play this is through TBT and UDN. I am currently working on an options strategy to best play this theme. Hopefully I will post shortly with my findings.

"On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”

Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.

And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.

In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.

As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely."


1 comment:

java said...

Whenever i see the post like your's i feel that there are still helpful people who share information for the help of others, it must be helpful for other's. thanx and good job.

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