US Greenback - The Path to Monetization
By Frank Barbera CMT. August 26, 2008
Unfortunately, we live in turbulent times. ‘Clarity’ can sometimes be a difficult commodity to come by and real confidence, even more rare. At this juncture, it seems clear that the US Government has set itself upon a course of unlimited damage control. Institutions will continue to fail in the coming year, and Uncle Sam appears ready to step up with his giant tube of crazy glue, intent on making sure that nothing falls apart. It is likely a self-defeating course of action, as bail-out after bail-out will require a steady stream of new digital money. Monetary inflation is the likely end game result.
In the process, confidence is likely to steadily erode and with it, the purchasing power of the Dollar. While many are currently proclaiming a new Dollar bull, we see nothing in the current fundamental monetary climate that would justify such an outcome. While all markets are given to periodic recovery swings and regular counter-trend movements, in order for a secular trend to alter course, there needs to be a solid fundamental under-pinning, which in the case of the Dollar is entirely absent. For the Dollar, large Current account deficits remain, and now, the Federal Deficit is once again running out of control, poised to hit records in the years ahead. It is likely, ultimately, this concern about the ability of the US government to fund its many obligations which will start trouble in the Current Account and a more aggressive period of foreign Dollar diversification. For those who missed it, Fed Governor Richard Fisher of the Dallas Fed, presented a lot of the grim statistics in a speech he made back in late May. Hearing this from those in the so-called ‘lunatic fringe’ is one thing, but hearing it from a Fed governor is quite another. ‘Clarity,’ potentially straight from the horses-mouth. I might add that this speech was given before Fannie Mae and Freddie Mac ran into real trouble, an outcome that now threatens to place an additional 5 Trillion dollars of mortgages and mortgage guarantees onto the back of US tax payers. Here are a few of Fisher's highlights which are not for the faint of heart:
“The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965. Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy. Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percentwant to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the “funded” entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.
Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income. Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.
Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?
If these possible solutions to the unfunded-liability problems, throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else. We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid. If these measures seem draconian, it’s because they are draconian.”
Clearly, Mr. Fisher has blunt views and has plainly laid out some of the serious problems at hand. Perhaps there is a growing psychological awareness among those in high offices, including (very strangely) Mr. Greenspan, of the scope of the monetary collapse potentially dead ahead. I say this because it is interesting to note how many officials have gone on record with blunt quotes about the true state of affairs in just the last few months. The elusive ‘clarity’ which for years was routinely buried and hidden from public view, has surfaced many times in recent months. Perhaps these public officials are looking ahead and assessing what will be the very angry mood of the global population when a massive crisis has occurred and blame is in need of being assigned. At that time, candid quotes like these will seem like prescient warnings--a la “I told you so"--and perhaps ameliorate, or re-direct, the pointing finger of culpability. It is doubtful in many cases that this will succeed. Nevertheless, the odds are that paper money across the board will fall relative to commodities in coming years, that few national currencies will stand up well in the coming storm. Thus, for investors, the first place to start is to obtain a grasp of commodities, not simply as things, but as items for which increased output cannot be easily engineered. Scarcity will be the chief calling card for money, along with portability, and divisibility leaving the Precious Metals with no equal.
Still, some national currencies may fare better than others, and may hold ground against the approaching storm. In this vain, a good bet for relative stability in my view is the Canadian Dollar which is supported by one of the premiere natural resource economies, along with Australia. While both the Loonie and the Aussie currencies are likely to fare well, the fact that Canada has the Tar Sands deposits and is so energy self sufficient suggests that the Canadian Dollar should remain in a secular uptrend for many years to come. Importantly, over the last few weeks, we have seen the Canadian Dollar push down to new multi-month lows and in the process generate very substantial oversold values. In my view, these ultra depressed values are likely setting the stage for a protracted recovery in the Canuck Buck which could easily move back to new highs above the 1.12 peak set in November 2007 within the coming year.
Above: Canadian Dollar with long term Overbought-Oversold gauge.
For the Dollar Index, the outlook ahead is considerably less encouraging. Over the last few years, the index has constructed a declining Elliott pattern that seems to be subdividing into a larger third wave decline. The recent advance in the Dollar has seen the index retrace about 1/4 of the prior decline, which is text-book action for a bear market. Unfortunately, when viewed from a longer-term point of view, the break down below 78 to 80 which had been Dollar Index support for many years, suggests a strong and continued secular bear move. In fact, seen against this very long term chart, the recent rally looks like little more then snap back action lifting prices back up to the under side of what is a veritable wall of resistance.
Above: US Dollar Index – the anatomy of Primary Wave One and Two, with Intermediate Wave (1) of Three bottoming in April of this year, and with Intermediate Wave (2) of Three in the process of peaking right now.
Above: US Dollar Index – a classic A-B-C counter trend rally off the low in April, which should be the peak for Intermediate Wave (2) in this zone over the next few days, too few weeks at the most.
Above: Intermediate Wave (2) has retraced about 1/4 of the prior decline and is in the area of a more important top.
Above: The Dollar Index with a very long term view, where we see how small the current rally really is, and how prices are simply snapping back to the underside of long term price resistance. The odds are high this rally fails in this neighborhood, and reverses lower in coming weeks, moving to new lower lows between now and year end. Ultimately, a panic – waterfall style currency devaluation is likely ahead, brought on by a serious banking crisis that will necessitate money printing on a grand scale. Precious Metals will soar, and natural resource based currencies should fair well in this horrendous episode.
Above: Dollar Index with long term %B medium term Overbought-Oversold Gauge.
Perhaps one of the most telling indications of the fleeting nature of the Dollar Index rally is the action on a gauge called “%B.” Developed by John Bollinger, this gauge uses price action in relation to long term trading bands to determine whether a given market is relatively high or relatively low. In the case of the Dollar Index, the recent readings on %B are among the most overbought values ever seen. Even more telling is that from the oversold extreme low seen on November 8th, 2007 to the recent overbought extreme high seen on Monday, August 18th, the NET gain for the Dollar Index from low oversold extreme to overbought high was a move from 75.43 to a close of 77.15, or 172 basis points or 2.28%. Given that the rally retraced so little of the prior decline and is now historically overbought, this kind of sub-par performance is almost always an indication that a major downside reversal is imminent, and that new lower lows lie just ahead.
Above: the Australian Dollar is presently near its 200 day lower band and is also fully oversold on its long term overbought-oversold gauge.
Rounding out our update of foreign currencies, we see that the Aussie Dollar is also deeply oversold at the kind of technical readings not seen since the early 2006 major lows. In addition, the Euro which we track using the Proshare ETF – FXE (NYSE), is also in the process of recording a more important bottom.
While this type of bottoming out action can take a bit more time, it is not impossible that the Euro could be putting in a “W” type bottom right now. As can be seen on the hourly chart of the FXE, there is a positive divergence setting up on RSI which is holding up at higher lows, even as price fell to a token new low just this morning. The 145.50 to 147.80 zone is likely to be major long term support for the Euro and a rally back up toward the 1.51 to 1.52 area is likely in the coming weeks. Any move above 149.00 on the FXE ETF is likely a bullish confirmation of the bottom.
That’s all for now,
© 2008 Frank Barbera