Some Heretical Thoughts on the U.S. Dollar   (November 21, 2011)

The value of the U.S. dollar is created by demand, and other heresies.

Like everything else here, my thoughts on the U.S. dollar do not fit any one conventional ideology. In other words, they will likely offer abundant sources of annoyance for virtually everyone. Put another way: heresy has its costs.

I am a trader at heart, so the U.S. dollar is no different than pork bellies or oil. It is a commodity that can be traded with relative transparency, and it moves in cycles and trends like every other tradable commodity, stock, option, futures contract or bond. I have no emotional attachment one way or the other to the USD/DXY, nor do I think it "should" do this or that or that "because of X,Y and Z."

The vast majority of commentators implicitly express an emotional attachment to the USD. Establishing an emotional bond with a trade is an excellent way to lose your capital. As the trading saying goes: marry your spouse, not your trades. The reason is that once you have formed a love/hate attachment to a trade, then you are willfully blind to any indications that your position might be "wrong" in the sense of being a losing trade.

This is called "confirmation bias," seeking out information which supports your pre-selected point of view, and ignoring evidence to the contrary. All such biases describe the effects of emotions on the key trading decisions, i.e. form an opinion about future price and then open, close or add to a position.

It is not much of an exaggeration to state that recognizing and escaping emotional ties to trades is essential to becoming a successful trader. The successful trader does the opposite of confirmation bias: rather than seek out evidence in support of his trading thesis, he/she seeks out evidence which undermines or challenges it.

The primary emotions connected to the U.S. dollar are hatred, revulsion, animosity, scorn, mockery and certainty of its demise. Up until very recently, the investment community was 96% bearish (by at least one measure) on the USD. Now that the euro is swirling the drainhole, there is a grudging recognition that the USD/DXY may gain a bit of strength at the euro's expense, but this strength is necessarily ephemeral (in this view) and thus illusory.

It's not too hard to see the emotional wellsprings of this generalized loathing. Many hate U.S. hegemony, and the dollar being one expression of this hegemony, they are duty-bound to loathe the USD as a tool of hegemony. As a result, they constantly seek our reasons to support their animosity.

Others see gold as the only real store of transportable wealth, and since it is a given in this ideology that the dollar must decline as gold rises, that is, the two are directly and causally correlated, then valuing gold requires one to mock and scorn the USD.

Others scorn the Fed's policy of weakening the dollar to goose equities and inflation, and their mockery of the dollar reflects their disdain for the Fed's policies and goals.

While we can understand or even sympathize with these emotional wellsprings, as traders we recognize they are akin to those held by "true believers" that Apple stock will rise to $1,000 per share. Maybe, maybe not, but establishing a quasi-religious or semi-romantic attachment to one side of a trade greatly increases the probabilities of being wiped out at some point.

From the point of view of those without emotional attachments to either side of the trade, then those with fervent beliefs are like rabid fans of sports franchises. It's certainly fun to love/hate a franchise, but it's not a sound basis for trading successfully.

Conventional opinions about the USD/DXY tend to be "folk" views based on a single causal relationship. One such view is the Federal Reserve is intent on "inflating our way out of debt" and do so it must "print" a lot of money, which will then trigger inflation, which will then drive the dollar's value down, both when measured in gold, oil, land, etc., i.e. tangible commodities, and also against competing global currencies, i.e. other fiat currencies.

If we accept this premise and causality, then we "know" the dollar will continue losing purchasing power/value until the Fed has completed its inflate-us-to-wholeness-and-prosperity campaign--and everyone knows that will take a long, long time as our debts are so monumental.

The dollar is thus a poor store of value and should be shorted or sold.

This makes sense as far as it goes, but like all "folk" prescriptions, it discounts or ignores other causal dynamics. Examples of "folk" investing beliefs include "real estate will never go down because they're not making any more land and the population is growing," and "these companies will only go up because the Internet will keep growing for decades."

In the first example, the fact that land is not being made except as hot lava entering the ocean and the population is rising were not the only, or even the key, causal dynamics in real estate. A a result, a naive trust in "folk" causality led to vast losses.

In the second example, it is true that the Internet continues to grow, but once again that was not the sole, or even the key, causal dynamic in the stock prices of Internet companies. So the object lesson here is to differentiate between beliefs that can lead to financial losses via placing trades based on those beliefs and beliefs which can be held without cost, i.e. hey, how about them Yankees, etc.

Since a single "folk" prescription is the basis for many observers' view of the USD, we might treat "sole-source causality" gingerly as a reliable basis for actually risking money on a wager, oops, ahem, I mean an "investment."

Like all fiat currencies, the USD/DXY is both a potential "store of value" and a means of exchange. The general view grants this dual nature, but focuses on the poor prospects of a fiat currency as a store of value when limitless quanitities of said currency can be printed or borrowed into existence.

History shows that the causal connection between printing and inflation/hyper-inflation is real. It is less authoritative when the currency is borrowed into existence, but let's stipulate that any currency being printed with abandon will lose purchasing power/value.

Why? Printing more paper does not create more wealth, productivity or things to sell; it simply depreciates the value of existing currency.

So over a long timeline, any fiat currency being printed in quantity above the actual expansion of goods and services being produced will make a poor store of value.

But how long is our time line as traders? One year? Five years? Twenty years? The farther out we extend trends based on current conditions, the lower the accuracy of our guesses. Does anyone dare claim to know the price of anything ten years hence?

So traders tend to be wary of bets on what price may or may not obtain five or ten years hence, especially as volatility has systemically increased, and may continue to rise for structural reasons.

Rather than focus exclusively on the USD as a "store of value," shouldn't we also ask: Are there any causal factors which affect the value of currency as a means of exchange?

In other words, can currencies gain or lose value as means of exchange? If so, does this have any bearing on our view of currencies as commodities?

For example, consider this quote from Zero Hedge: The Complete And Annotated Guide To The European Bank Run:

It is important to emphasizes that a bank’s decision to hold sovereign debt is not an expression of an investment preference. Rather, it is a decision related to liquidity management. As such banks seek ‘risk free’ assets that can be used to access liquidity at any time, particularly at the time of crisis.

While this quote refers to sovereign debt, the same principles (liquidity and risk management in times of crisis) apply to currencies.

This dual nature of currency naturally creates confusion. Currency wadded up under the mattress may well depreciate to a curiosity, but gold is not a means of exchange on a global scale.

Even as non-experts, we can ponder the nature of global currency exchange, which is on the order of $2 trillion a day. How many dollars are traded as stores of value? How many are traded as means of exchange? The answer illuminates which one generates the "value" of an unbacked, paper currency.

In other words, commodities gain or lose value according to supply and demand. Currencies which are seen as relatively "risk-free" in terms of liquidity can gain in value because the demand for them is rising faster than the supply is increasing. The only way they could lose value is if they were printed in quantities that exceeded the demand for liquid, low-risk means of exchange.

We might also ask if demand for currencies can be broken down into demand for "liquid means of exchange" and "low-risk store of value." Pursuing this, we might speculate that the demand for Swiss francs may largely come from those seeking a store of value, while the demand for USD may arise from those seeking a liquid, low-risk means of exchange.

Thus we may have to differentiate between various sources of demand to establish a trend of value.

If we pursue the causality dynamics of supply and demand, then we also must examine the size of global markets and demand for liquid, low-risk currency and compare that to the increase in money supply, i.e. "money printing." Though there is no definitive source, estimates of global financial wealth tend to be around $160 trillion, with the U.S. accounting for around $45 trillion of that. (For scaling purposes, note the U.S. GDP is $15 trilllion and the European Union GDP is around $16 trillion).

Global trade between the major trading nations is on the order of $15 trillion.

It is rather transparent that the need for currency for trading purposes is very large, as is the need for currency for liquidity purposes.

Since the "folk wisdom" many are basing their perception of the USD on is vast printing by the Federal Reserve, it seems useful to inquire about the scope of this "printing." Although I am not an expert, it seems the Fed printed about $1 trillion which it then used to buy mortgage-backed assets that were impairing the private banking sector's crumbling balance sheets.

The Fed printed another $1 trillion or so and used it for various shore-up-the-dikes measures, from funding the discount window to support liquidity to buying U.S. Treasury bonds as part of its manipulation of interest rates. Much of this "new money" has ended up in the banks as dead-money reserves to present an illusion of solvency.

It seems very little of this freshly created money actually ended up in the economy where it could influence supply and demand for money or goods. We might thus conclude that the driver everyone assumes is the one and only real driver for valuing the USD is more a popgun than a blunderbuss.

We might also wonder just how much of an effect this "new money" (very little of which actually entered the real economy) would have on $15 trillion in global trade, and a financial system shuffling $160 trillion in financial assets.

We might conclude that there is little demand for the USD as an enduring "store of value" but an immense and rising demand for it as a low-risk means of exchange and liquidity.

A stubborn crowd on the other side of a trade is one feature of an attractive trade. As the trend erodes their confidence and accounts, they offer a steady pool of buyers of the scorned side of the trade. When the trend breaks technical thresholds, the shift from one side of the trade to the other cascades.

From the point of view of a Pareto distribution, the 4% long the USD/DXY may well exert outsized influence on the 64% at some point. When the percentage of longs rise to 20%, then they will exert outsized influence on the other 80%.

It's looking to be a very interesting few months ahead in the global marketplaces for equities, bonds, commodities and currencies. Nobody knows what will happen to price or anything else. For traders, emotionally detached situational awareness trumps conviction based on the comforts of belief.

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