Monday, November 29, 2010

Aussie toppy?

An extraordinary article at Seeking Alpha caught this blogger's eye today. In it, one Ananthan Thangavel argues that the Aussie dollar is better than gold.

There can be no surer signal that you are close to a top than when boffin traders announce your currency is more valuable than the yellow metal.

And sure enough, the argument suffers some serious flaws.
Markets are worried about the threat of default by these debt-ridden European countries. While this is a possible outcome, it is a highly improbable one. Throughout the history of time, governments who have faced huge debt problems inflate their way out of the debt. In such a manner, governments print money to pay down their debt, thereby reducing the nominal value of the debt. Since the debt is measured in nominal terms (i.e. $10,000) and not the value of what that debt could purchase, governments often resort to money printing in order to ease the burden of debt repayment.

This outcome has been largely accepted in the US by commodity markets, evidenced by huge advances in the price of agricultural commodities and precious metals. The Eurozone presents a different challenge, as it is an economic alliance without a single government controlling it. This means that ECB President Jean-Claude Trichet must determine what is best for the entire Eurozone simultaneously, even as countries like Germany face no real debt problem while countries such as Greece are on the precipice of default.

It is our belief that the IMF/ECB-dictated austerity measures will ultimately prove to be unsuccessful. In exchange for the bailout funds, Ireland, Greece and the other weaker European countries must agree to strict austerity measures that will raise taxes and cut jobs and expenses for the government. However, as these governments cut back their spending, their GDPs will be adversely affected, causing tax receipts to decline even more and continuing the debt contagion spiral.

Instead of relying on austerity measures to right the balance sheets of the weak Eurozone countries, the ECB will eventually succumb to pressure to enact US-style quantitative easing and monetary base expansion. Until May, the ECB had remained steadfast in protecting the Euro and not enacting potentially inflationary policies. However, Trichet gave way and started purchasing weak Eurozone countries' bonds in order to cap their yields, a move very similar to the US Fed's quantitative easing, and also a policy he had sworn he would not undertake. As Trichet and the ECB realize that traditional policies will not be enough to ensure even modest growth in the Eurozone, Trichet will further relax his stance on inflationary policies. Simply put, the weak Eurozone countries have no choice but to inflate their way out of the debt, and Trichet will realize that the only choice he has is to either allow inflation to reduce the nominal amount of the debt, or risk the dissolution of the Euro entirely.

For these reasons, precious metals and commodities remain in a structural bull market (click on chart to enlarge). While gold and silver have already logged impressive performances for the year, they are in the beginning of a multi-year bull market. As extraordinary policies such as quantitative easing and government repurchases become commonplace among the US, Japan, and eventually Europe, investors will lose confidence in developed market currencies and increasingly turn to developing market currencies and precious metals as stores of value.

This blogger will observe that whether the ECB engages in EQE (European Quantitative Easing) or it doesn't, the Aussie isn't, thankfully, going to rise much further. If we get EQE, the global reflation trade is toast. The euro will replace the $US as the global whipping boy currency. By default that means a rising $US, falling commodity prices and reversed risk trades.

Unless you think US domestic demand can carry the global business cycle with a rising dollar, which is a highly questionable proposition, then EQE spells the end of global reflation and the end of the rise of the Aussie. Precious metals will also take heat but will be stronger because of the implications for competitive devaluation and trade war.

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