Wednesday, May 6, 2020

Investment Strategy - 2



Continuing from yesterday (see here)
Before I share my thoughts on USD and Gold, I would like to make it clear that I am a simpleton who:
(a)   does not understand the economics beyond its first lesson which says all economic decisions involve a trade off and price of things having economic value is determined by their demand and supply at that given point in time;
(b)   does not know how to play with data on Microsoft Excel Sheet;
(c)    likes to discover investment themes in streets, markets and fields; and
(d)   seriously believes that numbers invariably follow the good story.
In my view, the currency of any country is nothing but an “unsecured zero interest bond” issued by the respective central bankers. This bond usually loses its value with the passage of time due to inflation.
Since 2008 global financial crisis, central bankers in the developed world, especially US Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ) and Bank of England (BoE), have created enormous amount of virtual currency (not physical) under various QE programs.
In the second step of QE, the central bankers have exchanged this virtual currency with interest bearing sovereign and corporate bonds. This way while the banks are saddled with the virtual currency that cannot be put in the ATM machines for the savers to withdraw and spend; the central bankers are able to earn additional income by way of interest on the bonds bought by them from the banks and fearful savers. This additional income has helped the governments in extending a variety of stimulus payments to the citizens. Moreover, this enormous buying of securities by the central bankers has also created an artificial scarcity in the debt market and hence allowing the governments to borrow at significantly lower cost. It may be pertinent to note that over US$17trn worth of bonds are now trading at negative yield.
In the third step of QE, the central bankers of developed countries have tried their best to create an acceptable level of inflation in their respective economies so that they can also make some capital gains as the “virtual currency” rotting in the bank accounts depreciates in its value.
While this is the usual mechanism of monetary policy since 2008-09, the case of USD has another manifestation. Besides being the medium of exchange and "unsecured zero interest bond" for the US citizens, the USD is also used as a medium of exchange for a large part of the bilateral global trade. Accepting USD status as an unchallenged global currency, many countries have pegged the exchange rate of their local currencies to the exchange rate of USD. So, even if an Indian trader agrees to sell some goods to a buyer in Dubai and accept payment in AED (UAE currency), in effect his transaction value is measured in USD terms as AED exchange rate is pegged to USD.
The exchange rate of USD in relation to other world currencies is influenced by the physical USD in circulation. The enormous amount of virtual USD created by Fed has helped reducing the supply of physical USD to the world and hence increasing the relative value of USD. For example, the US asset prices (especially equity and bonds) have seen material rise in prices thus attracting investments from world over; and the large fiscal stimulus enabled by QE has made businesses in US relatively more profitable thus reversing the current account deficit trends (large US CAD traditionally has been a major source of physical USD supply to the world).
So far so good for US as it's all win-win for businesses, government and common people. But unfortunately all good things must come to an end.
Taking advantage of low interest rate on USD funds and plenty of liquidity, many global borrowers had borrowed money in USD. As per some estimates, about US$13trn of this debt will come up for repayment in next few years.
"the $13tn short dollar positions (foreign dollar debt held mainly by foreign corporation and investment vehicles) is the largest position ever taken in the history of global financial markets. It can only mean a massive, uncontrolled dollar rally.
QE will not fix this. Swap lines will not fix this. A debt jubilee would fix this or multiple trillions of dollars in write-downs and defaults.
It is the dollar strength that brings to world to its nadir (just like the 1930s). It is the dollar system that is the really big problem.
This eventually breaks the dollar after a super-spike as global central banks are forced to find alternatives. They are already working on digital currencies for exactly this.
The biggest event of all of our lifetimes has now begun to come clear. We are still only in the first phase – the panic. It will most likely play out in three acts over several years:
  • First, the panic, which is the liquidity phase.
  • Then the hope, which is the correction phase.
  • And finally, the insolvency, the brutal phase that changes everything, including the system itself."
    In my view, these phases will play out in much shorter span of period (may be 5-6years).
    The strength of USD itself will divert the global trade away from USD, as the commodity producers may not be able to manage their local economies with their produce priced in expensive USD. We shall see more bilateral trade and multiple smaller trade blocks. The first signs of this trend shall emerge from rise in volumes of oil traded in CNY; de pegging of Arab currencies; more jurisdictions granting legal tender status to cryptos, etc.
    US government defaulting on its debt obligations to China, as reported by a section of media (see here), may further expedite the process of USD cessation as global reserve currency.
    ...to continue tomorrow

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