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Thursday May 5, 2005 - 09:26:37 GMT
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Dollar vulnerable to the Japanese quagmire


"In the long run, trade is not helped by a monetary unit which continually deteriorates in value.”

Ludwig von Mises

FX Trading

Is there a risk to our view that the dollar continues to rally on relatively positive US growth? You bet there is. We recently shared this risk to our view with the Members of our service and thought you might find it worthwhile.

Argument: The US is becoming stuck in the same economic quagmire that has snared Japan. It’s the post-bubble payback environment that Morgan Stanley economist Stephen Roach so often talks about.

“The risk in my view, remains that the Chairman [Fed Chairman Alan Greenspan] may have been premature in taking this victory lap. In large part, that’s because history tells us that major asset bubbles have long and lasting consequences that are not easily remedied by conventional policies. While the painful experience of the 1930s is the most obvious example in modern times, Japan’s persistent deflation fully 15 years after the bursting of its bubble is hardly a lesson to take lightly. Nor, unfortunately, is the state of the US economy as it faces what may well be yet another pitfall in its own post-bubble journey,” writes Mr. Roach.

We are still in a real low interest rate environment five years after the bubble popped, as measured by the Nasdaq stock market top in March of 2000. After eight Fed Funds rate hikes, the funds rate is still slightly negative in real terms…CPI 3.1% Fed Funds 3.0%

The Fed, by its own making has engineered asset bubbles as a way to stimulate demand. By lowering rates and driving up financial asset prices—real estate, bond prices, and the stock market—it has given consumers a degree of collateral value to leverage against in order to create purchasing power…debt is the way the wealth from asset bubbles are monetized.

Household debt is now approaching 90% of GDP


This is a dangerous game that cannot be sustained. You can only paper over structural economic problems for so long…Wage and salary growth is now at a new all-time low…this means the consumer burdened with debt could be in big trouble!!

This is a reason why the Fed probably can’t be as aggressive as it would like…Damned if they do and damned if they don’t ratchet up rates…

Now the so-called “soft patch” problem for the US economy is upon us. But it may be much more than that, consider these statistics from the first quarter US GDP report (Source: Weldon’s Money Monitor):

• Biggest inventory increase in five years
• Slowest domestic demand in more than three years
• GDP growth ex-inventories +1.9%...well below trend growth…
• Capital expenditures posted their first single-digit growth rate in four years
• Domestic demand slowed to +3.2% from +4.5% in the $q
• Personal consumption expenditures posted their slowest quarterly growth rate since 4Q of 2002.

In a normal economy i.e. not stuck in a low interest rate environment, the Fed can cut rates or the government can provide fiscal stimulus—in this economy the federal budget and current account deficits are out of control—there is little to expect on that front.

This is a recipe for a Japanese-like quagmire. And if this becomes reality, policy makers may once again decide the only way out is more stimulus, which means more credit creation through lower interest rates and the reflation trade is back in vogue with a vengeance.

Tomorrow we get a look at US non-farm payrolls for April. A bad number will give credence to the quagmire view—a good number and all will be forgotten. Stay tuned.

Jack Crooks


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