...

December 17, 2010

Pre-holiday cheer is certainly evident in the financial markets

Pre-holiday cheer is certainly evident in the financial markets. The overwhelming consensus is that the Congressional agreement to not raise taxes while extending hundreds of billions in new stimulus will finally allow the recovery to take hold. The good feelings are underscored by less-than-awful employment reports and modest slowdowns in foreclosures. Another point of optimism is the continued buoyancy of the US dollar, which has weakened over the past few months, but has not collapsed.

However, I believe the dollar's survival remains tenuous and highly dependent on factors outside of the control of US policymakers. As I see it, the dollar is caught between four major forces: American debt levels, weakness of the euro, underlying strength of the yuan and, lastly, threats to its privileged international reserve status.

In 2010, the major collapse of the US dollar, which many of us expected to see, did not materialize. Indeed, the dollar experienced periods of relative strength, due largely to an absence of apparent domestic inflation and concerns not just about the value of the euro, but its continued survival. In recent weeks, there have been some signs of economic recovery in the United States, of rising inflation in China, and of increasing concern about the euro. As a result, the dollar is finishing the year with some wind in its sails.

For now, the markets seemed convinced that the trillions of dollars injected into the economy by the Fed and the Administration will not be inflationary. I suspect this illogical consensus has in no small part been made possible by the government's success in disguising the real level of consumer price inflation. However, the level of government debt continues to accelerate, promising serious problems ahead.

This reality was made clear by the recently negotiated tax/stimulus package. The deal contained absolutely no commitment on the part of either Republicans or Democrats to tackle the country's staggering debt problems. But, in the short term, it may help to boost morale; and, in the current environment, the short term is the only term that seems to matter.

I believe the European picture is a cause for deep concern. With the recent warnings of further credit downgrades, it now appears the European debt contagion is spreading. Even as anti-austerity riots are spreading on the streets of Athens, the debt scene is shifting to Spain. Recent reports indicate that in 2011, Spain needs to find financing for €171 billion in public debt, local authorities need an additional €28 billion, and Spanish banks need another €91 billion. This adds up to a total of approximately €290 billion, or some 28 percent of GDP. This is on top of a Spanish national debt that currently stands at 53% of GDP, and a marked increase over the 2010 deficit of 11.2% of GDP. These types of figures are already eliciting calls for an increase in the €440 billion eurozone rescue fund.

Meanwhile, the German economy continues to exhibit strong growth, which may soon demand a hike in euro interest rates. Periphery euro states would find this extremely threatening. It may even prompt a split between strong and weak and the creation of a 'two speed' eurozone. Fundamental disagreements between European Central Bank (ECB) chairman Jean-Claude Trichet and German Chancellor Angela Merkel are creating further political uncertainty.

These factors may have caused a major flight of capital out of the euro and into the US dollar, blunting what should have been a much rougher period for the dollar. I believe that euro weakness is thwarting Fed Chairman Bernanke's plan: devalue the dollar in order to inflate the economy and partially erode the Treasury's debt.

Meanwhile, in Asia, China still pegs its yuan to the dollar, allowing only small increases in its value. To maintain the relative valuations, China must purchase US dollars on the open market. By absorbing the excess liquidity created by the Fed, China is importing American inflation. Figures released earlier this week reveal the danger. It may take time, but the pressures of domestic inflation may finally persuade China to revalue in 2011. A revalued yuan will enable China to better afford the commodities it needs to sustain its growing economy. It will also cause a precipitous drop in living standards in the US as we are forced to live with the result of our own inflation.

But our problems will not end there. China likely will seek conditions in return for agreeing to revalue. China may demand that the G-20 accept its proposal to remove the US dollar from its privileged role as the world's reserve currency. From my vantage point, this would render the dollar a terminal patient.

Forecasting the dollar's short-term relative value is an extremely difficult exercise. Sadly, logic holds little sway in the current marketplace. However, over the longer term, I believe dollar weakness will undermine the market - just as we saw with the dot-coms and real estate. At some point, fundamentals will be felt.

Related: iShares Dow Jones US Real Estate (ETF) (NYSE:IYR) , iShares FTSE/Xinhua China 25 Index (ETF) (NYSE:FXI) , iShares MSCI Emerging Markets Indx (ETF) (NYSE:EEM) , iShares Lehman 7-10 Yr Treas. Bond (ETF) (NYSE:IEF)

Peter Schiff`s comments on the economy, stock markets, politics and gold. Schiff is the renowned writer of the bestseller Crash Proof: How to Profit from the Coming Economic Collapse.
eXTReMe Tracker