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“The US is not a superpower. The US is a financially dependent country that foreign lenders can close down at will. Washington still hasn’t learned this. American hubris can lead the administration and Congress into a bailout solution that the rest of the world, which has to finance it, might not accept.”

-Paul Craig Roberts

I read this quote just a few minutes ago from a respected American who has served his country well.  As an American, it’s painful and embarrassing at the same time to get up each morning and read sentiments like this.  It makes me want to move to Canada (kidding).

Valéry Giscard d’Estaing, a French Minister of Finance in the 1960’s referred to the benefits the United States had in the US Dollar being the international reserve currency as an “exorbitant privilege”.

Yesterday the S&P 500 closed flat on the day on anemic volume; it feels like everyone is on summer vacation.  We learned yesterday that the Chinese are selling their holding of US Treasuries in favor of Europe and Japan.  We are financially dependent on foreign lenders and our biggest creditor is saying “no mas” - on this news the S&P 500 traded flat on the day.   

The dollar sent the right message yesterday, declining 0.50% and it is headed lower.   The actions of the Chinese are telling the rest of the world to flee dollar-denominated paper assets.  This is a problem for the dollar as the Federal Reserve appears to be a lender of last resort for the U.S. Treasury.  While the selling of foreign-held dollar-denominated debt has been orderly so far, the inflow of foreign-held dollars into the U.S. will debase the dollar and lead to higher inflation.  Despite what the FED sees (it’s focused on the “core” figure), the signs of inflation abound in the economy. 

(1)    Gold traded higher yesterday (looking to gain for a fourth day in a row) and has rallied 3.1% in the past month.

(2)    Copper traded up 0.8% yesterday and is up 13.3% over the past month.

(3)    Last Friday, the US CPI number crept higher and will again in August.

(4)    Today’s UK inflation reading is above the BOE target rate

(5)    The US PPI number will also post an upside surprise

Since the US does not have the balance sheet to execute on any creditable plan and the world has little faith in our political leaders, it’s hard to see a way out.  The “Fiat Fools” in Washington have already done everything in their power to spend or to create whatever money was needed to prevent systemic collapse in 2008. 

Yet, today we seem to find ourselves in a precarious position.  While the situation is not overly similar to 2008 (yet); Lehman Brothers’ collapse is one important difference that shocked markets. Many facets of the economy are on a knife edge: housing is once more coming to the center of people’s attention as a concern and unemployment remains at elevated levels. 

Should inflation meaningfully take hold, it would be a death knell for the margin story embedded in the current estimates for the S&P 500.  The only action that will expeditiously calm the markets is more spending or creating of U.S. cash (which creates inflation).  Daryl Jones has written extensively on this; our economy is addicted to foreign financing just as acutely as it is addicted to foreign oil. 

The futures are rallying today on the back of China rising for the third day (up 0.4%) on signs that the Chinese economy is maintaining some momentum in June.  But this is not the case in the US.  The surging trade deficit and anemic retail sales (plus the Fed’s own admission) suggest that 2Q GDP will be revised downward and that 2H10 GDP will be even slower. 

With consumer credit continuing to contract and confidence readings trending downward, downward sequential movement in GDP growth rhymes with what the data is indicating.  We estimate that personal consumption growth will slow to less than 1% in 4Q10 and discretionary spending growth will slow to a rate close to what we experienced in 1Q09. 

The unease with which Valéry Giscard d’Estaing viewed a US Dollar denominated world reserve currency is not a relic of the 1960’s.   In 2009, Luo Ping, director general at China’s Banking Regulatory Commission, said in New York, “Once you start issuing $1 trillion-$2 trillion…we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do”.  Yesterday, we saw this sentiment manifest itself in action.  Keith highlighted Ping’s comment in real-time back in early 2009, and the selling of U.S. Treasuries by the Chinese is indicating that the turn in 10 year US Treasury yields is coming.

Function in disaster; finish in style

Howard Penney

Exorbitant Privilege - hpel