Reflation Investing – Which Currencies Benefit?

Reflation refers to policy makers’ attempts to “reflate” the economy, to prop up what many would consider a broken system.

Reflation refers to policy makers’ attempts to “reflate” the economy, to prop up what many would consider a broken system. Federal Reserve (Fed) Chairman Ben Bernanke made it very clear in his March 15 interview on 60 Minutes that he will attempt to stem the tide of market forces:

Question: “Are you committing, in this interview, that you are not going to let any of these banks fail? That no matter what their balance sheets actually look like, they are not going to fail?”

Bernanke: “They are not going to fail”

Bondholders around the world rejoice: the debt of Citi and AIG may now be as good as U.S. government debt (the inverse of this does not sound particularly enthusing however: that U.S. government debt may now be as good as that of Citi and AIG).

Here’s a brief lesson on the law of unintended consequences: if you rule out failure as an option, your negotiating power is greatly diminished. Take the automotive industry: last fall, politicians touted that bankruptcy was not an option. Unsurprisingly, neither bondholders nor labor unions were willing to give major concessions. However once bankruptcy became an openly discussed option, suddenly all stakeholders became much more flexible. Similarly, why would Goldman Sachs accept cents on the dollar on any outstanding contracts with AIG as the counter-party, if its liabilities appear guaranteed?

Like so many of the initiatives taken with the best of intentions, they slow down any recovery. Another example is the administration’s “stimulus plan.” The only thing clear about the plan is that it is going to be expensive; because taxes and the governments’ cost of borrowing may go up, the impact on the economy will be dampened. There are also conflicting messages, such as bailouts for home owners on the one hand, but reduced mortgage deductibility on the other hand. Ultimately, home prices continue to be out of line with incomes of potential buyers and government price controls masqueraded as interest rate subsidies or bailouts do not get to the heart of the problem. You also don’t fix the banking system by keeping bad banks afloat, but by dismantling them to create good banks.

For those interested in our analysis of what happens if things turn sour, please read our recent analysis on “Depression Investing – Which Currencies to Hide In?” Today, however, we look at the likely scenario that at some point, some of the vast amounts of money thrown at the system will stick. Because of the inefficiencies of the policies employed, it will take longer for the money to stick, but at some point banks may be fed up sitting on what is currently over $600 billion in excess reserves – that’s money literally thrown at the banks by the Fed, but not used to make loans, either because the banks don’t trust their own balance sheets; or they don’t trust their clients balance sheets; or potential clients are not interested in taking out loans. While excess reserves are an important barometer of the Fed’s attempts to get the banks to lend, another measure we monitor is required reserves. Required reserves are reserves that banks need to keep based on deposits held; however, someone’s loan is someone else’s deposit, thus an uptick in required reserves is an indication of increased economic activity. Required reserves have grown from a little over $40 billion last summer to $60 billion in January, before falling back a little in February.

Last October, there was a serious threat of a disorderly collapse of the financial system. Governments around the world rushed to guarantee the banking system. According to Bernanke, the guarantee of the banking system was one of two important steps taken during the Roosevelt administration to get out of the Great Depression. The second step, Bernanke has emphasized in the past, was to devalue the dollar by going off the gold standard. Devaluing the currency allows prices to float higher, bailing out those with debt. Indeed, Bernanke is already working on weakening the dollar: as the Fed buys those securities that foreigners traditionally buy, foreigners are discouraged from making new purchases in these as they are now intentionally overvalued. Specifically, foreigners traditionally buy agency securities (those for Fannie Mae and Freddie Mac) and government bonds; the Fed has been an active buyer in the former and announced it will increase its purchase activities of the latter.

In our view, the U.S. will be a leader when it comes to trying to reflate the economy. Germany in particular has rebuffed efforts by the U.S. administration to commit to spending 2% of Gross Domestic Product (GDP) on a stimulus plan, saying the markets need confidence, not spending. Export driven economies all welcome spending packages, but rely on the U.S. to do much of the heavy lifting. The argument is similar: if the U.S. does not want GM to fail, why should Germany provide capital to Opel, a large employer and subsidiary of GM in Germany – especially since GM has raided the cash from profitable foreign subsidiaries. It almost looks like the U.S. is trying to bail out the entire world. Conversely, resentment in the U.S. is growing against foreign institutions benefiting from U.S. bailout plans.

What does all this mean for investors and currencies in particular? We know that a lot of money is being spent; and we believe that this money is not being spent very efficiently. We also believe the business models of many companies, especially financial institutions, are broken. As a result, we do not see a quick recovery in lending, earnings or hiring. But we are printing all this money, so where does it go?

Some may conclude that as the world reflates, export oriented economies will benefit the most. We caution against making this conclusion as access to credit will continue to be tight – if nothing else, the almost $3 trillion in debt raised by the U.S. government this year is money not available to weaker sovereign countries (or the private sector in the U.S. and abroad); we also expect a recovery in consumer spending to lag the expectations of many. As a result, we continue to caution about currencies of weaker countries in Eastern Europe, Asia and Latin America.

Will the U.S. dollar benefit? Bernanke’s view that currency devaluation may be beneficial to economic growth speaks for itself. But even if there are no active efforts to debase the currency, we are cautious about the U.S. dollar. That’s because we simply do not see a viable exit strategy to all the money that is being thrown at the system. Some of the Fed’s programs can be phased out, but not all. In our view, the Fed may never be able to sell some of the mortgage backed securities (MBS) it has acquired and continues to acquire at a rate of tens of billions a month. Importantly, because we do not see any efforts to put policies in place that encourage consumers to reduce their debt but instead provide cheap money to keep consumers’ leveraged to the hilt, we do not see how interest rates can be raised if and when inflation breaks out. Quite the contrary, we believe the Fed may welcome inflation, as inflation bails out those with debt and allows home prices to rise; or, at the very least, to have the relative prices of homes become less expensive as the general price level rises. This is a policy fraught with many risks.

Not surprisingly, gold has been a main beneficiary of the trends we see. Because industrial activity is likely to lag in this “recovery,” gold being a precious metal with low industrial use, is a barometer of the money being printed. As reflationary efforts take hold, the money is likely to flow to other commodities – we see trends of that already – before possibly reaching corporate earnings. The Australian dollar is highly correlated with the price of gold; we like the Australian dollar as a reflation play because the Australian economy is highly sensitive to the price of commodities; Australia is also a large exporter of commodities to China, the one country that can afford its stimulus plan. Australia is fiscally in much better shape than the U.S., although it also has a high current account deficit. That current account deficit worked against the Australian dollar when commodity prices imploded, but may cause the Australian dollar to have a more pronounced upward move as the world reflates. We like Australia’s smaller neighbor New Zealand, especially because the government there has had much more of a hands off approach to the global crisis; as a result, similar to Australia, the New Zealand dollar was harder hit during the downturn, but may benefit at an above average rate in a reflationary phase.

The Canadian dollar may also benefit from the reflation trend. We would like to caution, however, that we underestimated the vulnerability of Canada to the U.S. economy. Canada has shown restraint in its aid to the banking sector, it has a commodity-oriented economy and has shown fiscal discipline in the past. However, recent moves by the Bank of Canada to consider printing money need to be monitored closely.