Forex Blog

Forex Blog

Interview with Dollar Daze: Avoid Positions that Entail Currency Risk

Posted: 14 Nov 2010 05:05 AM PST

Today, we bring you an interview with Mike Hewitt of Dollar Daze, whose “belief is that the paper currencies of the world are presently undergoing a devaluation.” Below, Mr. Hewitt shares his thoughts on the US Dollar, Chinese Yuan, inflation, and why you should be paying attention to Gold and other commodities.

Forex Blog: I would like to begin by asking about your background. What interested you in the US Dollar, to the extent that you decided to blog about it on a regular basis?

I first began investing in earnest around the top of the dot.com era in the late-90's. At the time, I spent much time perusing the various mainstream media financial sites. I invested primarily into the heavily advocated technology stocks. Additionally, I worked at Nortel which at that time was Canada's premier company, representing everything the so-called 'New Economy' entailed.

In 2005, I decided it was time to begin documenting articles of interest and place down some of my own thoughts and conclusions. Through several incarnations, this developed into what DollarDaze is today.

Of course we all know how the 'New Economy' ended. Like many of my peers, my investments plunged. While in terms of percentage the losses were staggering, fortunately since I was beginning, the actual dollar amounts involved were quite modest. From that early experience I decided that my understanding of how economics and markets worked needed to change.

I began reading various books and came across a chapter on central banking and fiat currency. For the first time in my life, I realized that gold did not back paper money – not the US dollar, not the British pound or even the Euro. No modern currency is backed by anything tangible. This topic became of great interest to me and I sought out any additional material I could addressing this issue.

Forex Blog: You blogged recently about the dilemma faced by the People’s Bank of China, whereby it desperately wants to limit its exposure to the US Dollar but that any attempts to actually do so would almost certainly cause the value of its reserves to fall? Can you elaborate on this, and explain what you believe to be the PBOC’s most likely course of action?

Beginning in late 2004, the PBOC began buying US debt at an impressive rate, and actually surpassed Japan as the largest holder in mid-2008. A large accumulation of any currency becomes a burden for the holder as they cannot be quickly unwound without driving the underlying currency down and precipitating the very capital loss that the holder is attempting to avoid. China's situation today shares many eerie parallels to that of France in the 1930's.

Following the events of WWI, France experienced a decade of currency instability. This ended when the French government mandated the French central bank to buy foreign exchange on the market to avoid excessive currency appreciation. This effectively pegged the French franc to the British pound sterling and U.S. dollar.

Through a process of maintaining an undervalued currency, France recorded trade balance surpluses. At one point it was estimated that the Banque de France held more than half of the world’s volume of foreign reserves.

When the Bank of England suspended their obligation to sell gold at a fixed price in response to a collapse of the banking system in continental Europe, the result was an immediate and sharp devaluation of the British pound. The central bank of France held an estimated £62 million in paper (at that time equivalent to over 450 tonnes of gold). In order to stem their capital losses when the pound sterling dropped, the central bank of France added fuel to the fire by liquidating much of their paper position.

Roll the clocks forward to the new millennium and we see a very similar scenario, but with different players. The Chinese government has enforced a pegged currency through the purchase of foreign reserves. But the important question is whether the end-game will be the same as before.

From what sources are available, the PBOC appears to be both gradually reducing their exposure to US denominated debt and perhaps more importantly, cycling out of longer-term US debt into short-term paper. Perhaps the PBOC can strategically use Bernanke's QE2 as an opportunity to further reduce their exposure without instilling a panic flight from the US dollar.

Forex Blog: On a related note, I enjoyed your analysis of the “Growth of Global Currency in Circulation” and was surprised to learn that the Chinese Yuan is being printed at an even faster rate (relatively) than the US Dollar. With this in mind, do you think that calls for the Chinese Yuan to appreciate are unreasonable?

The PBOC has been expanding their money supply at a higher rate than the US Federal reserve for many years now. Much of the explosive growth in China is being fuelled by monetary expansion.

I would be hesitant to speculate on any fiat currency which is being produced in great quantities as being a source of strength. Yes, there are factors suggesting that the Chinese yuan is undervalued, but at the same time, the economy of China is not immune to the negative effects of an inflation induced boom caused by monetary expansion.

Interestingly enough, China experimented with paper money around 800 AD and fully abandoned it six centuries later following several boom-bust cycles. The first issue of official paper notes in Europe from a chartered bank was in 1661 by the Bank of Sweden.

Forex Blog: The Federal Reserve Bank has been accused of (inadvertently) stoking the ongoing currency war through the expansion of its Quantitative Easing (QE2) program. Given that all Central Banks continuously expand their money supplies, do you think accusation is fair? More importantly, do you think that the Dollar will continue to decline as this policy is gradually implemented?

I recently compiled statistics comparing expansion of the monetary bases for different currencies. The three largest are shown below.

MonetaryBase

As one can readily see, the monetary base of all three currencies are increasing, but it puts into perspective just how truly large the actions of the Federal Reserve were to the crisis of 2008. This chart doesn't include any data from the QE2 program.

While these increases are not directly inflationary, they do present an enormous potential for currency debasement. These reserves can be thought of as being similar to what a major new discovery of a mineable deposit would have to the price of the metal. The price of the metal is only indirectly affected until the newly mined metal reaches the market, at which point it will plunge.

Forex Blog: You have criticized the Fed for its “ardent” fight against deflation. If you look at the experience of Japan over the last 20 years, it would seem to prove that deflation is associated with currency appreciation but economic stagnation? Do you think that deflation in the US would follow a different form?

I believe it important to be very specific with what we mean by saying 'deflation'. Originally, the term 'deflation', and its counterpart, 'inflation', referred to changes in the money supply. At present, the term 'deflation' relates to decreasing prices. I think this change in definition obfuscates the issue because prices may decrease for various reasons – increased supply relative to demand, price wars, technological advances in production, or efficiencies in distribution – all affect price.

When stating Japan experienced deflation over the last 20 years, I speculate that this definition has been further restricted. Instead of now referring to general price levels, it is concerned primarily with asset prices. This continues to confuse the issue by further removing the cause-effect relationships of increasing supply on the overall economy.

At the peak of the Nikkei at the end of 1989, there was approximately ¥38.5 trillion yen in circulation. Twenty year later, that figure has more than doubled to ¥82.7 trillion. To me, that is inflation.

I would speculate that the US will begin a similar route, but holding the privileged status of being the 'de facto' reserve currency of the world, this will affect the global economy.

Forex Blog: The series of long-term currency charts that are displayed on your home page suggest that you subscribe to the Purchasing Power Parity (PPP) school of currency analysis. Is this a reasonable assessment?

I hope to update those charts to reflect the historical trend of different currencies relative to gold. The reason being is that they are currently based on CPI statistics from the BLS. Given that I do believe government statistics such as the CPI to be inaccurate of the real world, I am not entirely satisfied with these charts.

I hold that gold, being a material that functions well as a store of value, provides a much more objective standard to use as a measuring tool.

Forex Blog: Do you think that gold represents the best long-term hedge (aka store of value) in the context of the US Dollar’s continued decline? How do you reconcile the rise in Gold with the fact that inflation in the US is at a 50-year low?

I simply do not buy into the notion that the inflation rate, as measured by the CPI, is an effective method. While the fundamental notion of measuring a 'basket of goods' throughout time seems as a good methodology, the various manipulations through which this calculation is subjected (geometric weighting, hedonics, substitution) removes any credibility.

I know that I am paying more for groceries, gas, utilities and other general living expenses than I was before. John William's site Shadow Government Statistics calculates the CPI the way it was done in previous years and finds the rate to be around 8-10%. That figure feels much more in line with my own personal observations.

Gold is moving up because its monetary value is being realized by a growing portion of the populace concerned with what the increasing money supply will do to the dollar.

Forex Blog: What is your medium-term prediction for the US Dollar. In other words, how will QE2, currency wars, renewed appetite for risk, etc. affect the Dollar after the next few years?

I advocate a strong fundamental position in vehicles which function well as a store of value, such as gold.

I would hesitate holding any position which is exposed to currency risk, particularly long-term bonds. These massive purchase programs by the US Federal Reserve are exerting an enormous downward pressure on interest rates. The Fed is called the buyer of last resort. They may soon find themselves to be the only buyer.

Equities are feeling more and more akin to participating at a casino. In the not too distant history, the purpose of buying a stock was to receive a dividend. Nowadays, it seems like greater fool theory is the rule. Like the flipping of over-priced condos, the goal is simply to find someone willing to pay a higher price to unload on.

1. I would like to begin by asking about your background. What interested you in the US Dollar, to the extent that you decided to blog about it on a regular basis?

I first began investing in earnest around the top of the dot.com era in the late-90's. At the time, I spent much time perusing the various mainstream media financial sites. I invested primarily into the heavily advocated technology stocks. Additionally, I worked at Nortel which at that time was Canada's premier company, representing everything the so-called 'New Economy' entailed.

Of course we all know how the 'New Economy' ended. Like many of my peers, my investments plunged. While in terms of percentage the losses were staggering, fortunately since I was beginning, the actual dollar amounts involved were quite modest. From that early experience I decided that my understanding of how economics and markets worked needed to change.

I began reading various books and came across a chapter on central banking and fiat currency. For the first time in my life, I realized that gold did not back paper money – not the US dollar, not the British pound or even the Euro. No modern currency is backed by anything tangible. This topic became of great interest to me and I sought out any additional material I could addressing this issue.

In 2005, I decided it was time to begin documenting articles of interest and place down some of my own thoughts and conclusions. Through several incarnations, this developed into what DollarDaze is today.

2. You blogged recently about the dilemma faced by the People’s Bank of China, whereby it desperately wants to limit its exposure to the US Dollar but that any attempts to actually do so would almost certainly cause the value of its reserves to fall? Can you elaborate on this, and explain what you believe to be the PBOC’s most likely course of action?

Beginning in late 2004, the PBOC began buying US debt at an impressive rate, and actually surpassed Japan as the largest holder in mid-2008. A large accumulation of any currency becomes a burden for the holder as they cannot be quickly unwound without driving the underlying currency down and precipitating the very capital loss that the holder is attempting to avoid. China's situation today shares many eerie parallels to that of France in the 1930's.

Following the events of WWI, France experienced a decade of currency instability. This ended when the French government mandated the French central bank to buy foreign exchange on the market to avoid excessive currency appreciation. This effectively pegged the French franc to the British pound sterling and U.S. dollar.

Through a process of maintaining an undervalued currency, France recorded trade balance surpluses. At one point it was estimated that the Banque de France held more than half of the world’s volume of foreign reserves.

When the Bank of England suspended their obligation to sell gold at a fixed price in response to a collapse of the banking system in continental Europe, the result was an immediate and sharp devaluation of the British pound. The central bank of France held an estimated £62 million in paper (at that time equivalent to over 450 tonnes of gold). In order to stem their capital losses when the pound sterling dropped, the central bank of France added fuel to the fire by liquidating much of their paper position.

Roll the clocks forward to the new millennium and we see a very similar scenario, but with different players. The Chinese government has enforced a pegged currency through the purchase of foreign reserves. But the important question is whether the end-game will be the same as before.

From what sources are available, the PBOC appears to be both gradually reducing their exposure to US denominated debt and perhaps more importantly, cycling out of longer-term US debt into short-term paper. Perhaps the PBOC can strategically use Bernanke's QE2 as an opportunity to further reduce their exposure without instilling a panic flight from the US dollar.

3. On a related note, I enjoyed your analysis of the “Growth of Global Currency in Circulation” and was surprised to learn that the Chinese Yuan is being printed at an even faster rate (relatively) than the US Dollar. With this in mind, do you think that calls for the Chinese Yuan to appreciate are unreasonable?

The PBOC has been expanding their money supply at a higher rate than the US Federal reserve for many years now. Much of the explosive growth in China is being fuelled by monetary expansion.

I would be hesitant to speculate on any fiat currency which is being produced in great quantities as being a source of strength. Yes, there are factors suggesting that the Chinese yuan is undervalued, but at the same time, the economy of China is not immune to the negative effects of an inflation induced boom caused by monetary expansion.

Interestingly enough, China experimented with paper money around 800 AD and fully abandoned it six centuries later following several boom-bust cycles. The first issue of official paper notes in Europe from a chartered bank was in 1661 by the Bank of Sweden.

4. The Federal Reserve Bank has been accused of (inadvertently) stoking the ongoing currency war through the expansion of its Quantitative Easing (QE2) program. Given that all Central Banks continuously expand their money supplies, do you think accusation is fair? More importantly, do you think that the Dollar will continue to decline as this policy is gradually implemented?

I recently compiled statistics comparing expansion of the monetary bases for different currencies. The three largest are shown below.

As one can readily see, the monetary base of all three currencies are increasing, but it puts into perspective just how truly large the actions of the Federal Reserve were to the crisis of 2008. This chart doesn't include any data from the QE2 program.

While these increases are not directly inflationary, they do present an enormous potential for currency debasement. These reserves can be thought of as being similar to what a major new discovery of a mineable deposit would have to the price of the metal. The price of the metal is only indirectly affected until the newly mined metal reaches the market, at which point it will plunge.

5. You have criticized the Fed for its “ardent” fight against deflation. If you look at the experience of Japan over the last 20 years, it would seem to prove that deflation is associated with currency appreciation but economic stagnation? Do you think that deflation in the US would follow a different form?

I believe it important to be very specific with what we mean by saying 'deflation'. Originally, the term 'deflation', and its counterpart, 'inflation', referred to changes in the money supply. At present, the term 'deflation' relates to decreasing prices. I think this change in definition obfuscates the issue because prices may decrease for various reasons – increased supply relative to demand, price wars, technological advances in production, or efficiencies in distribution – all affect price.

When stating Japan experienced deflation over the last 20 years, I speculate that this definition has been further restricted. Instead of now referring to general price levels, it is concerned primarily with asset prices. This continues to confuse the issue by further removing the cause-effect relationships of increasing supply on the overall economy.

At the peak of the Nikkei at the end of 1989, there was approximately ¥38.5 trillion yen in circulation. Twenty year later, that figure has more than doubled to ¥82.7 trillion. To me, that is inflation.

I would speculate that the US will begin a similar route, but holding the privileged status of being the 'de facto' reserve currency of the world, this will affect the global economy.

6. The series of long-term currency charts that are displayed on your home page suggest that you subscribe to the Purchasing Power Parity (PPP) school of currency analysis. Is this a reasonable assessment?

I hope to update those charts to reflect the historical trend of different currencies relative to gold. The reason being is that they are currently based on CPI statistics from the BLS. Given that I do believe government statistics such as the CPI to be inaccurate of the real world, I am not entirely satisfied with these charts.

I hold that gold, being a material that functions well as a store of value, provides a much more objective standard to use as a measuring tool.

7. Do you think that gold represents the best long-term hedge (aka store of value) in the context of the US Dollar’s continued decline? How do you reconcile the rise in Gold with the fact that inflation in the US is at a 50-year low?

I simply do not buy into the notion that the inflation rate, as measured by the CPI, is an effective method. While the fundamental notion of measuring a 'basket of goods' throughout time seems as a good methodology, the various manipulations through which this calculation is subjected (geometric weighting, hedonics, substitution) removes any credibility.

I know that I am paying more for groceries, gas, utilities and other general living expenses than I was before. John William's site Shadow Government Statistics calculates the CPI the way it was done in previous years and finds the rate to be around 8-10%. That figure feels much more in line with my own personal observations.

Gold is moving up because its monetary value is being realized by a growing portion of the populace concerned with what the increasing money supply will do to the dollar.

8. What is your medium-term prediction for the US Dollar. In other words, how will QE2, currency wars, renewed appetite for risk, etc. affect the Dollar after the next few years?

I advocate a strong fundamental position in vehicles which function well as a store of value, such as gold.

I would hesitate holding any position which is exposed to currency risk, particularly long-term bonds. These massive purchase programs by the US Federal Reserve are exerting an enormous downward pressure on interest rates. The Fed is called the buyer of last resort. They may soon find themselves to be the only buyer.

Equities are feeling more and more akin to participating at a casino. In the not too distant history, the purpose of buying a stock was to receive a dividend. Nowadays, it seems like greater fool theory is the rule. Like the flipping of over-priced condos, the goal is simply to find someone willing to pay a higher price to unload on.

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