Why the dollar is doomed

You cannot get rich by borrowing money, and yet Americans seem to believe that their profligacy will have no consequences, says Dan Denning in The Daily Reckoning. But eventually foreign investors will grow tired of propping up the US economy and start recycling their dollar surpluses into local markets. But there are ways for western investors to protect their portfolios from the inevitable fall-out...

A whole raft of economic data is supposed to tell us this week what we can expect from stocks, shares and the economy. New construction spending, Christmas sales, the Fed's last meeting notes (what will they do next?), payrolls, factory orders, hourly earnings...all new grist for our analytical mill. And all a waste of time. Mostly.

Take the US, for instance. You can learn everything you need to know about the American economy by sitting at the gate of a terminal at Los Angeles International Airport for two hours. On the one hand, diversity. You'll hear Chinese, Spanish (seemingly the co-official language of California), French, and dialects from the subcontinent that sound musical. A lot of people are coming to America, or at least passing through it and spending money.

But don't expect to find any good service. The bars and pubs were packed with people and trash, much like the concourse. The service everywhere, almost without exception, was uninspired and shoddy. Now, don't get me wrong. I've not become an elitist in my travels. After all, you're reading a scribbler who paid his way through college manning the till at a Texaco station.

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What I'm getting at are the extraordinarily exaggerated expectations in America over what it takes to get and stay ahead. 'States Take Lead in Push to Raise Minimum Wages,' reads a New York Times headline. Do they not know that 3 billion people are competing for Western jobs today? Can't they understand the maths, that means wages will fall until Americans - like the British and Europeans - catch down with their global brethren?

As a would-be economic missionary over the last few years, I've found that the Anglo-American economic gospel is flawed, maybe even heretical, if you ask Dr Kurt Richebcher. The economic pagans of the world do not worship the god of consumption. No one will be left unchanged by our inevitable encounter with the ambitions of the rest of the world.

Granted, not all of America's jobs can be outsourced. But what's really amazing when you travel outside America and then come back is the expectation that the American standard of living is a birthright that doesn't have to be earned by hard work. I'm generalising. Of course, there are exceptions. Lots of people work hard every day. But I wonder if most people have any inkling of the great global wealth migration I described in 'The Bull Hunter', the one that will punish non-saving, non-industrious, debt-laden consumers, but reward certain investors.

Take a look at the world's stock markets and you'll see what I mean. The Dow finished down last year. Up was the Nikkei by 40%. Up was the FTSE by 17%. Up was Australia's ASX 200 by 17%. Up were France, Germany, and Switzerland.

Say what you will about Old Europe politically. Economically, there are still problems too, namely a lack of consumer spending to drive growth. But maybe most consumers in Europe are less sure than their American cousins that the future will be infinitely better. They are less willing to pile on credit today and pay the interest on it with declining real wages. Americans feel no such compunction, and finance their high expectations with rising rates.

But borrowing money does not create wealth automatically. Business investment generally does. And in 2006, like in 2005 and 2004, a lot will come down to whether businesses invest. 'US growth may hinge on business,' says another headline. Duh. The story goes on to point out that with falling house prices, business investment should step in to fill the breach and drive the economy. New investment will create new incomes and everything will be fine.

But wait, there's more! 'Despite high debt levels,' we are told, 'it is still safe to say that Americans will somehow continue to buy on credit, and with energy prices falling, wages now diverted to gasoline purchases should be freed up to spend on the array of goods and services that drives the economy.'

That's right - energy prices will fall. Higher interest rates will not dent consumer spending. What's more, higher interest rates will not deter businesses from borrowing either. Quite the contrary. Businesses will spend! Spending and consuming rather than saving and producing will be vindicated as the surest way to wealth in a competitive world.

People who think like this are the same kind of people who took videos of the 2004 Boxing Day tsunami as it rolled toward them. They are doomed.

Now is a good time to become an exception to the rule. If your local stock market is down, look to foreign markets. If real wages are falling, look to higher stock market returns from overseas to drive your portfolio. And when all else fails, buy gold and energy investments. They are going up as a consequence of the tectonic shifts in the global economy.

The UK yield curve has been inverted for more than 12 months now. The US yield curve - the spread between short-term and long-term interest rates - inverted briefly last week. No one much seems to care, though. It used to be that an inverted yield curve predicted a recession. Anyone demanding higher interest rates for, say, a two-year loan than for a 10-year loan has some pretty serious concerns about the immediate future. To ease those concerns, they demand compensation through a higher yield on their short loan.

None of that matters anymore, we are told. Why? Well, long-term interest rates are being kept down by foreigners who simply adore US Treasury bonds. This steady bull market in long-term US bonds keeps long-term rates down, while the US Fed raises short-term rates. If it's a conundrum - as outgoing Fed Chairman Alan Greenspan once described it - surely it must be a pleasant one. Will it end anytime soon?

Yes. There are two reasons why. First, Asian central banks have supported the dollar by buying US bonds and keeping rates low. They've done this to recycle trade profits back into the American economy and to keep Americans solvent. They also had the nagging problem of what to do with huge dollar trade surpluses.

As the returns on US investments decline...as stocks, bonds, and trade profits fall while interest rates rise and consumer spending declines...it will make more sense to overseas investors to begin investing in their own markets. That kind of investment will do what it always does: create demand - ie, spending. In other words, the whole purpose of Asian macroeconomic policy will shift from producing cheap goods for America to promoting more balanced growth at home. And yes, we're back to the Money Migration again.

Why buy bonds when you don't need to support the dollar anymore? Why, indeed. Long-term rates will move up as the world's dependency on US growth wanes. And then there's OPEC.

As you may know, huge petrodollar surpluses have supported the US bond market - and more and more of them are being directed toward investment in local markets, not the US bond market. Granted, building a city from scratch in the middle of the desert, as the Saudis plan to, might not be the most efficient kind of investment.

But then again, what do I know about Saudi investment needs? I do know that the rest of the world often looks at America with a suppressed and knowing grin. They know the gig can't last when it's financed with their cash or borrowed money. They know living standards aren't a cultural birthright. And many of them are willing to work harder, for less, and for longer.

You can't make easy generalisations about how an entire country or region behaves economically. But if there is any use of statistics, they at least tell us what people are doing with their money. That, in turn, tells us what kind of choices they're making. And if we can go one step further, we can try to figure out why a person makes one kind of choice rather than another.

We won't get very far doing this, of course. Why does a housewife in L.A. buy a second SUV instead of buying Japanese banking stocks? Why does a merchant in Bombay buy a gold bracelet instead of Google? We can't know their intimate motives. But we can know that some people find consumption to be the natural role at the top end of the global food chain, while others delay consumption, save, and invest.

What does all this mean for the bond market, the yield curve, and the stock market? It means that competitive firms deriving profits from a growing global market will be great investments. It means firms that rely on continued consumption at low interest rates in the Anglo-Saxon economies will not be great investments.

It also means that there is an inherent spring-like nature to long-term rates right now. They are coiled for a rise. It's as if a benign-seeming fat man has been sitting on them, looking for a cool place to rest after a hot day toiling in the sun.

The man knows he can't sit there forever. That he must get up and find more productive things to do with his time and his money, take them places where they can keep his wealth growing and his children prosperous, or at least better off.

When he gets up - when the deliberate foreign buying of long-term US bonds slows down or dries up - then rates will skyrocket. The spring will be sprung. This is an ugly proposition for those who have a lot of debt. And if you've read 'Empire of Debt' by now, you know who I'm talking about.

It is a beautiful proposition for gold, however.

By Dan Denning for The Daily Reckoning

Dan Denning is the editor of Strategic Investment, one of the most respected 'big-picture' investment newsletters in the US. A former specialist in small-cap stocks, Dan is also author of 'The Bull Hunter' (John Wiley & Sons, 2005).

You can order your copy at a 30% discount here:

'The BULL HUNTER: Tracking Today's Hottest Investments'


And for more on investing in gold, read on...