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It’s not hard to understand the relationship of the dollar with human emotions like greed and fear. And that relationship is rarely more visible than it is today …
When investors are willing to take on more risk, stocks, emerging market currencies and commodities all bounce. On the other hand, when fear is prevalent, the dollar soars, Treasuries take off, and gold starts sniffing towards $1,000 an ounce.
This relationship between greed (risk) and fear (safety) is the driving force of financial markets right now. For investors and traders alike, understanding this environment and making the judgment on where the cycle of risk appetite stands is the key to success.
Before I go on, though, here’s a look at the basic definitions of these two market forces and how they apply to investor sentiment …
Greed (Risk):
Possibility of Loss
Or Injury
Risk-taking is the foundation of capitalism, incentives and rewards. It inspires creativity, growth and advancement. When expected returns compensate for the risk taken, risk appetite rises. For example, if you’re presented the opportunity to risk $1 to make $5, you might take that risk. However, if you have to risk $5 to make $1, you might think twice before jumping in.
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Fear (Safety):
Freedom or Security from
Danger, Harm, or Loss
Safety is a tenet of preservation — keeping what you have and preserving its fundamental value.
During the recent run-up in asset prices, an extended period of easy money meant that investors, bankers, traders, speculators … even home owners could risk someone else’s money and reap the rewards for themselves.
Sure, a deal gone bad might have caused them to lose a job or their good credit, but not necessarily any of their own money. The reward to risk evaluation was lopsided. And the key to economic growth — incentives — became skewed.
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| When markets across the globe tumbled, self-preservation and preservation of capital hit center stage. |
In June 2006, when the housing market topped, asset values across the globe tumbled as credit lines were reined in and the leverage-induced bubbles burst. The leveraged losses reinforced the panic and accelerated the speed of decline — self-preservation and preservation of capital hit center stage.
Now, a mental tug of war is going on for most investors: Keeping what they have vs. attempting to get back what they lost.
Therefore, there is an ebb and flow of risk-taking and risk-aversion steering the markets.
Risk Aversion and the Dollar …
When investors from around the world decide where to park their money in this climate, the U.S. dollar is consistently the winner. Why?
The United States:
- Is the world’s wealthiest country,
- Has a stable legal tradition,
- Has historically responsible macroeconomic policies,
- And has a top-notch credit rating (more on this in a moment).
The massive flow of global capital into Treasuries, the dollar and safe-havens like gold is the sign of another lopsided risk-to-reward relationship. Only this time the lopsidedness is slanted to safety. In other words, the risks heavily outweigh the returns. This is the direct result of the global economy’s structural injuries, the breakdown in trust and confidence, and the extreme uncertainty of the future.
And with economic conditions continuing to deteriorate, credit still tight and consumer and corporate balance sheets in disarray, this global risk aversion is likely to be around for quite awhile.
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The Dollar Safe Haven …
But for How Long?
Sure, the U.S. dollar and the Treasury market were the place to be when stocks were falling off of a cliff, when commodities plunged, when real estate markets began to collapse and when the real economic consequences began to be felt. But now, the damage is known, and it’s known to be widespread. And the respective solutions from world economies are on the table.
So how can the dollar remain the place for safe harbor?
After all, the U.S. Treasury is creating money out of thin air, and the government is spending, committing, lending money it doesn’t have …
So here is the important question you should be asking:
Aren’t all of these stop-the-bleeding tactics massively inflationary and an ultimate doomsday scenario for the dollar?
In the short-run, no. In the long run, perhaps.
The Fed is well aware of the inflationary consequences and has made it clear that it will be on the offensive when the time comes. For now, avoiding deflation and stimulating economic activity is priority number one.
Sure, the patchwork plans of the government are hard to watch without getting queasy. But it all comes down to this: The problem is global, and it will be approached by coordinated efforts. The UK is aggressively fighting with all the fiscal and monetary tools possible. Ditto for Japan. The Eurozone, begrudgingly and in lagging fashion, has committed to doing the same.
The global mantra in dealing with this continued recession: “By any means necessary.”
So, when every major central bank is cutting rates to the bone, when governments are creating massive spending plans and creating new money to put in consumers’ hands, the inflationary impact becomes global.
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| Until we can determine which central bankers are best managing inflation, the dollar wins by default. |
When the inflationary impact is global and the ultimate outcome uncertain, the demand for U.S. dollars remains high. It’s a hedge on global depression — a worst-case scenario hedge that aligns your money with the biggest, broadest economy in the world.
With the interrelated nature of global economies, there is not a relative outperformer in this crisis. So the dollar wins by default! And until the impact of stabilizers and stimuli turn inflationary and until we can determine which central bankers are best managing inflation, the dollar should continue its strength.
Regards,
Bryan
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