Midland Asset Management

The end of the US dollar as the world’s reserve currency is one of the more popular financial conspiracy theories given extra umph by the recent writings of Zhou Xiaochuan (Chinese Central Bank Governor) and the recent G20 meeting in London last week.  As of 4/8/09, $6.9 trillion of Treasury debt was held by the public, and inter-government borrowing was $4.3 trillion, for a total of $11.4 trillion (doesn’t include unfunded liabilities of around $60 trillion).  China holds somewhere around 12% of US debt through various government entities (excludes Macau, Taiwan and state banks). 

A reserve currency is not decided upon; it creates itself.  After the break-up of the Bretton Woods Agreement in 1971, the US dollar became the reserve currency because no other option existed.  Two things are needed to create a reserve currency: 1) enough liquidity to support a global financial system, which needs a Central Bank with enough independence from the central government, and 2) the economy of the reserve currency needs to be large enough to withstand large changes in that currency RELATIVE to other economies.  The Swiss Franc, Japanese Yen, Euro, British pound, Australian dollar and Canadian dollar do not meet both requirements.

The major economies have either started (Switzerland, Japan and US) or are going to start (Europe, Oceania etc.) to print money (called Quantitative Easing).  Foreign exchange pricing is a relative, not an absolute, process, so the US dollar could remain relatively stable, only because it is the best of the worst.  There is a real risk of this debt supercycle falling apart, as the bond market vigilantes may eventually not want to own this or that country’s debt (longer issue of unknown timeline).

Bottom line:  I am agnostic as to whether the US dollar remains the reserve currency of the world.  My job is to avoid making a directional bet on the US dollar or any currency or country.  The final outcome lies somewhere in the middle of these asymmetric outcomes.  Your investment strategy thinking should consider such a path. 

Always Asking, Never Assuming™

Christopher Holtby

One of the advantages of growing up in Canada was my realization that our country was globally insignificant, both economically and politically (I am a few weeks away from becoming a US citizen).  When you realize that you are not the biggest and baddest kid on the block, you are more humble about your actions and spend a lot of time understanding all of the other players and the economic/financial inter-relationships.  The re-emergence of China as a world economic superpower poses an interesting challenge for America and the rest of the world, as China is the largest creditor and America is the largest debtor.   

China’s current prime minister, Wen Jiabao, has talked about his country’s “great power” and the need for the American government to fulfill its fiduciary obligation regarding the protection of China’s $1 trillion nest egg in US Treasury bonds.  This week’s meeting between the G20 has been called the G2 meeting, because President Obama and President Hen Jintao of China make the rest of the world nervous about this Pacific duopoly.  China actually is unsure of its new role in the modern world, as historically it remained insular (roughly 2000 BC to 1900 AD).  

Since Deng Xiaoping’s partial introduction of free market principles in the early 1980s, China has lifted hundreds of millions of citizens from subsistence living.  Yet on the world stage, it has remained largely silent regarding issues ranging from Sudan to Iran and has obstructed progress through its permanent seat on the UN Security Council.  

A popular magazine in China, Liaowang, believes America will never cede control of world order.  In essence, they don’t trust the motivation of the gweilos.  The Chinese have been following Deng’s example of keeping a low profile, not taking the lead, watching developments patiently and keeping its capabilities hidden. 

Bottom line:  The G2 are joined at the hip and will fail or succeed uniformly.  Investors need to plan for fits and starts regarding Asian emerging investments, as the Chinese are patient, and the Americans are not.  

Always Asking, Never Assuming™

Christopher Holtby

“Government,” observed the renowned Austrian economist Ludwig von Mises, “is the only institution that can take a valuable commodity like paper and make it worthless by applying ink.”  President Roosevelt was as incompetent and culpable in extending the severity of the Great Depression as Herbert Hoover.  Why?

1)     He seized physical gold assets held at banks.  This created the fear that government no longer respected private property.

2)      He devalued US dollar, which was fixed to the price of gold, by lowering the value of gold by an arbitrary figure of 21% because it was a lucky number (John Morton Blum, From the Morgenthau Diaries: Years of Crisis, 1928-1938 (Boston: Houghton Mifflin Company) 1959, p. 70).  This is an example of how solutions were not structurally vetted.  

3)      He created the National Labor Relations Act in 1935, which was better known as the “Wagner Act”.  It took labor disputes out of the courts of law and brought them under a newly created federal agency, the National Labor Relations Board, which became prosecutor, judge and jury, all in one.   

4)      A tax on corporate retained earnings, called the “undistributed profits tax,” was levied.  This lowered production of all goods and and caused a decline in the hiring of new workers.  

5)      Roosevelt raised the top tax rate to 79 percent and then later to 90 percent.  This curtailed incentive to create wealth, thus reducing the ability hire more workers.

6)      From the summer of 1936 to the spring of 1937, the Fed doubled reserve requirements at the nation’s banks.  This meant banks had less money to lend out.  This reduced the amount of money available to create new opportunities and eventually new jobs.  Even though the Federal Reserve is independent of the legislative and executive branches, the Fed is heavily influenced by them.

It was the ending of World War II that unleashed the reconstruction of the US landscape that ended the purges of the Great Depression.

Bottom Line:  No government in history has ever had a game book telling them what to do during a crisis.  This means investors/businesses need to stay flexible with their assumptions and investment timelines because the rules can change without long-term logic.  The same legislators who created this crisis are now trying to solve it.

Always Asking, Never Assuming™

Christopher Holtby

A primary dealer is a financial institution that the Federal Reserve uses to adjust the amount of Federal Funds (amount of money held at the Federal Reserve) swishing around the system, and to keep the Federal Funds rate at the target rate set by the Federal Open Market Committee.  There are two problems with this system: 1) there are only 16 primary dealers left (50% of which are foreign institutions), and 2) the target Federal Funds rate is between 0% and 0.25%, making the bid/ask spread wider, and thus, US Treasury bonds more expensive for non-primary dealers.  

Every morning around 9AM at the Federal Reserve Bank of NY, the Fed, Open Market Desk, and Treasury determine the level of reserves needed for that day.  Once the needs are determined, either to increase or decrease the reserve, electronic bids are sent to the primary dealers.  Why would any firm want to be a primary dealer?  Because: 1) They get information about bid/ask spreads, volumes, etc. due to increase of Treasury borrowings and quantitative easing programs, and 2) They can re-distribute Treasury securities throughout the global financial system at a bid/ask spread when they sell/buy them at no spread.

The Treasury and the Fed will likely want to increase the number of primary dealers in order to reduce geographic risk (many primary dealers are based in Manhattan) and increase the depth of the Treasury market in light of a surge in supply.  The European Central Bank uses a different system and has over 500 counter parties, compared to our 16.   

Bottom line:  A boring section of the bond world is now an important part of any tactical asset allocation decision thought process. 

Always Asking, Never Assuming™

Christopher Holtby

During the spring rush (called the chun yun in Manderin), around 196 million Chinese head back home to celebrate the Lunar New Year.   Comparing this to the American Thanksgiving holiday (11 million people moving around) or the Muslim Hajj (2.5 million people), the Chinese chun yun is of great significance to the Chinese internal provinces’ politics and economics.

Typically, migrant workers during the spring rush went back home, with money, to their families in the Chinese countryside.  The countryside has not participated in the rapid growth and creation of wealth that the coastal areas of China have experienced.  Separately, the coastal provinces, which are export dependent provinces, needed to have their goods on boats heading for the Americas or Europe by late October to reach the shelves for the holiday season.   A portion of those workers then left their work in late October due to layoffs and headed home, planning to return in mid-February to resume work.  This year, the opportunity for work, especially in the province of Guangdong (1/3 of China’s exports), is not likely to be robust.

Moa Zedong, China’s first communist leader, was the leader of the famous Long March.  This march from the peasant countryside began the communist revolution in China more than 50 years ago.  The greatest fear of current Chinese leaders is an unfed and unhappy peasantry.  Lean years tend to spark more protests than the boom periods.  The biggest challenge for the Chinese government will be keeping their workforce working.  Estimates abound that China GDP growing at less than 5% is considered a zero growth rate, considering the number of new workers entering into the workforce.   

Bottom line:  The current Chinese leaders understand the risks when peasants are discontent.   A truly black swan event would be another Chinese revolution.  

Always Asking, Never Assuming™

Christopher Holtby

John Maynard Keynes was a classical economist, who wrote a seminal book in 1936 called the General Theory of Employment, Interest and Money ( a good read…equal to Peter Bernstein’s book Against the God’s: The Remarkable Story of Risk).   Anyway, he coined the term the Paradox of Thrift or the Savings Paradox.

The paradox explains an environment where a population saves money during a recession, causing aggregate demand (total demand for final goods and services in the economy) to fall, and leading to lower net savings of that population (downward spiral of lower demand, more job losses, more using up of the family savings, and thus lower total savings in the population).

There are assumptions to this paradox, including the definition of net savings, a population’s GDP, definitions of aggregate demand, interest rates, types of consumption, etc.   This paradox, though not intimately discussed by Keynes but by other economic scholars, does not address the Paradox of Thrift in a globalized economy and financial market as we find ourselves in today.  For example, if internal demand in China and India increase by just a few percentage points, how might this influence our cost of capital (US Treasury yields) versus our exports to those countries?  How will the baby boom generation save?…spend just a little less or a lot less?

Bottom line:  The Paradox of Thrift needs to be considered when considering your investment choices, your investment time lines and your willingness to accept uncertainty in your ending legacy wealth values.

Always Asking, Never Assuming™

Christopher Holtby

Japan’s real estate and stock market bubble burst in early 1989.  Due to concerns about re-inflating the prior bubble and the Japanese culture of “bailing out” public institutions, the Japanese policy makers raised rates by 2% shortly after the stock market bubble burst.  It took the Japanese policy makers 18 months to start decreasing official interest rates.  For example, at the time of the bubble burst, rates were approximately at 4%.  It took 3 years before interest rates were at that level again.  The hawkish (meaning scared of inflation) stance caused debt deflation to really become entrenched into the Japanese economy.   Fiscal response that was meaningful to the Japanese economy took around 3 years from early 1989, and quantitative easing by the Bank of Japan took around 10 years.

The Federal Reserve, Treasury Department and the President-elect’s office have taken an opposite course of action compared to the Japanese Diet and the Bank of Japan.  They have focused on by-passing the banking system (not using the SOMA structure entirely), creating the Term Auction Facility, creating ad-hoc measures to bailout financial institutions, creating the Commercial Paper Funding Facility, launching the Supplementary Financial program, creating the Troubled Asset Relief Program, guaranteeing ALL money market funds from 9/19/08-12/19/2008, creating the Term Asset-Backed Securities Loan Facility, increasing the number of countries that have access to the Fed’s currency swap desk, paying interest on bank reserves held at the Federal Reserve, and so on. 

Bottom line –  the Federal Reserve and Treasury Department are “printing money” through many different avenues to win the battle over debt-deflation.  As history shows us, the Japanese yen appreciated 2% during the five years of massive quantitative easing by the Bank of Japan.

Always Asking, Never Assuming™

Christopher Holtby