ENJOY THE DOLLAR RALLY WHILE IT LASTS

From the desk of John Thomas

The Mad Hedge Fund Trader

Wednesday, June 29, 2011

Any trader will tell you the trend is your friend, and the overwhelming direction for the US dollar for the last 220 years has been down.

Our first Treasury Secretary, Alexander Hamilton, found himself constantly embroiled in scandals. Take a ten dollar bill out of your wallet and you’re looking at a world class horn dog, a swordsman of the first order. When he wasn’t fighting scandalous accusations in the press and the courts, he spent much of his six years in office orchestrating a rescue of our new currency, the US dollar.

Winning the Revolutionary War bankrupted the young United States, draining it of resources and leaving it with huge debts. Hamilton settled many of these by giving creditors notes exchangeable for then worthless Indian land west of the Appalachians. As soon as the ink was dry on these promissory notes, they traded in the secondary market for as low as 25% of face value, beginning a centuries long government tradition of stiffing its lenders, a practice that continues to this day. My unfortunate ancestors took him up on his offer, the end result being that I am now writing this letter to you from California—and am part Indian.

It all ended in tears for Hamilton, who, misjudging former Vice President Aaron Burr’s intentions in a New Jersey duel, ended up with a bullet in his back that severed his spinal cord. Cheney, eat your heart out.

Since Bloomberg machines weren’t around in 1790, we have to rely on alternative valuation measures for the dollar then, like purchasing power parity, and the value of goods priced in gold. A chart of this data shows an undeniable permanent downtrend, which greatly accelerates after 1933 when FDR banned private ownership of gold and devalued the dollar.

Today, going short the currency of the world’s largest borrower, running the greatest trade and current account deficits in history, with a diminishing long term growth rate is a no brainer. But once it became every hedge fund trader’s free lunch, and positions became so lopsided against the buck, a reversal was inevitable. We seem to be solidly in one of those periodic corrections, which began six month ago, and could continue for months or years.

The euro has its own particular problems, with the cost of a generous social safety net sending EC budget deficits careening. Use this strength in the greenback to scale into core long positions in the currencies of countries that are major commodity exporters, boast rising trade and current account surpluses, and possess small consuming populations. I’m talking about the Canadian dollar (FXC), the Australian dollar (FXA), and the New Zealand dollar (BNZ), all of which will eventually hit parity with the greenback. Think of these as emerging markets where they speak English, best played through the local currencies.

For a sleeper, buy the Chinese Yuan ETF (CYB) for your back book. A major revaluation by the Middle Kingdom is just a matter of time.

I’m sure that if Alexander Hamilton were alive today, he would counsel our modern Treasury Secretary, Tim Geithner, to talk the dollar up, but to do everything he could to undermine the buck behind the scenes, thus over time depreciating our national debt down to nothing through a stealth devaluation. Given Geithner’s performance so far, I’d say he studied his history well. Hamilton must be smiling from the grave.

Since nothing less than the fate of the free world depends on the judgment of Ben Bernanke these days, I thought I’d touch base with David Wessel, the Wall Street Journal economics editor, who has just published In Fed We Trust: Ben Bernanke’s War on the Great Panic.

I doubted David could tell me anything more about the former Princeton professor I didn’t already know. I couldn’t have been more wrong, as David gave me some fascinating insights into the inner soul of our much vaunted Chairman of the Federal Reserve.

Bernanke was the smartest kid in rural Dillon, South Carolina, who, through a series of improbable accidents, and intervention by a local black civil rights leader, ended up at Harvard. He built his career on studying the Great Depression, then the closest thing to paleontology economics had to offer, a field focused so distantly on the past that it was irrelevant. Bernanke took over the Fed when Greenspan was considered a rock star, inhaling his libertarian, free-market, Ayn Rand inspired philosophy in great giant gulps.

Within a year the economy had suddenly transported itself back to the Jurassic Age, and the landscape was suddenly overrun with T-Rex’s and Brontesauri. He tried to stop the panic 150 different ways, 125 of which were terrible ideas, the remaining 25 saving us from the Great Depression II. This is why unemployment is now only 9.5%, instead of 25%.

The Fed governor is naturally a very shy and withdrawing person, and would have been quite happy limiting his political career to the Princeton, NJ school board. To rebuild confidence, he took his campaign to the masses, attending town hall meetings and pressing the flesh like a campaigning first term congressman.

The price tag for Ben’s success has been large, with the Fed balance sheet exploding from $800 million to $2 trillion, solely on his signature. The true cost of the financial crisis won’t be known for a decade or more. The biggest risk is that we grow complacent, having pulled back from the brink, and let desperately needed reforms of the financial system and the rebuilding of Fannie Mae and Freddie Mac slide.

How Bernanke unwinds this bubble will define his legacy. Too soon, and we go back into a real depression. Too late, and hyperinflation hits. That’s when we find out who Ben Bernanke really is.

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“We’ve seen the S&P 500 drop 50% twice in the last decade. That is the new normal”, said Richard Kang of Emerging Global Advisors.