Tags: Fed | dollar | euro | taper

It Might Be Time to Start Accumulating Dollars

Tuesday, 17 Dec 2013 12:09 PM

By Hans Parisis

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Federal Reserve Chairman Ben Bernanke made some interesting remarks at the ceremony commemorating the 100th anniversary of the signing of the Federal Reserve Act on Monday, saying the Fed must continue to be willing to make tough decisions, based on objective, empirical analysis and without regard to political pressure. He also added the legitimacy of Fed's policies rests on the understanding and support of the broader American public, whose interests the institution are working to serve.

I think it could become really interesting what Bernanke will say on Wednesday at the occasion of his very last press conference as Fed chairman after the Federal Open Market Committee has concluded its two-day session and where starting tapering of its $85 monthly bond buying program will be decided.

I don't believe long-term investors should really worry that much if the Fed starts tapering this week or within the first months of 2014. Of course, that's not the case for the "traders" category. Fact is, the Fed will start and continue "tapering" if the data on the Fed's objectives for growth — employment and inflation — will allow it. Maybe it's good to remember that all this is strictly and only about the American economy as a whole and the Fed can't and won't take into account what could be the impact of its decision to taper on the rest of the world.

For long-term investors who have interests in emerging markets, it could be wise to do some homework and check if the country(ies) where they have asset allocations have experienced serious currency depreciations, reserve losses and stock market declines when talk turned to tapering during the summer, because there is a great probability we'll experience other negative corrections (yes, in plural) in 2014 again.

Please keep in mind that for emerging markets the so-called "relative good" policy fundamentals as well as nice economic performances that include lower budget deficits, shrinking public debts, higher reserve levels, better "real" GDP growth, etc., should not be considered as fully safe "insulations" to the longer-lasting impacts Fed tapering will cause, especially on rising yields on top rated bonds like U.S. Treasurys.

All investors should take this seriously for the simple reason it will be an unavoidable development that will represent a sizable financial shock that will be coming from beyond the emerging markets' borders.

To refresh our memory rising yields moving back to normal rates mean the U.S. 10-year Treasury benchmark yield, which is now close to but still below 3 percent, could go back to its average yield it had over the last 32 years of about 6.5 percent. The highest yield was on Sept. 30, 1981, at 15.84 percent, and the lowest yield was on July 25, 2012, at 1.43 percent.

Yes, the era of "money-for-nothing," which is an abnormal situation that was put in place because of the financial crisis that fully started in 2008, is quietly coming to its end, although it will probably take several years.

Coming back to Europe for a moment, on Monday, the European Banking Authority (EBA), the European Union's banking watchdog, signaled a serious and worrisome situation whereby local banks in the still troublesome euro area countries are again buying their own still weak sovereign debts.

No one can overlook the fact the numbers revealed by the EBA show net exposure of the 64 leading banks of the euro area to sovereign debt rose to 1.59 trillion euros, or $2.19 trillion, between December 2010 and June of this year.

For example, in December 2010, Spanish domestic banks held 78 percent of their own sovereign debt, while in June 2013, they held 89 percent of their local debt for an amount of 138.46 billion euros, or $190 billion.

In December 2010, Italian domestic banks held 59 percent of their own sovereign debt, while in June 2013, they held 76 percent of their local debt for an amount of 207.8 billion euros, or $285 billion. And we could go on for Greece, Cyprus, Ireland, etc.

As a long-term investor, I would take this warning very seriously and certainly not participate in the "wishful thinking exercise" that the eurozone is getting out of the crisis, notwithstanding it didn't lose one of its wheels in 2013. We should also keep in mind that in 2014 we'll have to digest the results of the bank stress tests.

Finally, with the new government in Germany now installed with Chancellor Angela Merkel remaining at the helm and Finance Minister Wolfgang Schaeuble keeping his post, I don't think it's an overstatement to say the euro area's "banking union" won't be happening tomorrow.

In this context, it is noteworthy that on Monday, European Central Bank (ECB) President Mario Draghi openly criticized during a hearing at the European Parliament in Brussels plans of several eurozone governments on how they think to deal with failing banks in the future by saying, "I am concerned that decision making may become overly complex and financing arrangements may not be adequate." So, that's where we are today.

From my side, I wouldn't bet on a real and sustainable euro area recovery any time soon. I know, some say markets in Europe are cheap and therefore they should be bought. In my opinion, buying those kinds of cheap markets is still not buying "cheap." Besides that, I also expect the euro to move lower against the dollar in 2014, mainly because the countries that generate sizable foreign exchange reserves will probably see their foreign exchange reserves accumulations coming down and therefore will have to cut down their euro purchases.

In this context, it's interesting to take notice that China increased its holding of U.S. dollars by $163 billion during the third quarter of 2013. We only have had superior numbers in the second quarter of 2009, the third and fourth quarters of 2010 and the first quarter of 2011.

No, I wouldn't write off the dollar yet. On the contrary! I personally would be inclined to start accumulating gradually dollars in case it dips below the 79 zone in the U.S. Dollar Index, for the very simple reason that tapering and higher yields will come in the near future.

If not now, then certainly in the coming months. Of course, I could be wrong, as could be anybody else.

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