US Fiscal Expansion and the Dollar

It sounds absurd, but the immense amount of government spending in the US with huge budget deficits is actually helping the dollar get stronger vs almost all the world's currencies.  Logically, it makes no sense for the value of a nation's currency to go up vs more fiscally sound countries.  Shouldn't more dollars in circulation from all that government pork spending/lower tax revenue make the dollar less valuable?  It can only happen in a world where the US is the reserve currency.  A similar thing happened in the early to mid 1980s when the US government ran big budget deficits, which kept the economy hot, and thus interest rates high.  The USD kept going up during that time, because of interest rate differentials and a growing use of the USD as a reserve currency due to expanding world trade.  This time, its mainly due to interest rate differentials.  There is a belief in the market that the US will be able to keep interest rates higher than all the other developed economies because of its Argentina-style fiscal policy.  If Argentina tries to run this policy, its currency gets crushed and interest rates soar because of the high inflation.  

 Eventually, water finds its level.  Currencies don't permanently have more value when the government decides to go crazy and go on a spending binge on the nation's credit card.  The dollar went sky high and then straight back down in the 1980s.  By the way, there was no recession during this period, as the government was running big deficits at the same time there was a productivity/labor boom as more women entered the labor force and computing power skyrocketing. 

The circumstances between now and the 1980s is totally different.  There is no productivity boom.  And its the opposite when it comes to the labor force, as its not growing, which is inflationary.  It used to be commonly believed that aging demographics was deflationary, mainly due to what happened in Japan.  But Japan had deflation not because of an aging population, but because it had low M2 money supply growth, a trade surplus, keeping its currency strong, and from importing cheap goods from China.  When you have fewer workers, and more retirees that receive government benefits while doing nothing but consuming, that reduces the ratio of labor output to money in circulation.  That's inflationary.  That leads to wage inflation.  That's what's happening in the US.  There is no free lunch from huge fiscal expansion.  It is at the root of almost every high inflation episode in human history.  

Inflation will be a long term problem for the US because there is no political will to cut back on spending, reduce Social Security/Medicare benefits, and to raise taxes.  The mantra is still deficits don't matter.  Ironically, people cared more about the national debt and big budget deficits in the 1980s and even 1990s, when it was a much less serious problem.   Now, when its a big problem, the public just doesn't care.  They want their stimmy checks and government cheese.  At the same time, they complain about inflation.  They can't connect the dots.  So the politicians continue to pander to them and hand out freebies for votes.  

The Fed is effectively the central bank for the world, and its forcing other central banks to follow its course or have its currency devalued.  Japan is a prime example of a country that has decided to go at its own pace, ignoring the Fed's tightening monetary policy, which has resulted in the market crushing the yen.  Europe, Australia, Canada, South Korea, etc. have decided to follow the Fed's tightening to a certain extent, allowing their currencies to depreciate more gradually.  But they pay a price for this.  Those economies are more interest rate sensitive than the US, mainly due to variable and short term fixed rate mortgages being the norm in those countries.  In particular, the other developed economies outside of the US have a larger percentage of bank loans based on LIBOR/SOFR type money market rates, and less long term funding from bond issuance.  Thus, you are seeing a much slower economy in the developed world outside of the US because they decided to follow the Fed.  Either keep interest rate differentials small and really slow down the economy, or face a brutal currency devaluation like Japan. 

The fight against inflation started by the Fed and followed by many other central banks has been more effective at slowing growth and killing inflation overseas than in the US.  European inflation numbers are heading down quickly, and likely to easily go below 2% in 2024, opening the door for Europe to start rate cuts before the US.  Europe is also suffering more from the higher rates as the policy transmission has been much quicker and pervasive.  Germany is already in a recession, and will likely soon be followed by many others in Europe.  There has been and will be less fiscal expansion in Europe and Asia vs the US, which contributes to the growing GDP gap.  

We are now at the point where the monetary policy is starting to be felt in Europe, as the PMIs are very weak and signs point to a very hard landing with Lagarde in the cockpit wearing an owl costume.  Its looking like the US recession people were calling for at the beginning of 2023 is going to happen to Europe at the beginning of 2024.  Remember, about 40% of the S&P 500 revenues come from overseas.  Most of that is from Europe and Asia.  While I don't expect the US economy to do as poorly as many predict in 2024, I do expect the European and Asian economies to be even weaker than consensus.

Last week was all about Yellen trying to play Fed chairman by manipulating the supply of bills and coupons.  Its like rearranging the deck chairs on the Titanic.  There is only so much you can do to "improve" on a horrible situation.  The coupon supply will still be huge and hard to digest at these yields unless you get more weak econ. data and more dovish cooings from Powell and co.  We've seen time and time again when the going gets the tough, the authorities come to the rescue.  Yellen and Powell caving to higher bond yields was the story for last week.  Considering how much hedge funds reduced net equity exposure in October, you had a lot of dry tinder soaked in gasoline waiting for a match to ignite it.  Yellen and Powell were the matches.  

When you see such an explosive move like you did last week, something that blew me away, its usually got some staying power.  I doubt its the start of a huge rally that lasts several months like in March, but more like a 3-4 week rally that takes us to strong resistance near the top of the range, up to around 4450-4500.  

For the bond market, in a rare occurrence, the call options punters were right to bet on a big bounce in TLT.  I don't have much confidence in the long bond sustaining a long rally, but will not short it until you get closer to the August highs in 10 yr yields around 4.30%.  At current levels, I see very little edge in a short term trade.  Overall, still leaning bullish on stocks and neutral on bonds.