The Tipping Point

February 10, 2003 – I will be the first to admit that the future cannot be predicted just because some line on an uptrend channel is broken on some chart. Technical analysis is useful, but it does have its limits.

Consequently, I also use a healthy dose of fundamental analysis in these letters. So if my fundamental analysis confirms what my eyes are telling me from the charts, there is then a reasonable likelihood that a breakdown from an uptrend channel is meaningful.

In other words, when a break from a trend channel occurs, it may be signaling a change in trend. However, we don’t know from a chart whether any trend will prove to be meaningful, or just a head-fake. Fundamental analysis helps to explain not only why a change in trend may be occurring, but also how significant and prolonged that new trend may be. As a case in point, take a look at the accompanying chart of the US dollar index.

First, we can see that the index has been in a sharp downtrend since topping out in 2000 and 2001. Second, the index has now broken down from a 10-year uptrend channel. So far that break has not been significant, but it occurred nonetheless even as the dollar in recent weeks has strengthened against some components of that index, most noticeably the Japanese yen. That observation in itself indicates that not all is well with the dollar.

So the question becomes, are there meaningful fundamental reasons for this break of the long-term uptrend in the dollar index? The answer is a resounding yes.

To list but a few points that I have mentioned and/or analyzed in past letters: (1) the US dollar’s real interest rate (i.e., nominal interest rates minus the inflation rate) is negative, taking away the incentive to hold dollars, (2) commodity prices are rising, as evidenced by the recent 6-year high in the CRB Index, signaling renewed inflation, (3) the trade deficit last month exceeded $40 billion, which is now at a magnitude that makes it increasingly unlikely the rest of world will continue to finance these trade imbalances at current dollar rates of exchange, and (4) a number of countries – including the big trade surplus countries like China – have announced their intention to diversify their foreign currency reserves into the euro, and in China’s case, into gold as well.

Taken together, these and other problems for the dollar have led me to the conclusion that the greenback is in a downward spiral that will take it much lower. This same conclusion can be reached from the accompanying chart. Consequently, we have been playing – and continue to trade – the short-side of the dollar.

However, I have been suggesting in these letters that the current downward spiral in the dollar is not just some near-term phenomenon from which the dollar will eventually recover. Rather, I have been suggesting that we are witnessing the ‘beginning of the end’ of the dollar. What does that mean?

Well, to be honest, neither I nor anyone else can foretell what the implications of the ‘end’ of the dollar may mean. But we know that no fiat currency has ever survived, so I ask myself, why should the dollar be any different? Given the way the dollar is being mismanaged and abused (I noted above only four of many different problems for the dollar), I can see no reason why one should be optimistic about the dollar’s future prospects. To the contrary, the writing is ‘on the wall’, and in this regard, I think the ‘tipping point’ is near.

The tipping point is that level beyond which there is no return for the dollar. It is the point beyond which the dollar cannot be saved, and its death spiral begins.

It seemed that we were at the dollar’s tipping point in 1980 when inflation was well into the double-digits and the prime lending rate of US banks soared to over 20%. But though we looked into the abyss, the dollar did not fall over. This time around, I don’t expect that we will be so lucky.

It is clear that the demand for the dollar is declining. For example, even though annual growth rates in the money supply are declining, the dollar index is still falling. Thus, the demand for dollars is falling more rapidly than their supply, with the result that the dollar’s rate of exchange is falling against the world’s other major currencies. This trend will accelerate, leading to what I have been calling a ‘flight from the US currency’. Demand for dollars will continue to decline and then eventually begin to evaporate at an accelerating rate, much like it has for the Argentine peso, which is beyond its tipping point. So why is the tipping point so near for the dollar?

The answer is in pure mathematics, or more specifically, the mathematics of compounding interest rates and the resulting financial burden of carrying debt. In 2002 the federal government paid $332.5 billion of interest on its debt, representing an average interest rate of about 5.6%. This interest expenditure comprised 17.9% of total federal revenue, a multi-decade low. Falling interest rates and rising revenue in recent years has worked wonders for the federal government’s finances.

Not too many years ago, the expenditure for interest on the federal debt was 25% of federal revenue, and was approaching 30% in the late 1980’s and early 1990’s. Though the federal debt has continued to grow since then, the impact of this debt on federal finances has dropped because falling interest rates have reduced the financial burden of that debt. But now the economic recession has hit the budget with the force of hurricane Andrew.

The fanciful Bush budget projects that average interest rates paid by the federal government in the current fiscal year will drop to 4.9% and that the total interest expense will remain unchanged at 17.9% of total federal revenue. Mr. Bush’s budgeteers will probably be wrong in at least three respects: (1) revenue will prove to be overstated, (2) total interest expenditures will be understated, and (3) other federal expenditures will also be understated as the war and the slow economy continue to adversely impact federal finances. These errors will move the federal budget closer to the tipping point. And what is that?

The point of no return is reached when interest expenditure on the federal debt exceeds 30% of federal revenue. Could a company survive if 30% of its revenue was being paid as interest expense? Not likely, and further, monetary experience in other countries (particularly in Latin America in the 1980’s) shows that when this 30% threshold is reached, destruction of the country’s fiat currency is not far behind.

The current budget is projecting an all-time record deficit of $304 billion. Even if interest rates don’t rise, that deficit understates what will probably be the final result. Regardless, consider how easy it will be for the dollar to slip into a death spiral. With federal debt now at nearly $6.4 trillion and rapidly growing, a 1% rise in interest rates adds $64 billion to the annual deficit, which in turn swells the debt, which in turn raises annual expenditures for interest on the debt, which raises the deficit some more, and this vicious cycle begins all over again. The compounding interest paid on a federal debt that is spiraling out of control means that the tipping point is rapidly approaching.

Thus, the federal government is in a bind, for which both alternatives will destroy the dollar. Does it raise interest rates to reverse the move to negative real interest rates in the dollar and stop the inflationary pressures that are growing, which is an action that in turn causes the federal interest expenditures to go over the tipping point and destroy the dollar? Or does the Federal Reserve keep interest rates on hold to prevent federal interest expenditures from reaching the tipping point, which is an action that in turn causes the inflationary pressures in the dollar to build and destroy the dollar from inflation?

In either option, the dollar gets destroyed, which is I think the message from the page-1 chart of the dollar index. That break from the 10-year uptrend channel is significant. Is it any wonder why the primary trend in gold is rising?