Dear Client,
The turmoil in the European currency markets has been the lead item in American newspapers every day now for weeks. Most of the reportage comes from fellows who first thought of currency relationships about twenty minutes before typing commenced. Just out of pique then, you could count on hearing from us. However, we have also gotten many serious calls wondering how events affected us, and whether we weren’t tempted to take profits now since the German bond market has rallied so strongly in dollars. Obviously, as value investors, we recognize this investment must have lost some luster today compared to six months and twenty percent ago. Still, we believe these bonds have much further to go, at least in appreciation, if not in time.
The dreams of European currency union was shattered as investors suddenly came to doubt various leveraged banking systems could withstand the Bundesbank’s austere monetary policy, designed as it is for the wholly unleveraged German financial system.
For our part, we feel a bit like guests at a hanging who wonder whether the posse hasn’t got the wrong guys. We know that after the scaffold is built and the crowd has come to town it can be a little dangerous to disappoint the mob with quibbles about just who’s guilty or not. Still, the mob seems to have forgotten that it was dollar weakness from July 21 on that induced European central banks to intervene, buying dollars and issuing their own currencies seemingly without regard for whether there was indeed long term investor demand for their monies. In the event, they have reaped a whirlwind, as overnight money rates in non-Teutonic Europe range from 17% for the Spanish, 20% for the Italians and 22% for the French. At a time of low inflation in all these countries, these extraordinary real interest rates nearly assure continuing and perhaps worsening business.
The contrast with America could not be starker. Our Administration never spies a downtick in the dollar that it does not applaud, so long as the selling is orderly enough not to make the morning paper’s front page. Indeed, the President himself has taken to running political advertisements hailing America’s coming export boom and the benefits of his malign neglect policy for our currency. How, in an age of instantaneous information flows, can intellectual fashions be this disparate? The Europeans, remembering the toll devaluations past brought in high inflation and even higher capital costs, have elevated the admittedly noble goal of a firm currency to the level of national obsession. Common sense dictates that there are competing interests to be considered as well. How, for example, can the Swedes believe that the benefits of Common Market membership, which neutral Sweden has managed until now to do without, could be worth 500% interest rates and the virtual bankrupting of their nation’s banks?
In America, by contrast, keeping up with the German Joneses is the last thing concerning our Authorities. Re-election looms, and the dollar can shift for itself. Yet is there really no longer term costs to be considered? Since the first World War dollars have been welcome everywhere in the world as a medium of exchange, even between two participants who had no immediate American trade plans. Were that to change, if foreign businesses wanted in trade only yen or Euro-currencies, a tremendous American advantage in trade would be ended and the already frightful American trade deficit made worse. In particular, how long will the Arab oil kingdoms accept their income is in dollars but their expenditures are overwhelmingly in other currencies?
Perhaps the oddest aspect of American finance is the continuing childlike faith shown in the Federal Reserve Board to make right soon whatever is going very wrong in the economy today. It has been six quarters and many rate reductions since the end of the Persian Gulf War, when the recession was ostensibly scheduled to end as consumers re-emerged from watching CNN’s war coverage. General Schwartzkopf’s memoirs have made it to the stores faster than those returning consumers. Still the Fed is hailed as omnipotent, despite its ineffectual efforts to here.
This is all the more remarkable considering Europe just staged a spectacular show of “markets over Ministers”. In the space of ten days, an edifice that central bankers had spent 13 years erecting was treated no more kindly by the markets than a mobile home by a hurricane. We were even treated to the spectacular display of the Bank of England, that distinguished old lady of Threadneedle Street, making English rates 10%, 12%, 15% and 9%, all in a day, in the first central banking “do over” in recorded history. Just as it seems to take a hurricane to get people to build their houses further in from the beach, so our bond market is happily oblivious to the obvious winds of inflation an endless series of dollar devaluations is sure to create.
This is quite a U-Turn for us, as those of you with us for a decade or more can attest. We were, ten years ago, a touch early reaching for American bonds at mid-teen rates when inflation raged unabated and we thought deflation was the order of the day. Although it turned out very well in the end, we still have slightly singed fingers from the experience. Consequently, we are leaving our small gold position small until the day it begins making us real money. Still, we walk in the office every morning fully expecting this will be the day.
The stock market as a whole, on the other hand, continues to trade as if Mr. Micawber were running the largest mutual fund in the country. Essentially bankrupt companies continue to trade at many billion dollar market capitalizations “in the hope that something will turn up.” Should that something ever turn out to be interest rates, scenes of Dickensian poorhouses may fill the thoughts of the currently blissful owners.
For we do think higher rates and some form of American currency controls are the coming surprise. Higher rates, because the lesson of the European experience is that when an unnatural alignment of monetary systems is finally swept aside, “the Authorities” are as much ineffectual onlookers as much as the public at large. This could not have been illustrated in more vivid style, and surely whatever the sins of the EMS, they are as nothing compared to the absurdity of 3% American rates when the rest of the world pays the rates cited above. Currency controls, perhaps, because that same beleaguered Fed may believe announcement of a discount rate hike to be akin to shouting “fire” in a crowded theatre just now, and prohibiting Americans from fleeing with their money may first, temporarily, seem the better part of prudence.
Wishing you and yours well, we are,
Sincerely yours,
Edwin A. Levy
Michael J. Harkins