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The Relative Strength of Countries

There is a current fixation on the U.S. deficit which has received mass media attention in recent weeks.  The fear mongering has caused a frenzy in gold, as well as people looking to invest in the US Money Reserve, commodities and other inflation protecting asset classes.  Unfortunately, currencies do not trade strictly on the country’s ability to pay its debt or its government’s monetary policy.  Instead, every currency trades against every other currency  These relationships make currency trades a tangled web of monetary policy/response and relative fiscal discipline.   When placing a trade on the dollar, the trade is for the United State’s relative standing against every country in the world.  This means that you cannot simply state that the United State’s negative current account balance, massive deficit, and loose monetary policy make the dollar weak because the situations of some other countries look even worse. With that as the backdrop, I would like to show why it seems that the current fear over the dollar is a bit overblown.

 

The US government balance looks horrendous, but so do others

The US government balance looks horrendous, but so do others. Source: IMF

The world is filled with a mix of spenders and consumers.  Citizens or governments of specific countries can save and invest or borrow and consume.   The US government has been running at a deficit for decades, as have a lot of other countries in the developed world.  This can almost be viewed as a privilege for those with stable governments and diverse economies.

 

Debt to GDP for UK, US, and Japan.   Source: IMF

Debt to GDP for UK, US, and Japan. Source: IMF

What is even more sobering than current deficits are the comparisons of gross debt to GDP.  The sad truth is that Japan is much closer to a sovereign default than the US can even imagine.  Its demographics are shifting from a nation of savers to an older generation of retirees being supported by a small working class.  Their government stimulus through the 90′s and this decade have put them on a perilous trajectory towards financial ruin and it is the reason that David Einhorn, hedge fund manager of Greenlight Capital, is betting that Japan is in the midst of a “death spiral”.

 

Demographics look grim for Japan

Demographics look grim for Japan. Source: John Mauldin

If you happened to think that the United States had a terrible problem with the baby boomer’s retiring then I suggest you look at the dependency ratio’s above created by John Mauldin.  The dependency ratio tells you how many old age retirees above 65 are depending on 100 working citizens.  Assuming that birth rates remain where they are today, Japan’s number of elderly will jump to over 75 retirees for every 100 workers by 2050.

On a relative basis, things could be a lot worse for the United States.  On a realistic standalone basis, things look pretty terrible for the United States.  There will be a lot of tough choices that need to be made in the coming years as budget deficits grow and looming entitlement dilemmas need to be solved, but I do have faith that those in control at the federal reserve will do everything in their power to stop an inflationary disaster.  Ben Bernanke has stated in the past few weeks that the United States needs to address its deficits and the FOMC has shown hawkish fear over future  inflationary pressures.  This is not to say that the federal reserve and the US government will not continue a gradual weakening of the dollar to fund current and past deficits.  Monetization of debt will occur, but it will not be the path of Argentina.

If we believe that a currency crisis is not at hand, then certain trades may make sense given the economic conditions.  Interest rates will not stay at their relatively low level.  That is why I recommended selling call options on TLT. Commodities (not just gold) diversify an investment portfolio and add protection against inflation over time. I do not expect inflation to kick in during the near term with 10% unemployment and tight consumer credit. As a short-term play for an anti-crisis view of the dollar, look at selling call options on oil or gasoline as the slow winter demand will tug on the fear driven prices.

Disclosure: Short TLT, Short USO

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Posted in Derivatives, Economics, Educational, Markets, Politics, Trading Ideas.

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4 Responses

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  1. Alexandra Gibson says

    My grandpa is also a Baby Boomer and we love him a lot.-:`

  2. Gabrielle Ross says

    my grandfather is also a baby boomer and he is also a war veteran,”:

Continuing the Discussion

  1. Six Global Risks to Spark a New Crisis – SurlyTrader linked to this post on November 11, 2009

    [...] As I noted in “The Relative Strength of Countries“, Japan is in dire straights.  With a deficit of over 10%, a debt to GDP ratio of over 200% [...]

  2. Aging Demographics | SurlyTrader linked to this post on June 30, 2010

    [...] demographics of developed nations is becoming increasingly dire. I have looked briefly at old age dependency ratios in the past, but I think that as we assess sovereign risk and growth rates it is an opportune time to revisit [...]



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