Currency War - Act III Will Be a Major Devaluation of Euro

Not because they want to, it is because they will be forced to do so. The history of the early 1930’s is being replayed today. After the financial meltdown in 1929 that led to the Great Depression, countries were under huge financial stress. England was the first to go off the gold standard in September of 1931, which caused its currency to devalue by 30%. The US was next, with FDR issuing an executive order prohibiting ownership of gold punishable by a fine of no more than $10,000 and imprisonment of not more than 10 years. Citizens were required to turn in their gold for $20.67 an ounce. Once the government owned the gold, they moved the official price of gold to $35. This move effectively devalued the US dollar by 70% when measured against gold. The US and Britain now had a competitive advantage over other countries – their goods were cheaper – which caused economic pain in other countries. France finally had to devalue its currency in 1936 to stay competitive.

Today’s currency war is no different. The first to declare war in today’s currency war was Britain and the US by expanding bank balance sheets – i.e., printing money. The effect of this policy has been to devalue the dollar against other currencies. When this happens, it stimulates our economy because the goods in the US are now cheaper on the world markets. This is why it is not surprising that manufacturing has led us out in this recovery. Act II is occurring in Japan. The Yen has dropped more than 17% in value since October as the new government actively pursues a devaluation strategy. They are doing this to spark growth in Japan.

Act III will be the devaluation of the Euro. Why? Because if they don’t, Southern Europe will dissolve into social chaos and the EuroZone will change dramatically from what it is today. There are two distinct parts of Europe, northern and southern. The northern part of Europe is still doing relatively well while southern Europe falls further and further into economic decline. The chart below, taken from Der Spiegel, graphically demonstrates one of the key differences between northern and southern Europe today – the percentage of children living at home between the age of 25 and 34. Understandably, discontent is rising among the youth. In Spain, the unemployment rate for those under the age of 25 is now over 55%. This is the level Egypt had two years ago before Mubarak stepped down from power.

In James Rickards’ book, “Currency Wars”, the first part of the book describes how he was a member of a team competing in a currency war game at the Applied Physics Laboratory in Washington D.C. in 2009. The strategy Jim employed in the game was that Russia and China would create a currency backed by gold. The biggest loser was the United States at the end of the game. Is this war happening today? Maybe! Central banks around the globe purchased gold at record levels last year. The biggest buyer over the past decade has been Russia. Maybe Putin formulated his own war game a decade ago.

Currency wars are not new and countries will always look at ways of besting other countries. Typical of currency wars is the devaluation of all currencies. The thought becomes, if you print, then we will print. If there are more dollars – Euros, Yen, Yuan, etc. – inflation will be the outcome.

What does this mean for your portfolio?

If the currency wars continue, the biggest losers will be bond holders. Why? If inflation comes back, bond investors will demand a higher rate of interest on those bonds. For example, if an investor were to buy a 10 year bond today yielding 2.0% and interest rates rise to 4%, the loss the bondholder would suffer on the price of that bond would be more than 15%. Bond investors have the biggest risk and we believe it is important to be over-weighted in shorter-term bonds at this time. At some point, the best investment will be to short Treasury Bonds – through exchange-traded-securities. The timing of this is important because in the short-run, the Federal Reserve has unlimited resources – they can print money – to buy bonds causing a short-term drop in interest rates. But this drop will be limited by inflation. Commodities also tend to do well during currency wars because they are a hedge against inflation.

Sincerely,

Your THOR Team