DR.

KURT RICHEBÄCHER

CURRENCIES AND CREDIT MARKETS

No. 252 I April 1994

"The supply of capital funds will in the long

run simply consist of the savings of the community.
But over any short period the savings
may be supplemented by a release of cash either from
existing balances or from bank loans. It
R.G. llawtrey, A Century of Bank Rate, p. 175
Frank Cass & Co. Ltd., 1962.

HIGHLIGHTS

We again reemphasize our warning to investors: Liquidity, liquidity, liquidity! Nothing else
matters.

The world's financial markets continue to be shaken in recent days. Is this the beginning
of the
unwinding of the great, global financial bubble? Although it's inevitable, it's still too
early to tell.
Nonetheless, the risks clearly
remain on tbe downside.

Very few people grasp just how enormous the present bubble really is. Compared to Japan's
a few
boom years agò, the present one may appear relatively modest. But in terms of its global
reach, this bubble is tbe most dangerous
and pervasive in financial history.

Most financial market pundits still don't realize what's going

on and are at a complete loss to
explain the carnage. Paradoxically, these blind apologists for the market deçlines
now all call for
a return to
sanity. The way we see it, a semblance of sanity has returned.

Every crisis is caused by abnormally low interest rates. By stimulating excess spending,
is
illiquidity
always .the inevitable result. In that regard, this time was no different. What
was unusual is
that the spending excesses went largely into the financial
markets rather than the real economies.

Why have the European bond markets succumbed to the general

downturn. in global bonds?
Aren't they supported by better fundamentals? While that is true, bond markets have all one
thing in common -

massive speculation.

The dollar bulls have again been discouraged. Despite the unanimous dollar optimism
and DM
bearishness, the U.S. currency
has sagged. Structural reasons still support our view of
an ongoing
secular dollar bear market.

There is apowerful elemental force quaking underneath recent market dynamics a "dashfor
-

cash." Overall, liquidity is at its lowest in many decades. As the speculative bubble unwinds, the
only place for investors is in the safety of liquidity.

For investors, as we have repeatedly emphasized, liquidity remains all important. Short-term
bonds in the hard-currency markets
and cash-equivalent investment remain the recommended
harbours for conservative investors.
 NO LONGER TRASH. THE DASH FOR CASH BEGINS

Cracks gaps. fissures. all continue to spread and shake the world's fmancial edifice. Yet,
..
. . . . .

the professional pundits are at a loss to explain the cause of the tremors. They grasp at anything to
explain the troubles the Whitewater scandaL the murder of the
- presidential candidate in Mexico, the
open trade squabbles affecting China. Japan and others. the hedge funds as long as it's unrelated to -

message: "Perpetual
economic and financial fundamentals and allows them to preach their favourite
If
prosperity and continuing bull markets in global stocks and bonds.

In short, tremendous complacency There remains an overwhelming belief that the U..5..
still prevails.
in financial
economy is leading a world economic recovery, though subdued one, and that the sell-off
a

world economic outlook crucially depends on how and

markets is just "correctioo.lf In our view, the
a

when the bubble the great financial mania that has raged over the past two, three years
- finally -

depressing effects on economic activity..

unwinds. As the bubble deflates, it will have profound

As we see it, the prognosis for financial markets remains

precarious.. At best, we have probably only
bust it ultimately must
experienced the beginning of the bust of the great global financial bubble. And
Highly leveraged investment positions particularly in bonds -

running into the trillions of dollars

-

still ovetbang the world's finan~ system ~ short, ~re's much more pain to come.. The irresponsible
tf
slogan of the bubble era, "cash is tras~ If now gives way to a panicked "dash for cash..

THE SMOKING GUN

It's nonnal to see nw;kets make a partial recovery of their losses following the initial steep downturns.
However, since we pointed out the extent of the carnage in the world's stock and bond markets in the
last letter, recovery attempts have been
extremely.feeble. in fact, they couldn7t have
. .
Global Bond YIeIck CIG-vorl

been poorer. Now, as we write, markets are Receat Mar.3Ow Challle from

weakening funher. led by losses in the Anglo- Low(~) 1994{") Low (b.p.)

American bond markets. Gaunany 5.31 6.51 70

2.6 4.01 141

Japan

The neighbouring table

provides an updated Sp.m 7.7S 9.19 144

picture of the extent of the disaster. U.S. long-

1S3
ux 6.1 7.63

178
teon interest rates have continued to rise 5.16 6.94
-

u.s.

now as high as 7.16%, 130 basis points higher Global ~ M..rlrellllll'T A I"adlcø... Wf!l!k1Y cto.e\

than the lows of last October trapping teems

-
Receat Mar.. 30, CbaqeFrom
of desperate speculators with looming -losses~ HJah 1994 Receat HI&b (..)
The same applies to the speculators in European Prmcc 169.13 154.91 -8.8"

and Japanese bond markets who have financed Gamaay 126.61 120.91 -4_S~

their leveraged purchases wi~ super-cheap

i
485.45 389.45 419.841,
j HoaaK<DI
{ short-tenn rates or through various derivative Japan 104..2J 100.13 -3.3%
I

1 instIUrænts. You can smell the fear and pain.. Malaysia 613.75 46838 -23.7~
~ Yet, the pundits council calm and complacency. 1&22.61 7656.7 -13.2CIJ
~
:t
Maico
~ U.K. 210.71 19036 -9.1tJ,

I What was it really that suddenly routed stock u.s. 194.14 1&435 -5.3~
~
and bond markets around the globe, bardly
i
sparing any country? And, as well. what
I explains the other big forecasting flop of the season
-
a strong dollar as far as the eye could see?
I
I \

I
Currea.da u.d Credit Market. April 19M
 3

Even the old standby support for the dollar~ the usafe havenl1 argument, has lost its power recently,
though there's political strife galore around the globe.

Was it the Fed's "pre-emptive" rate hike aimed against inflation? Though there has been a second hike
since the first one on February 4, 1994, the market sages still dismiss the market turmoils as an aberrant
move. The common, comforting theme is that all that's needed to reverse the rise in U.S. interest rates
is a renewed confidence in the Fed's anti-inflationary vigilance.

It was exactly this that the Fed's first rate hike was supposed to do. Only, it misfIred very badly. While
the FedYs second tiny rate hike was widely anticipated and taken into stride well in advance, U.S. stocks,
bonds, and the dollar are suffering a steady erosion nonetheless.

Could these events foreshadow that much worse is still to come not only in bonds, but also in stocks
-

and the derivatives markets? The crucial question really is whether or not this sudden, global slump in
stock and bond prices could turn into an unstoppable, self-feeding downward spiraL To answer this
question properly a thorough investigation needs to be made of the sources of the vast flows of money
~

that have driven this financial boom How much of it came from savings;. how much from inflation and
speculation?

In past letters we have documented and analyzed the rampant bond speculation in the United States.
Increasingly, this speculation has spilled over into foreign financial markets last year. Therefore, for
some time, we have advocated investments in nothing but short-term bonds. even in the hard
. .

published figuresy in fact, make it ever so clear that the speculative mania
currency countries. Recently
has infected markets everywhere.

Therefore, for the time being, liquidity should have priority in investment portfolio, whatever the

currency. Accordingly, we warned in the last letter: l1Liquidity, liquidity, liquidity. Nothing else
Yet we hasten to add that the magnitude of the speculative excesses and the market
"

matters.
fundamentals do differ tremendously between countries. At the very least, that implies differences in
future investment risk.

KNOCK-ON EFFECTS

It's been consternating to many market watchers that the slump in U.S. bonds has had such a widespread
and immediate domino effect all around the world. (See table on page 2). Most surprising, above all,
was the concurrent, sharp rise in. European bond yields. EconofiÙc conditions on the two continents
could hardly be more different. Yet, European bonds have been dragged down in the same undertow.

Now that the U.S. recovery is entering its fourth year with signs of renewed acceleration,
a small rise

in interest eminent sense.

rates makes But the European economies are barely limping along. That,
along with the prospect of falling inflation, in the consensus view, should imply that European interest
rates, both short and long, should still be declining even if the Federal Reserve does hike its rates.
Taking this tack., the recent sharp rise in European bond yields ought to reverse over the course of the
remaining year" Or should one expect otherwise?

Again, we dissent. For us, the trashing of Europe's bond markets is not puzzling at all. The connection

CUlTenC:ies and Credit Markets \ AprU 1994

 4

between events in different markets may be tenuous, except for one unifying link: frenzied, leveraged
speculation4

ON THE TRAIL OF AN INTERNATIONAL SPECULATIVE ORGY

We realize that our view of bursting global, speculative bubble meets with great hostility among the
a
professionals in the financial markets. First of all, it spoils their windy excuses that none of this was
foreseeable. At the same time, it strikes us that there wasn't a single bank or broker anned with their -

vast, elite rese3.ICh staffs as they are that took the slightest bother to seriously investigate ~e
-

possibility of a bubble. All clung ad nauseam to their worn-out, phoney slogans4

What makes us so brazen to belief that a giant speculative bubble is on the verge of busting contrary
to the strong consensus of tile majority which has hailed this bull market as the natural result of healthful
economic and financial developments?

Firstly, it's a historical fact that

financial "bubbles" are never recognized before they burst Predicting
a bubble bust is like forecasting an accident- it's a contradiction in tenns4 One of the main reasons
that's so, is. that bubbles generally occur dUFÍIlg times of low price fu this respect, Mr. Mieno~
the Governor of the Bank of Japan, was the Despite
~on.
great, great exception. very low inflation rates, he
identified the soaring land and stock prices in Japan in me late 19808 as "asset price inflation" and a
speculative bubble and prescribed a
monetary tightening to bring it to a halt.

Last year, the International Monetary

Fund (IMF) published a survey about G6 MONEY GROWTH
"asset price inflation" in the 19808, U.s.. Japan. Germany. U.K.. France. Canada
mentioning Japan, the United Kingdom Year-over-year % Change, (M3 or M2)
Australia, New Zealand, the Nordic 1.(1

countries and, on a
more limited scale,
the United States. The study stressed that 12
II
these asset price inflations," in all cases,
took place during times when credit and 10

broad money grew well in excess of

a
Gross Domestic Product (GDP). This
condition, in fact, supported the
6
that
stereotypical
~nt
bull markets in these countries were
the respective

.4
therefore "liquidity-driven" bull markets.
The resulting boom was celebrated as a
2
healthy development, not as an "asset 72 76 78
7.. 80 82 8" 86 88 90 92 94111

price inflation". Source: Interu.atlonal Strategy and Investment

Harking back to the happy memories of the 1980 bull m.a.rkets~ the recent global fmancial boom has been
generally explained as being "liquidity-driventt as well TIle snag~ though, is that credit and broad money
growth is now near its lowest pace of the whole postwar period in many countries. An average of broad
money growth for the G6 countries is shown in the above chart~ How can there be a boom or even a
'bubble" under such tight monetary conditions? While it may is an explanation.
seem puzzling, there

Curruda and Credit Markell \ AprlIl994

 5

BUBBLES FROM THIN AIR

Bubbles need money. Where, then, did the money come from that floated up the global markets so
aggressively in recent years? Basically, there were two separate mechanisms that stoked up the asset
inflation in the two different parts of the financial market stocks and bonds.
-

In the case of the bond markets, overwhelmingly, the torrent of speculative money came from yield-
curve playing. Necessarily, this involved massive borrowing. In the case of the stock markets, the
money came from different source: an unprecedented portfolio shift on the fmancial balance sheet of
a

individual investors as millions of them were lured or chased out of existing cash balances and into
securities. Though hundreds of billions of dollars were shifted in this way, it largely didn't reveal itself
in the money aggregates.

All this, of course, is well known and widely discussed as we have explained before. But the truly
scandalous fact is that these conspicuously abnormal flows are almost unanimously lauded as healthy
and beneficial Whatever drives up securities prices, it appears, is treated as something that is
intrinsically healthy. The opinion-makers, of course, have a vested interest.

Admittedly, what has greatly surprised us is how long this yield-cwve playing and the associated flight
from cash has been taking place. Even more, it has worried us; for we always knew that the longer it
lasts, the worse the inevitable crash would be later.

WHERE THE BUBBLE BEGINS

As we have always stressed, the main tap feeding this global fmancial mania has been operated by the
Federal Reserve in the U.S... It slashed short-term interest rates to a level where they barely covered
inflation for a long period of time and supplied over-generous reserve injections in order to keep rates
abnonnally low.

The biggest bubble of all in terms of the sums involved although not in terms of capit.al gains
-

was
-

in U.S. Treasury bonds. As U.S. stocks and bonds began to look rather expensive last year, the game
increasingly shifted to Europe, Japan, and the emerging markets in Latin America and South East Asia.
The obviou.s motive for this- offshore buying was a quest for quick capital gains, not the current yields.
That, in itself, essentially implies that a massive selling phase would have to follow later.

Fuelled by an apparently inexhaustible flow of money from U.S. pension funds, hedge funds, mutual
funds, bank trading and broker desks and many sorts of other highly leveraged speculators, stocks and
bonds took off in a near vertical rise around the world in the second half of last year.

Just published figures from various central banks for 1993 shed new light on these cross-border flows
between the world's financial markets. We were prepared for staggering figures. But, what we found
even exceeded our wildest expectations.

During 1993, net U.S. purchases of foreign stocks and bonds reached $128 billion by far the largest
-

total in history. TIùs compares to $47.9 billion for the year before. Of the 1993 amount, stocks
accounted for $61.1 billion and bonds for an additional $67.2 billion. Yet at the same time, the U~S4

Currencies and Credit Markets \ April 1994

 6

billion in 1992 to $103..3 billion in 1993.

current-account deficit widened sharply from $66.4

total of purchases, we guess, was

Yet, this doesn't give justiçe to.the whole.phenomenon.. The true
to catch
probably closer to $200 billion, if not higher. That is because the U.S. official statistics fail
them most hedge funds. Their transactions
the large purchases of offshore-donñciled operatorS, among
are generally channelled through institutions in London.

more breathtaking. According to the

Partly for that reason. the British capital flow figures are even
statistics of the Bank of England7 U.K. net purchases
of overseas securities amounted to Ll2l billion
be sure, accounted for a very small part of
last year or about $180 billion. Genuine U.K. residents, to
only total about í30 billion.
this sum, conSidering that their annual financial savings

it look as though there were an ocean of liquidity. But is there

1be enormity of these sums makes side
really? Over the short run, of course, the money has boosted
the stock and bond markets. The flip
financial markets borrowing and
is that the two main sources of this prodigious flow of money into
-

into securities essentially create illiquidity over the longer run. The
mass exodus from liquid assets
-

chart below clearly shows the extent of the deterioration

7
in liquidity. Household deposits as a percent
of income' have fallen to new lows.

Every crisis is caused by abnormally low interest rates.

By stimulating excess spending, illiquidity is
were largely focused on
always the inevitable result. Unusual this time is that the spending excesses
the financial markets mther than the real economies.

mE RUN UP TO A CHASE FOR LIQUIDITY

We keep wondering about the tnie objective of the Fed's preemptive rate hike: cui"bing inflation in the
publicly hinted
real economy or in the financial markets?
At least one Fed governor, Lawrence Lindsey,
to the latter:

slúft in household finances to less

liquid assets are a threat to continued economic
"Low savings and a

less liquid ÚUJn at any time in memory. I believe that the household
recovery. .. Households are ..
sector poses one of the most serious risks to the continuation
of this recovery ." . ·

But just what is so

We couldn't agree more~ The chart on the next page shows conclusive evidence.
should be obvious to anybody certainly a central bank that a mass flight
dangerous about this? It
-
-

leveraged yield-curve play cannot go on forever. To let it get out of

from cash into securities or the
hand in the first place, openly courts disaster.

flight from liquidity by correcting the

In this light, the Fed has every reason to stop this hazard-causing
Though it may
underlying maladjustment -

that is by restoring a reasonable rate of return on cash.

to preserve household liquidity is higher short-term interest rates.
appear paradoxical, what's needed
Of course, that"s not true for the securities markets.

actually, it ought to be the main motive for the Fed's rate

Stalling the liquidity run-off may be
-
-

it would explain the Fed's particularly cautious interest rates hikes, supposedly in hope
of
hikes. If so,
damaging the economic recovery. The hope that this
gradually deflating the financial bubble without

\
Currendes aIld Credit Markets Aprtll994
 7

u.s. HOUSEHOLD LIQUIDITY

Liquid Deposits as a % of Total Financial Assets and Personal Income, Quarterly
4CJ01o
83%

.
, .. 380/0
.
'
: .......,.. .
"

;: : .~\.
~
f'- '''It
'II
360/0
% of Total AnandaI Assets ~ .......-
~:
78% ....:
J' .s RHScaIe
34%
J
.

)
)TJ% .

....
-
.

32% I
.
.. iig
. 3()O/o
"
ü: ..
.

28% Q.
168%
t!- o
;;.
o 260/0
~
As % of Personal Income
240/0
63% LH Scale

2~/o

2<)01'0
58%
71 76 n 7Q 81 83 85 87 89 91 93
58 81 83 65 87 80 73

Source: Flow or Funds, FederallleHrve Board. US.. Department of Commerce

can be done successfully is a common delusion of central banks.

ON THE TRAIL OF INTERNATIONAL CAPITAL FLOWS

Very few people, we think, have grasped the enormity of the

present bubble. Compared with Japan's
yields and stock valuations.
boom a few years ago, this one appears relatively modest in terms of bond
But in terms of global reach and the sums involved, this bubble is the most unique and pervasive- in

history.

of all the money that has prop 'led stock and bond prices so high and for so
Just what are the SOUICeS
long around the world? This is always the cardinal que~
;C)n. If you can identify the source, one can
easily distinguish between stable investment and gambling.

point out that one of the greatest propagators of the

Before we begin tracking these sources, we need to
options and futures mainly is virtually
bubble, the vast trade in derivatives instruments
-

r
-

Though represented by these instruments are enormous, good and complete

ÎIl11æaswable. the risks
\ statistics simply not available.
are Suffice it to be said that the
principal value of the transactions
underlying transaction volumes in both stocks and
represented by these instruments are many times the
bonds 4

America and Britain. that is

Statistically, as we showed earlier, much of the money has come from
. .

principle, that's a spurious make-believe story, too,

from Wall Street and the City of London. But in
The fact that the purchases originate from these countries
because both nations are deficit countries.

Cu.ncadel &Ad Credit Markets \ Aprtl 1994

 8

doesn't mean that the money came from there. Given their large current-account deficits, how can they
export money? The only liquidity they can export is borrowed liquidity~ That, in itself, virtually implies
a bubble~

To find out further infonnation, we checked the latest figures for portfolio capital flows for the receiving
countries. Germany, for one, was at the receiving end of a massive international bond speculation. An
examination of its inflows provides very interesting and clear picture of what makes
a a speculative
bubble.

In 1993, foreign net purchases of German bonds reached the stunning amount of almost DM 229 billion.
This inflow alone even overfinanced the huge public sector deficit. What's fascinating as well was the
general trend of these purchases.. In 1990, when the yields were at their highest, foreign inflows were
yields at
at their lowest In 1993, by contrast, an avalanche of foreign money was chasing German
levels near the lows of the past three decades. Does this make sense?

Of these foreign bond purchases, FOREIGN PURCHASES OF GERMAN

almost 60% came via London and SECURITIES
another 25% via Luxembourg. In DM Billions
London represents international
speculators; Luxembourg is the haven 1989 1990 1991 1992 1993
Year
of German tax avoiders. 22.4 3.7 -3.1 14.4
Stocks -3.0
Bonds 22.8 20.3 60.2 133.1 228.6
A CONTRAST IN LIQUIDITY:
GERMANY VS. THE U.s. Source: Bundesbank

Where, then, did the money for the huge foreign purchases of DM bonds come from? Most of
it, in

short, came from inside Germany. What happened is that German money simply took a round-trip. But,
nonetheless, we must distinguish between the players from Luxembourg and London.

To German tax. avoider who wants to escape the newly-introduced withholding tax.~
start with, the
exports cash to Luxembourg in order to buy DM bonds from a foreign address. Structuring purchases
this way serves to make the inCome from "these bonds tax-free. Conspicuously, cash outflows from
non-banks of a~ut DM 62 billion in 1993 corresponds closely to the OM -bond pucchases from
German
Luxembourg.

they are highly

What about the London-based speculators? The first thing to bear in mind is that
leveraged with borrowed money. But where and in what currency do they borrow? That's a key
question. would have the cheapest way to
Borrowing dollars and swapping them into D-marks been
fmance this speculation in DM bonds. But since the world was unanimously bullish on the dollar and
utterly bearish on the OM, the bond speculators preferred to borrow in DM.

Their main credit source is easy to spot It~s a conspicuous item in the German capital account statistics.
What these show is a steep rise of short-tenn outflows from German banks last year, amounting to more
speculative orgy in DM bonds was
than DM 120 billion. So what we see, believe it OT not, is that the
directly and indirectly financed by German banks through the Euro-market.

Curreadeø and Credit Markeb: \ Aprill994

 9

However, the German case is remarkable for yet another reason. It concerns the behaviour of the
German investor which differs -diametrically from his foreign counterpart. In reality, the German
investor had very little to do with the financial bubble. After Bood yields fell below 7% in late 1992-
early and 1993, German investors reduced their heavy buying.

What, then, did the German investors do with their money? Germany's rapidly growing broad money
(M3) provides the answer. While Americans, for example, were in a desperate dash from cash and into
stocks and bonds, the Germans were increasingly parking their savings in cash that is, in bank -

deposits which, in turn, drove the banks into heavy bond buying. The essential result of this circular
flow through the Gennan banks is soaring broad money.

1be main point that emerges from this is that Germany's strange, strong money growth is the
overwhelmingly result of the public's high liquidity preference, not from a credit acceleration. The facts
are undeniable. Consider this: over the last two years, total cash balances (M3) rose by about 20% in
Germany while in the United States by only 1 %.

We have highlighted this tremendous difference in the U.S. and German liquidity trends because it may
very well have important implications for their respective markets and the economies. In Germany,
domestic ÏnvestoIS have high savings and a rapidly growing pool of liquidity at their disposal to help
limit the rise in long-term interest rates, not to mention support for a further lowering of short-term rates.

t
The picture isn t so
assuring in some other TREASURY AND AGENCY BOND PURCHASES BY
major countries -

the U.S. NON-BANK FINANCIAL INSTITUTIONS..

U.S., Britain, Canada, As a % of Total Assets
32.aL
Australia and even
Japan. Sizing up the 31.01.

savings and liquidity

3O.0'It
trends, we wonder
how high longer-term 29.0'1,

interest rates can still

28.al.
rise as the speculative
bond mania unwinds. 27JJJJI

In the case of the

is 26.(11.
U.S., who left to
buy treasury bonds 25.0%
when the
all yield-
J1"

players 24.aL
curve -

who
virtually printed 23.0"l.
To 4Q 1994

~ money -

curb their
22.0%
purchases? As we've
85 86 87 91 93
again showed in the 88 89 (Ä) 92
Source: Plow 01 Funds; The Board of Governors of the Federal Reserve System
last letter,' the bond
purchases of U.S.
have been enormous in recent years. Particularly, the non-banks financial institutions
intennediaries
were enormous players in the bubble. The chart above tracks the extraordinary role of this latter group

Currea.du and Credit Markets \ April 1994

I
 10

in the development of the U..S.. bond bubble. So, who will be the end buyer when these positions come
under liquidation pressures? We have no answer. And nobody else has either.

DIVERGENT INTEREST RATE TRENDS

Looking at the adjustments in the medium- and long-term interest rates, we notice two different
movements: firstly, a generally sharp, global rise in yields; secondly,
a decoupling in other words, -

a renewed, more pronounced divergence

-

in longer-term rates.

Since the start of the bond market declines October 1993 -

the best relative performers were the
-

European hard currency bonds. Among the major countries, the U.S., U.K., Spanish and Italian bond
yield spread between U.K gilts and
markets suffered the biggest losses.. During this period the to-year
German bonds jumped from a low of 46 basis points to
130 basis points.. With a yield jump of 158
basis points, U.S.. to-year Treasury yields (6.74%) have now overtaken corresponding hood yields
(6..33%) which only rose 42 basis points.

Most commentators are wringing their hands at the claim that the bond markets have lost all traces of
reality.. We would say, that at long las~ reality is
returning. The markets with the biggest losses are
naturally the ones where speculation was most rampant. With the silly expectation that international
yields have to converge, the global speculator concentrated on the high-yielding bond markets, which
in their eyes, seemed to have the most room to fall and therefore promised the
biggest capital gains.

In order to reap maximum profits, much of the bond market speculation was also overlaid with
a

currency plaY4 Given the accentuated bearishness about the OM and the yen,
it became a favourite

strategy to leverage such bond purchases by borrowing mark or yen. As the bond price would rise and
the mark and the yen decline<L the speculators figured on reaping bundle of profits, or so the theory
a

went Instead, now, both the currency and bond plays have gone awfully wrong.

IN PRAISE OF SPECULATION

According to the textbooks, stabilizing influence on markets because the smart

speculation has a
seizing its advantage. That may well
speculators spot any aberration and immediately smooth it out by
have been true when the long-term investor dominated the markets and the speculator was the exception.
profits for
Today, we have the reverse. Speculation has become a prime business and chief source of
"Speculators
numerous financial institutions and corporations. To quote Keynes on this point: may do
enterprise. But the position is when enterprise
no harm as bubbles on a steady stream of serious
ft
becomes the bubble on a whirlpool of speculation..

What makes it worse than ever, in our opinion, is the lemming syndrome prevailing in the world

financial community.. uniformity in the thinking and predictions of the

There is an unprecedented
Kong.. The
economists, analysts and the media from Frankfurt to London, from New York to Hong
financial players have been schooled in the same theories, read the same broker research and newspapers
it remarkable
and all converse in the English language. In fact, in our travels, we have always found
how alike the financial community is in each of the world's financial centres. The result of it is that
primitive slogans and crackpot theories can catch on like wildfire. Serious research has mostly gone out
the window long ago.

Currendes and Credit Markets \ Aprlll994

 11

THE DOLLAR DISAPPOINTMENT

Following all the bullish hubris, dollar speculation has again flopped even though the dollar bulls were
superficially right in their assumptions.. Their bet was that strong U..S. economic growth and a scissor
movement of interest rates between the U..S. and Germany rising in America and falling in Europe
-

would translate into a robust dollar..

While the expected rate changes are indeed happening, and though the U .S.. economy is even stronger
than expectations, the dollar has instead weakened.. Certainly, we have never wavered in our view that
the dollar and for that matter, the British pound, too was still in the grips of a long -term secular
-
-

bear market.. Our opinion here has been primarily based on structural reasons: namely, poor savings
rates; deficient investment ratios; and the associated large, chronic trade and current-account deficits..

Ye~ temporary counter moves to a long-term trend are something that always need to be reckoned with..
While the dollar bulls were right on several variables, they were wrong on the key point: To boost the
dollar against the DM, more than just a positive economic growth differential between the two countries
is required.. The decisive element behind the cyclical ups and downs of the dollar are the relative
monetary policies of the U..S.. That's what-primarily determines the money flows. And on that score,
monetary policy was, and still is, much too loose in the United States..

Though the Fed has begun to move rates up, the D-mark has continued to gain.. We suspect that's
because the whole world has been excessively long in the U..S.. currency.. In other words, these rate
hikes have already been amply discounted by the dollar bulls.. So now, as rates begin to rise, there are
few potential dollar buyers left..

Considerably more Fed tightening may be required to strengthen the dollar.. But given the higWy
vulnerable and hyper-sensitive financial markets, its flexibility is extremely limited.. The earlier illusion
that rate hikes will tend to stabilize markets by allaying inflation fears has now become a faint memory_

But yet, we still detect alot of complacency. Many brokers still think that the recent market tremors
are nothing more than a blip on the road of a continuing bull market.. In response, we can only say that
there is general lack of understanding on the differences between investment and speculation..
a
Our
verdict remains the same: There exists a huge financial bubble, one which has only begun to deflate.
A careful distinction of the sources of money fuelling the bubble,
whether from savings or inflation,
proves that our view is the correct one.

Take the yield-curve-play flows of the banks, brokers, hedge funds and hundreds of other institutions
into the bond markets.. All of these flows are unsustainable involving an annual money creation of
hundreds of billions of dollars. Similarly, so is the asset shift out of cash into stocks and bonds. Any
beginner student in economics would realize that this can't last It's precisely these two sources of
money that have fuelled the boom.. the great global financial bubble.. All that's needed to smash the
.. .

bull markets is a marked slowdown in these flows. Anything worse would mean a full-scale crash..

How will the sharp rise in long-term rates and a pronounced slide in stock prices impact the real
economies? In short, very negatively, but the effects will certainly differ between countries depending
on their respective economic and financial fundamentals..

Currencies and Credit Markets \ April 1994

 12

CONCLUSIONS

Appraising the outlook for the economies and markets, it is imperative to realize just how
large and

pervasive the global financial bubble really is. The slogan "cash is trash'1 strikingly characterized the
recklessness and the stupidity of the opinion-makers in the financial community.

leached
Lately, after long last, the Fed's prolonged, excessive ease and the resulting fmancial boorru: has
into the real economy finally spurring some growth. The key legacy of the prolonged monetary ease,
it bursts,
though, is creation of the greatest speculative financial bubble in history, which, when will
inflict immeasurable damage on the U.S. and world economy.

Acting togethery the massive leveraging in the bond markets and the flight from cash into the stock
markets has created the illusion of a liquidity glut. The reality at least for the major countries
-
is -

deteri~ration of ~quidity. Given of bubble, risk

that there's actually been
is clearly
a
on the side of a
~tic
sèlf-feeding meltdown.
the extent the the

The outlook for the economies now rides on the unwinding of the great fmancial bubble. Once it begins
ì
1

~
~
in eari1est., it will severely depress some of them.
~
W Risks in global financial markets remain treacherously high, particularly for stock markets. The hard-
g
- ~ currency bond markets, though., retain the most supportive fundamentals.
i
~
Capital preservation remains the overriding objective.. Investors should continue to focus on short-term,
\
! cash-equivalent securities.
~
~

I Next Issue to be Mailed on May 4, 1994.

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~ All rlghU raerved by:
~
l Publllher and Editor, C""..aci4.1U14 c,.dit MlII'bU: Dr.. Kurt Rlchebãcher, GERMANY
~ TELEPHONE 49--'9..746908 FAX: 49..ø..152SIJ
ï Aaodate Editor: Wlltrcd J. B.aJan. CANADA
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?
i Copyright: Dr. Kurt Richebicher 1994
!

Curreada and Credit Markehi \ Aprtl 1994