Debt: a synthetic short position in the dollar
July 23, 2004
A short position is when you have sold something you
don’t own. Take a stock as an example. If you borrow the stock
and sell it you are short the stock. At some point you have to buy
the stock in order to give back that which you borrowed. Because
you will eventually have to buy the stock that you sold short, the
fact that you are short means there is latent demand for the stock.
It has been said that the tremendous amount of US
debt can be likened to a synthetic short position in the dollar
because the debt must be repaid at some point, and repaying the
debt will require dollars. This demand for dollars will then, supposedly,
increase the price of dollars and strengthen the dollar on foreign
exchange markets. A stronger dollar implies a lower gold price,
which is why the synthetic short position in the dollar has a few
gold investors worried.
Maturing debt is normally repaid by issuing new debt
with no net demand for dollars and, hence, no increase in the value
of the dollar. However, if the credit quality of the issuer is cast
into doubt, investors may not be willing to buy the new debt --
at least not at the same price as the existing debt. Several things
could then happen.
The borrower could default on the maturing debt and
not repay it at all. In this case the invested money is lost causing
a contraction in the money supply. Less money increases the value
of the remaining money and so defaults increase the value of cash
If the borrower sells assets to raise cash and pay
off the debt the result is the same. An increase in asset sales
will depress the value of assets and increase the relative value
If the US economy was a closed system one could therefore
make the case that debt represents a synthetic short in the dollar
since, at some point, dollars will be needed to repay the debt when
new debt cannot be issued.
But the US is part of a world economy and we have
to consider not only the value of the dollar relative to US assets
and labor, but also against other currencies.
The US government’s budget deficit is rapidly
increasing the supply of US debt, thereby increasing interest rates.
As a result of higher interest rates the US economy is likely to
slow down and a slower economy in conjunction with higher interest
rates can cause an increase in defaults and asset sales.
While defaults and asset sales are deflationary, and
hence increase the value of the dollar inside the US, I find it
hard to believe that foreign investors are going to fall over themselves
to snap up more US stocks and bonds. Imagine: falling asset prices,
rising interest rates and a contracting economy. Under those circumstances
why would foreign investors want to invest in the US?
If the US loses its appeal to foreign investors the
demand for dollars on foreign exchange markets will decline, and
the dollar will weaken against other currencies.
In summary then, the dollar could appreciate within
the US against assets and labor but simultaneously fall against
other currencies -- leading to higher gold prices.
Most currency traders do not share my views and still
see higher interest rates as positive for the dollar. The dollar
strengthened this week because Alan Greenspan gave an upbeat assessment
of the economy and his comments were interpreted to mean that interest
rates would continue to rise gradually while any sign of inflation
would be dealt with harshly.
Because the dollar strengthened the gold price
declined. Until we see evidence that higher interest rates are hurting
the economy the dollar will continue to strengthen as rates edge
upwards. And unless the dollar weakens in the face of higher interest
rates the gold price is unlikely to sustain a rally.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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