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 (dollars).
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 of dollars.
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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