Cumberland on Currencies; Gartman on Geithner; Kotok postscript on Geithner by David Kotok

January 14, 2009

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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What were formerly viewed as wild currency fluctuations are becoming more accepted in this post-Lehman failure period of the global financial crisis. Lately the strength has been in the yen. Many ask why?

We know that the economic situation in Japan is weak and the outlook is poor. We know that the Japanese exporters need a weaker yen not a stronger yen to help their business models. And we know that Japan has been mired in a deflationary recession for over a decade and the outlook for substantive reforms which would enable it to exit this quagmire seems to be elusive.

So why the yen and what will happen next?

We believe that the global mix of assets boils down to just four currencies. Most of the $85 trillion of bonded debt in the world is denominated in these four currencies: euro (30%), dollar (39%), pound (4%), and yen (13%). Most of the other currencies in the world (not all) are managed in one way or another or are tied directly to one of these four. Hong Kong, for example, runs its policy so that the Hong Kong dollar is fixed in a link to the US dollar. In Europe most of the non-euro countries in the European Union are managing their currencies in a narrow band so as to eventually gain entry into the euro system. Freer floating currencies like the Aussie, Kiwi, Krona or Loonie are important but are also relatively small portions of the globe’s total.

Let’s look at the big 4.

The dollar story is widely known. We have a huge developing federal deficit now measured in the trillions. And the Federal Reserve has rapidly expanded its balance sheet to more than triple the size of the pre-Lehman failure period. See www.cumber.com for a graphic illustration of the Fed’s balance sheet. Remember that when the Fed enlarges its holdings of assets (loans in the “lender-of-last-resort” role) it is also expanding the liability side of the balance sheet (printing money electronically) in order to pay for those loans. Many conclude this will lead to a disastrous decline in the value of the dollar and a fierce inflation explosion. We are not as sure about this outcome as are the detractors; readers will see why below.

The pound has been hammered as the Bank of England (BOE) cuts interest rates to record lows and is now following a balance sheet expansion policy similar to the Fed. Examination of the British central bank’s balance sheet shows a similar explosive form to that of the United States. BOE is now following the US policy prescription. We led the global move to easing and our currency weakened first. The others are playing catch-up and the BOE is now in second place. We expect the British pound to continue weak for some time.

The euro faces its harshest test since it was born a decade ago. The global economic slowdown and the fiscal crisis have combined to cause serious dislocations among the countries that are in the euro zone. The convergence of interest rates that underpinned the European currency miracle has reversed with a vengeance. Greece is probably the weakest country in the euro zone. Its sovereign debt is trading with a 250 basis point spread over the German benchmark bond. To put this in perspective, imagine if the debt of the State of Pennsylvania carried an interest rate of 5% while the debt of the State of New Jersey needed to pay 7.5% in order to clear the market. This gap in the cost of finance would have huge implications for state budgets, spending and taxation decisions. Pennsylvania would gain at New Jersey’s expense as citizens migrated their wealth across state lines.

In addition to Greece, Spain, Ireland and Portugal have been put on negative credit watch for a possible downgrade by Standard & Poor’s. Belgian debt is trading with a widening spread. Italy is, too. Wide credit spreads among euro zone sovereign debt issuers present a specific problem for the European Central Bank.

In the euro zone the monetary policy is centralized with European Central Bank (ECB). Fiscal policy is not centralized and is in the hands of each country. But the ECB must conduct its operations in only one currency, the euro. Therefore the ECB has to deal in the euro denominated debt of each of these countries. Think of what things would be like here if the Fed had to implement monetary policy the debt of the 50 states and not in the debt of the US Treasury or its agencies.

This wide spread among the ECB member countries adds to the pressure on the ECB. It wants to maintain a strong currency and has stricter rules regarding inflation than any other central bank. But it also doesn’t want to weaken the euro zone structure to the point where one the member countries will seek to leave the euro currency community. The explosion of the credit spreads between euro zone countries and the ongoing difficulty of policymaking have caused the euro to weaken. That seems likely for a while because the policy issues are quite difficult.

So the yen has emerged as the strongest of the big 4 by default. We believe that is about to change. The ECB is altering its tough policy slowly but it is altering it. Their balance sheet is starting to grow and may soon resemble the Fed’s and BOE. Meanwhile the Japanese are suffering. They are approaching the end of their fiscal year and their need for a strong yen to make currency translations positive will pass as the fiscal period closes. Japan has shown in the past that it can engage in massive quantitative easing in order to offset the yen strength. There is no reason to believe that this history will not be repeated.

We expect the surprise will be a return of robust dollar strength. The other central banks and governments are following the easing policy and the deficit prone fiscal policy; hence, all interest rates will converge to very low levels. The global recession has created a large negative output gap. That means the inflation risk that is foreseen by many will be deferred into the future.

When Japan’s policy accelerates into quantitative easing, all four of the large currencies will be in the same mode. The dollar led in the weakening because our Fed and our government moved first. The result is that we will come out of the recession first and that our economy will turn and commence growth ahead of the other large currency blocks. That means a stronger dollar. Currency strength goes to growth. And it is driven by real (inflation adjusted) interest rate differentials. As the world gets to a level playing field at very low interest rates, the dollar gains against the other choices. Remember this is a relative price game. All currencies are worthless except for what markets determine to be their expected values. In the relative price game, the US is likely to win this round. We are long dollar in our global; strategy.

Now to this: we note that there may be some difficulty in the new Obama administration with a tax scofflaw behavior of the Treasury Secretary designee. Dennis Gartman’s (www.thegartmenletter.com) letter from this morning is quoted below. Dennis is a keen observer of markets and politics and his comments need to be respected.

The Gartman letter wrote:

“ON THE POLITICAL FRONT, and to be
listed under the heading “You Really Cannot Make
This Stuff Up,” Obama’s nominee for the Treasury
Secretary’s Position… the position in government that
follows, in our opinion, just behind that of the Sec’y of
State,… Mr. Tim Geithner has created a very real
problem for President-elect Obama, for it appears that
he did not pay self-employment taxes that were owned
to the IRS for the years 2001-2004 when he was an
employee of the IMF. Apparently then, the IMF treated
all employees as “contractors,” and did not withhold
taxes. Geithner was responsible for his quarterly taxes
AND for self-employment withholding, which he
apparently failed to pay. He paid the taxes, but only on
the years ’03-’04, for which the statute of limitations
had not yet expired, and he paid them in late
November when it was clear that he might well be up
for a Cabinet position.
We shall not argue that the taxes in question were
sophisticated, and we shall not argue that the taxes he
had not paid were easily missed, and we shall not even
argue with the fact that Mr. Geithner paid the taxes as
late as he had and that he probably would not have
paid them at all had Obama not won and had he not
had some assurance he’d be a Cabinet rank official;
however, not paying the same taxes for ’01 and ’02
because the statute had run out is inexcusable.
Further, as we understand tax law, there is no statute
of limitations upon the non-payment of taxes due,
although perhaps there is some exemption that the
IMF was able to include in previous tax laws protecting
their “employees” from litigation. We shall leave this all
to the tax lawyers, spin doctors and Obama
Administration offices to wade through. All we know, or
think we know is that Mr. Geithner’s problems will
make those of Judge Kimba Wood and of Ms. Zoe
Baird of 16 years ago regarding payrolls taxes and
illegal household help seem really quite tame. Colour
Geithner gone! As they say, “Stick a fork in’im; he’s
done.” Obama has to be livid… and horrifyingly
embarrassed.”

We will not quibble with Dennis Gartman’s criticism. We agree with it. Dennis correctly asks if there is going to be a lesser standard for the Treasury Secretary than there is and was for federal judges.

Our postscript is to emphasize that in the post-Lehman, post-Madoff, post-SEC failure, post financial crisis period, confidence and transparency are now the two most important elements for the United States. Geithner would serve the new president and country best if he admitted error and immediately paid anything this is owed or suspect. Come clean and clear the air. If he does, the new leadership will be setting the standard for the new post-Madoff era. If he doesn’t, President-elect Obama must remove his nominee from consideration. Otherwise Obama’s “Audacity of Hope” will become dashed and replaced with despair. The world’s eyes are witching this one closely.

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com

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Copyright 2008, Cumberland Advisors. All rights reserved.

The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.

For a list of all equity sales/purchases for the past year, please contact Therese Pantalione at 856-692-6690, ext. 315. This report is currently about 600 pages in length. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. This does not constitute an offer to sell or the solicitation or recommendation of an offer to buy or sell any securities directly or indirectly herein.

Cumberland Advisors supervises approximately $1 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash management portfolios. Cumberland manages portfolios for clients in 42 states, the District of Columbia, and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.

Category: BP Cafe, Markets, Politics, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “Cumberland on Currencies; Gartman on Geithner; Kotok postscript on Geithner.”

  1. Bob_in_MA says:

    Just in case there’s anyone around who isn’t pi$$ed off about Geithner’s tax issue….

    From today’s NYT:
    “However, the I.M.F. does pay its American workers an amount equal to an employer”s half of the payroll taxes, with the expectation that they will use that to pay the I.R.S.”

    So he didn’t realize he was responsible for the tax, but he took the extra 7+% the IMF gave him to pay the tax?

  2. John from Concord says:

    “Geithner would serve the new president and country best if he admitted error and immediately paid anything this is owed or suspect.”

    I believe that he has already done so — back in December, IIRC. I also believe that, if you read a bit, you’ll find that this issue came out because Obama’s team disclosed it to the relevant Senate committee up front.

    Gartman’s understanding of the commodities and forex markets is first-rate; it’s a shame this his politics are so thoroughly juvenile. Most of us outgrew Ayn Rand long before our 30th birthdays.

  3. Brendan says:

    @ John from Concord:

    “Most of us outgrew Ayn Rand long before our 30th birthdays.” – Haha, so true! That’s great; I’m gonna’ have to remember that one for future reference!

  4. Mike in Nola says:

    My problem with Geithner is not the taxes; it is his being a part of the gang that got us where we are today.

  5. Bob_in_MA says:

    Sorry, John from Concord, that’s complete tripe.

    He had been told he was responsible for paying this tax, acknowledged it in writing, and took the extra 7+% the IMF gave him to pay the tax. But it is an honest mistake to then not pay it? Are you serious?

    This man is either a complete fool, or a simple cheat. Either way, they need to withdraw the nomination.

    From the Washington Post:
    “Documents released by the Finance committee documented the errors made by Geithner. One showed his signature on a tax worksheet that states that he has an ‘obligation of the U.S. Social Security tax, which I will pay on my fund income.’”

    [http://www.washingtonpost.com/wp-dyn/content/article/2009/01/13/AR2009011302033_2.html]

  6. Moss says:

    Commodities and politics do not mix well. Mr Gartman should stick to the former. Intent is always an important item to consider when making judgments. Dogma is what got us into this mess. Geithner will not be withdrawn and will be confirmed.

  7. mudpuppy says:

    Regarding the currency question, where does this leave gold? To hear the gold bugs talk, they all believe the gov manipulations will lead to hyper inflation and gold is the only thing worth owning. Yet what we are seeing is deflation not inflation. Gold is treading water. Will it rise or collapse? What say ye?

  8. gnomic says:

    So we are going to kick a smart, well qualified person to the curb because of some minor issues. Is this the best use of people? Why do we keep expecting people to be perfect and punishing them when they aren’t? I don’t care if they hired an illegal to clean thier house, watch thier kids, or failed to pay some taxes. I care if they can do job and if they are the best person we can get to do the job. I think some on the concerns raise on this blog when Geithner’s name was first raised are much more relvent.

    Besides, if we aren’t concerned about holding the current administration accountable for war crimes and violations of the Constitution, and obstruction of justice and violation of the law and lying and so on and so forth, why does anyone care about this?

  9. dgriff69 says:

    If Geitner is the best addition to the team that has to sort out this clusterf#ck, then so be it, they oughtta hold their noses and confirm him… but let’s not sugarcoat it. Either the next US Treasury Secretary is a tax cheat or he’s a finance professional who couldn’t figure out his own taxes for four years in a row. That we are concerned about the crimes of the last eight years is exactly why we SHOULD care about this. What happened to “Change we can believe in?”

  10. dunnage says:

    Geitner, what is so special about this Ghunga Din. What exactly has he been doing? NY Fed long enough to watch the Bear Stearns /Chase deal. Appreciated by Larry S, I guess.

    So we have Goldman Private and Goldman Public — nothing new, traditional supply-side; Can’t we find somebody for Treasury with functioning intelligence, and some kind of experience besides hanging around with all the right people.

    Hell, they thought he was perfect because he had done nothing, therefore a clean record. { oh, the boyish good looks }. And so he doesn’t pay taxes, like why should he? Then he does, but he’s cheap to a fault: good business practice — wouldn’t you like to work for him?

    The tax deal shows how seriously stupid the man is. Of course, that doesn’t disqualify the gentleman — he is unqualified because the episode is all that is worth noting in his career. With the slightest hint of class he could have paid up and moved on. But no. Sins can be forgiven, but stupid is forever.

  11. dunnage says:

    We should respect Gartman for reaching out, though be it with a fork.