Update on the Coming Currency Crisis: Re-Visiting the Dollar Milkshake Theory (w/ Brent Johnson)
BRENT JOHNSON: My name is Brent Johnson, I am the CEO of Santiago Capital in San Francisco. The dollar milkshake theory is something I coined about 18 months ago. Essentially what it is, is I believe that the central banks over the last 10 years have created this milkshake of all these different currencies, they've pushed liquidity into the global economy-- yen, euros dollars pounds. For a long time, it was just circulating out there but as of, I think 2016, we got into this divergent monetary policy where the US started raising rates while the rest of the world was still mixing the milkshake. Raising the rates and having rates higher on a relative basis to the rest of the world acts as a straw, which sucks capital into the United States. I think that that has happened. I think that will continue to happen. I think that means positive, although, it's not going to be smooth, and there's going to be times of great chaos along the way, I think it's positive for US asset prices. I think when I first came on and started talking about it on Real Vision, it was around May or June of 2018, and since then, what we had, we had a couple more rate hikes. Subsequently now, just in the last, 30 to 60 days now, we've had one rate cut with another expected one in the United States. I think what's really, really interesting about it is everybody in the various camps can, to a little extent, still say they're still in the game and their point of view is playing out. I had been calling for equity prices to go higher, and they went higher in 2018. They had a huge sell off at the end of 2018. I got very aggressive at the end of December and bought call options, because I believe the equity prices were going higher because of this theory and we had a great run, back to the all-time highs now or near the all-time highs as of middle of September, but that doesn't mean that they're going to bust out right now. We might have another pullback, it would not surprise me at all if we have another pullback before the end of the year, but ultimately, I think, equity prices are going to go higher. The other thing that's happened is bonds sold off pretty aggressively in 2018. The yields on the 10-Year went above 3% in the fall. We've seen that have a huge move back the other way, rates have fallen, the 10-Year bonds around the world have rallied like crazy. We've got the US 10-Years are down back to-- I think it got to 1.5. Then now, it's I think around 1.7. We had a huge rush back into Treasuries and not just US Treasuries, but Treasuries around the world. We went from 8 trillion of negative yielding bonds a year ago to $16 trillion of negative yielding bonds now, which is just unheard of. It's crazy. Then in the last couple weeks, that was done on the fact that even if the Fed started to get dovish, and they were thinking that monetary policy would be a factor-- and it still will be but you've seen just in the last 10 days, people are starting to push back on the negative rates trade and even some monetary authority are saying we're not sure that those negative rates are healthier or going to work. In the last 10 days, you've seen a big selloff in sovereign bond yields. I think the negative yielding debt has gone from $16 trillion back to $14 trillion or something like that. They're crazy numbers. It's a crazy time period, but I think, the dollar bulls a year ago, me included said, we're going to see a breakout in the dollar. It's broken out a little bit, but we haven't had the runaway breakout, yet. The dollar bears have said it was going to crash and it hasn't really crashed, but it hasn't really broken out yet either so they still think that they're in the right. It's anybody's game as to which way this is going to go. Now, I have it obviously have a strong opinion. I have a strong belief in which way this is ultimately going to go. We're in that period where everybody can still say they're in the game and it's going to be interesting how it all works out. Yeah. One of the things I think that's interesting is a lot of times, when people focus on the dollar, they look at the DXY. I talked about the DXY a lot too. The reason I talked about the DXY is it's heavily weighted to the yen and the euro and those are the two biggest competitors to the dollar. The yuan, to a certain extent, people think of it as a competitor but as far as the DXY, it's a minor component. The fact is, is that the Euro has weakened a little bit versus the dollar this year, and the yen has strengthened a little bit versus the dollar this year. While the dollar-- the DXY index is up a little bit, 3%, 4%, or 5%, the broader view of the dollar is that it has broken out, if you look at the Asian Dollar Index, it broke through a support of like a 20-year support line and if you look at the dollar versus a number or basket of Asian currencies, the dollar has clearly broken out. If you look at the dollar versus the GTN currencies, other than the yen, and I think the Canadian dollar, all the GTN currencies are down, in some cases dramatically versus the dollar. If you look at the Broad Trade Weighted Dollar Index, it broke through the long term resistance and it has not clearly broken out. If you just focus on the majors, which is the Euro, the yen and the dollar, not much is really going on, but if you step back and you take a bigger view of the dollar versus a number of world currencies, the dollar is clearly wreaking havoc. You've seen this in places like Argentina. Their currency is now down 60% versus the dollar in the last couple of years. Their stock markets are in the same range, same thing has happened to Turkey. Same thing has happened in Venezuela. This is I've talked before about the Highlander example between the dollar and gold are like Connor McLeod and the Kurgan from the Highlander movies. At the end, there can be only one and I think gold will ultimately win that battle, but I think that battle is a few years down the road. I think in the meantime, the dollar is going to go around the world cutting off these other currencies' heads. I think that's what we're starting to see. I think you're going to see more of it going forward. One of the big key issues to my overall thesis is the demand for the dollar. Now, a lot of people will say that the world is de-dollarizing, people don't want to use the dollar anymore, or they don't like that the US has been acting from a bully pulpit and directing the world order and so they're going to de-dollarize, they're going to leave the dollar, and that's going to decrease demand. The real world, the reality is, is that over the last 10 years, emerging markets and international entities outside the United States have issued $12 trillion to $13 trillion of-- I'm sorry, of dollar denominated debt. The demand for dollars for that debt that they have issued, if they had the same interest rate as the average outstanding US Treasury, which is 2.3%, then that would mean that these entities on an annual basis just to service the debt need $300 to $400 billion of dollars just to pay the service fee on the debt that they've issued. The bigger issue is that they've taken out this debt over the last 10 years. In 2007, or '08, it was around $4 trillion or $5 trillion, $6 trillion, now, it's $12 trillion, $13 trillion, but we're 10 years down, and so a lot of these loans are coming due. If you look at the payment schedule for maturities of a lot of these dollar issued debt by these emerging markets, the maturities are 2019, 2020, '21 and '22, so the next three or four years, they not only need the dollars to service the debt, they need the principal payment to pay it back off. I will often hear well, they'll just default. They're tired of the dollar, they're just going to default on the debt. That sounds like a great theory, and if they did that, that would decrease demand for the dollar, but the issue is that because all money is loaned into existence, if you default on debt, the supply of money crashes even further and faster than the supply, or the supply of money crashes even further and faster than the demand crashes. If people start defaulting, not only will the price of the dollar rise, because supply is just collapsing, but those countries who have now defaulted, they're going have even more trouble raising external capital, because nobody will want to loan them money again if they've just defaulted on a recent loan. If they start raising money in a non -US dollar, then do you think the US is just going to say, "Okay, no problem?" No, I think the US will then say, "Well, we're not transacting with you, not in dollars." Now, all of a sudden-- or they'll put new tariffs on them, or they'll say, "We're not going to do business with you, because you just defaulted on our banks." Now, they're locked out of the biggest consumer market in the world when they're already having financial troubles. This idea that they can just walk away from the dollar and have no negative consequences is, in my opinion, just it's not reality. I think one of the knock-on effects of my thesis of the dollar getting stronger is that it creates chaos in the rest of the world. It creates deflationary events in our world. It creates economic pressure, downward pressure on the rest of the world. As a result, I think that sends capital to the United States-- for no other reasons, just a safe haven bid. Then it creates this vicious loop where it pushes US asset prices higher, it pushes the US dollar higher, which creates even more pressure outside, which leads to even more flows coming. What that does is it increases the demand for US priced assets. You can see this being-- and where there's demand, the supply will be added. You've seen this in the corporate bond market in the last, I think in the last two months, they've issued $75 billion to $100 billion in new corporate issuance, and that's demand for dollars. Those are issued in dollars. There's great demand for dollar denominated debt. If the market wasn't there, then they wouldn't be supplying it. I think that that's further evidence that this is happening. I also have said that there will come a point where overseas investors will not just go to our Treasuries or our fixed income, but they will increasingly start to see US equities as a safe haven, or a way to seek some alpha. I've used the example before, of I think, a year ago, I talked about if I'm an Italian pension fund manager, and I'm looking at how to allocate assets, and I have a choice between buying an Italian bank or a US Bank, I'm buying a US Bank, or, if I'm buying a European credit, or a European corporate versus the US corporate, I think they'll increasingly start to allocate to US corporates. In the last month, we've seen the largest sovereign wealth fund in the world, which is the Central Bank of Norway, has recommended that they decrease their allocation to Europe and move those funds to US and including US equities. A lot of this stuff is taking longer than many of us think it will, but you can see it moving in that direction. I think as we move forward, we're going to see even more of that type of stuff that the Central Bank of Norway is already considering coming to the US. I think to a certain extent, this is already happening. It's why our assets or our US equity markets are near their all-time highs. Here's an interesting thing to do. Take a look at the European equity market, look at it in euro terms, it doesn't look horrible, but look at it in dollar terms, it looks really bad. Then flip it around and look at the Dow. Look at the Dow in dollar terms, and it looks okay. Not amazing, but looks okay. Look at the Dow euro terms, it looks really good. It's clearly broken out. If you're a euro investor, and you're looking to allocate and you use charts as part of your analysis, and you're looking to allocate to the DAX or do you allocate to the Dow? It's pretty simple. It's a pretty simple answer, in my opinion. Yeah. Back in 2016, I started talking about the dollar getting stronger. Even then, I said, at some point, we will get into a point where the dollar and gold will rise together. In the last year, we've seen that. A year ago, gold was around 1200. Now, it's around 1500. They've had hell of a run. Over that time period, the dollar's gotten a little bit stronger as well. I think that ultimately, there is nothing more bullish for gold than a strong dollar. Now, if you're a nondollar based investor, if you're denominated in euros, or yen, or Australian dollars, or pounds, or whatever it is, pesos, I think you can-- you should have and still can back up the truck on gold. I'm not convinced that we're breaking. Now, we've had a hell of a run in even dollar terms this year, which now you see gold rising and all currencies, and you're seeing the dollar and gold rise together. I'm not yet convinced that it's for real in dollar terms. It might be and if it is, that's fine, but it won't surprise me if gold pulls back in dollar terms in the short term. Ultimately, what I think will happen is the dollar will get so much stronger that it will literally break the global monetary system. There's really nothing more bullish than gold than the dismantling of the monetary order and the traditional monetary system. I don't think we're there yet. I think that a lot more pain needs to come, but when that happens, I think gold will be one of the biggest beneficiaries of that. One of the obvious impacts from the central banks around the world is not just the monetary stimulus that they provided, but they've been buying a lot of gold over the last several years as well. You see the Central Bank of Russia, the Central Bank of China, a lot of times those are quoted, but even smaller countries around the world have been buying gold. I think they buy gold for two reasons. One, they want to diversify their reserves. They've already got a lot of dollar reserves. They don't need to have it all in dollars. I think the other thing is that they know that if they have gold, they to a certain extent have a seat at the table if there's ever a renegotiation of the monetary system. The other reason that you buy gold is-- the reason that central banks buy gold is also the same reason that individuals buy gold. You buy gold to use in a crisis, when things really get bad, that's your insurance policy, and countries are not immune to really bad times. If you look around the world over the last six or seven years, gold and non-dollar terms has done pretty well and it's near its all-time highs in several currencies. Now, it's not quite back to its all-time high in dollars, it's been edging up, but it's still not back to its all-time high in dollars. If you look in euros, if you look in Australian dollars, if you look in Canadian dollars, if you look in the yen, it's still okay. Gold is doing exactly what it's always supposed to do for the non-dollar investor. Now, the interesting thing that I find with the central banks that are accumulating gold is nobody wants to cash in their insurance policy. If you get into a disaster, that's what it's for. Over the last two or three years, you've seen some countries get into the Dire Straits, have some disasters, and they've needed to cash that insurance policy in. You look at Venezuela, they've been selling their gold for dollars to fund their government. In Turkey, they had to sell gold to finance some of their trade and some of the government when the US put sanctions on them. I won't be surprised if that happens. I'm not saying that all the central banks are going to go out and sell their gold, but as countries come under pressure, that will be one of the options that they have. I think some of them, whether they like it or not, will be forced to use their gold as a means to fund their governments. Now, if we have a monetary disaster in the next six weeks, or the next six days, and there's not that-- I think there will be a progression before the monetary system resets. If it just resets right away, then they've got their gold, they don't need to sell it along the way. If this monetary crisis plays out over a two or three-year period, rather than a two or three-week period, or two or three-month period, as the knock on effects happen, I think some of these central banks will be able to force to sell their gold. Here's something just happened to-- I think it was July, maybe it was August, there had been this central bank sales agreement between the central bank-- between all the central banks and the Bureau of International Settlements which was a negotiated gold sales. You couldn't sell without being part of this gold coordinated selling program because they didn't want to have uncoordinated gold sales. Well, that's been removed. Now, a lot of people in the gold world have said this is bullish, they're removing the sales agreements, they're no longer cooperating, everybody's going in to buy. This agreement never kept them from buying to begin with, this was a gold sales agreement. It wasn't a gold buying agreement. Now, why are they all of a sudden removing a sales agreement if it didn't prevent them from buying to begin with? Well, I think they might have to sell some of their gold. I think they removed it because they know that some of them might have to sell their gold. Now, this is a great advantage for some people. Russia, if they want to buy more gold, well, if Turkey has to sell it, maybe Russia buys it. Some of them will see it as an opportunity, but some of them are going to have to sell their insurance policy, I believe. It'll be interesting to see how this all plays out. Ultimately, this is extremely bullish for gold in the long term, but I think you got to realize that just because it's bullish inevitably, it doesn't mean it's bullish imminently. I think if we haven't learned that over the last six years, we haven't learned anything. Yeah. Going back to China, I've been outspoken that China is in more trouble than many people think that they are. I continue to think that's the case. You've seen a dorsal starting to bubble up in Hong Kong. What a lot of people don't realize is the troubles in Hong Kong are not unrelated to the troubles in China. There's a friction there. I think both the Hong Kong monetary authority and the Chinese central bank are both under pressure from their dollar funding needs. I think that will as the dollar gets stronger, that increasingly plays into the troubles that they're going to have. At the end of the day, the limit that China has, you can't have an independent monetary policy and open capital account and a fixed currency. That's why they don't-- they have a fixed currency because they don't have an open capital account. If they want to internationalize, they're not going to be able to maintain that peg. I think when that peg goes, I think it goes hard and it goes fast. I don't see how China gets out of this without their currency depreciating remarkably. Now, whether it's forced upon them or whether they decided to do it on their own, I don't know. One of the biggest trades we have on right now is we're short the Hong Kong dollar. We think the peg is going to break. We think when that happens, that's enormously bullish for the dollar. It has a number of knock on effects around the world. We think that that will be incredibly deflationary for others that have dollar funding needs. One of the other biggest trades we have is long Canadian Bankers' Acceptance Notes. Now, many people probably never even heard of Canadian Bankers' Acceptance Notes. It's very similar to Eurodollar market. If you bought Eurodollar calls, because you thought interest rates were going to go down, so you buy the calls, because it's a bet that they're going to cut interest rates and people like Raoul and some other people around the world, John Burbank have talked about this great Eurodollar trade that they made a great call a year ago. This is the same play, but it's in a smaller market and how many people even know exists. I think there's like five people in the world that trade these things. We put a big trade on last week, and we've been putting it on over the summer, we put more on last week. We think that the Central Bank of Canada is one of the few central banks in the world that is not easing right now. Their policy rate is 1.75%. If you look around the world, Australia has cut, the ECB has cut, even the Fed has cut, Japan's got easy money, Poland's got easy money, Brazil's got easy money, New Zealand's cut-- there's this easy bias around the world that central banks believe that they're going to need to ease monetary policy. The Bank of Canada has so far resisted and we think the idea that Canada can stand alone against the rest of the world is just wrong. We think that they're going to be forced to cut. If they're forced to cut, these Canadian Bankers' Acceptance Notes will appreciate, but right now, they're factored in one cut in the next I think, 18 months in Canada. We think that it's possible that they have to cut dramatically more than that. When that happens, the straight on the BACs, the Canadian Bankers' Acceptance Notes, like, I don't want be dramatic, but just the math of these things that if we get it right, we can make three or four times our money and it's possible we'll make 10 times our money on that trade. Again, that doesn't mean there's not risk involved. Of course, you don't get those types of potential returns without taking risk but we think it's a risk reward that's worth taking and we have a high degree of certainty that it will pay off. The thing I like about these types of trades is if you're wrong, you don't lose that much. If I'm wrong, and Canada doesn't go into a recession, or doesn't have any deflationary pressures, and the world economy improves, well, then the other parts of the portfolio will do really well. If we're right, and they do, and they have to cut, you make an asymmetric return on this, where you can literally make three, five, 10 times your money, and the risk reward necessitates you doing this trade. As I said, at a conference recently, there's some trades that can be done, but they don't need to be done. Then some trades are so good, they must be done. I think this is a trade-- the trade for the strong dollar, because the trades are so asymmetric, I think they're trades that make must be done. Essentially, the way I see is I think the global economy is slowing. I think we're headed towards a global recession. You're starting to see it outside the United States, I think that will continue. I think it will eventually hit the United States. Before it hits United States, I think the flow of capital from around the world is going to come to the United States. I think that flow of capital is going to delay our hitting the wall, while everybody else does hit the wall. As that capital comes into the United States, I think that increases demand for dollar based assets. I think corporates, US government and other dollar based entities will issue dollar debt. I think it will be purchased. I think that will also find its way into the US equity market. I think it's very possible we have a repeat of last year, whereas we had a big selloff in late 2018. I think it's very possible we have that happen again in Q4 of 2019. I'm glad I was aggressive on equities at the beginning of the year so I don't have to be as aggressive now. If we get another selloff like that in Q4, I think I'll be aggressive buying equities later this year, the same way I was last year, because I don't think we've seen the high in the equity markets yet. I think the flow of capital to the United States trumps everything else. No pun intended, Trump has put policies in place that will increase, I believe, the desire for US assets. As that happens, I think we will have a blow off top in the equity market, I think we're going much higher. 30,000 or 35,000 on the Dow would not shock me at all and it's potentially, we go even higher than that. I'm going to say this, again, I say it all the time. This is a story that ends very, very badly. I'm not the Pollyanna that's saying everything's fine, buy US assets and put your head in the sand. I just think that this is the inevitable outcome of a global debt supercycle and the end of the monetary system. I think it ends via dollar strength. I think before it all ends, we get a supernova upward swing in the dollar, dollar based assets. Then there's going to be periods of time along this route that are really, really scary. It's not going to be easy. I wish it was, but it's just not going to be. I liken it to the Super Bowl and you listen, you either want to be in the Super Bowl or you don't and you either love it or you don't and I got to say it's scary but I love it. It's like Tom Brady leading his team down the field with three minutes left and they're behind by five, kicking a field goal ain't going to get it done. You got to get into the end zone. I don't know if I'm going to get it right. It's very possible I don't get it all right, but if I get a little bit right, I think we're going to do pretty good.