The US Dollar and the Cone of Uncertainty by John Mauldin, Mauldin Economics
Currently we have an international monetary non-system. Nobody has to follow any rules. Everybody does what they consider is in their own short-term best interest. The real difficulty is: What is in their short-term interest – for example, following ultra-easy monetary policy – could well backfire somewhere. It might be not in their long-term best interest. And as the easy monetary policy influences the exchange rates, it influences other countries. Almost every country in the world is in easing mode, following the Fed, and we have absolutely no idea how it will end up. We are in absolutely unchartered territory here.
– William S. White, former Chief Economist, Bank for International Settlements, in an interview for Finanz und Wirtschaft
I visualize this process [of forecasting the future] as mapping a cone of uncertainty, a tool I use to delineate possibilities that extend out from a particular moment or event. The forecaster’s job is to define the cone in a manner that helps the decision maker exercise strategic judgment. Many factors go into delineating the cone of uncertainty, but the most important is defining its breadth, which is a measure of overall uncertainty.
Drawing a cone too narrowly is worse than drawing it too broadly. A broad cone leaves you with a lot of uncertainty, but uncertainty is a friend, for its bedfellow is opportunity – as any good underwriter knows. The cone can be narrowed in subsequent refinements. Indeed, good forecasting is always an iterative process. Defining the cone broadly at the start maximizes your capacity to generate hypotheses about outcomes and eventual responses. A cone that is too narrow, by contrast, leaves you open to avoidable unpleasant surprises. Worse, it may cause you to miss the most important opportunities on your horizon.
– Paul Saffo, technology forecaster
Saffo borrows the term “cone of uncertainty” from weather forecasting. While you may not be familiar with the concept, you see it in use every time there is a hurricane forecast. The further away you get from where the hurricane actually is at the moment, the wider the “cone” predicting its possible paths.
For the past two letters we’ve been looking at the global scene and trying to figure out which issues will help us outline scenarios for 2015. We finish the series today by looking at the impact of the dollar bull market on the probabilities for various 2015 developments.
Let me say at the outset that I think a global currency war (kicked off by Japan last year and just now heating up) and a rising bull market in the US dollar are the big macroeconomic drivers not just for 2015 but for the next four to five years. I think all future economic outcomes pivot along with these two major forces – they are the lever and fulcrum, so to speak. As we look at all possible futures, as we map our own cones of uncertainty, it is certainly true that that our assessment could change with the emergence of important new trends at the outer fringes of the cone; but I believe (and have believed for some time) that we need to organize our forecasts around the currency war and the dollar bull market.
(Let me note that even though this letter is much shorter than usual in terms of actual words, for which readers may be grateful, it will print longer, as there are an unusually large number of charts.)
Before we jump into the letter, let me quickly suggest that you save the date for the Strategic Investment Conference next spring, April 30–May 2. We already have commitments from Ian Bremmer, Mohamed El-Erian, Niall Ferguson, Louis Gave, Jeff Gundlach, Lacy Hunt, Larry Meyer, Michael Pettis, David Rosenberg, and Grant Williams, and are close to finalizing an additional 4-5 headliners, which I expect to be able to announce in a few weeks. In short, the usual over-the-top group of speakers that I am somehow able persuade to show up in San Diego. Altegris Investments will have the web page up for you to register within a few weeks, and I really hope to see you there. I think this will be our best conference ever. Now let’s think about the dollar and its impact on macroeconomics.
The Beginning of a US Dollar Bull Market
Currencies are not supposed to have large movements in short spans of time and certainly not violent moves such as we have recently seen with the Russian ruble. Relatively stable currencies – ones that make moves measured in single digits over multiple years – are what you want to see for stable trade and world GDP growth. Violent moves like the ruble’s signal that something is seriously wrong, so wrong that it may well precipitate a deep recession. You very seldom if ever see a similarly rapid upward move in a currency. (Off the top of my head, I can’t think of one, but surely somewhere in history… and if I said “never,” I would probably be corrected by my astute readers.)
Over the last few centuries, as the world moved away from the gold standard and gold-backed currencies, the valuations of fiat currencies began fluctuating, sometimes wildly, over time. Currency wars following the onset of the Great Depression certainly contributed to the length of the downturn. After World War II, the financial leaders of the nations of the world came together and created a monetary system called Bretton Woods, named after the mountain resort in New Hampshire where it was created. Basically it was an anchored dollar system, where the dollar was convertible into gold and the rest of the world used the dollar for their reserves and generally pegged their currencies to it. The linchpin of the deal was the understanding that the US dollar would remain a stable currency.
We didn’t live up to that deal, printing too much money during the Vietnam War; and the nations of the world, led by France, began to ask to convert their dollars into gold. Since that would have drained the gold out of the United States, Nixon closed the “gold window.” We won’t get into the argument about the propriety of his move here.
The chart below shows the US Dollar Index (the DXY, which is heavily weighted to a comparison with the euro) since 1967. Prior to 1967 the dollar was generally stable. As the value of the dollar began to slide in 1970 – a troubling development if you were holding dollars in Europe – the world began to wonder if perhaps the United States was taking advantage of its position. Note that after the closing of the gold window in ’73 the dollar continued to fall but with greater volatility. This was mostly due to the Federal Reserve’s allowing inflation and printing money.
Then Paul Volcker came along and began to raise interest rates, and a major dollar rally