The Dollar Party

As Robert Lucas, Nobel Prize in Economics, said recently: If we knew the timing of the next asset bubble, we would sell our assets one week before. Perhaps he was trying to show the futility of regulations and policies against bubbles. But his remarks – typical of a free-market brilliant economist – might represent the beginning of an authentic short-term “research program” devoted to the U.S. recovery and to the U.S. inflation.

Yes, Bernanke more than tripled the monetary base and adopted a policy of benign neglect with respect to the dollar, hoping the currency would devalue, just like in 1933 when Roosevelt did the same thing and avoided deflation.

The economic analyst’s task from now on is to guess the timing of the U.S. recovery and the U.S. inflation, because this will provoke a major change in U.S. economic policy: raise in interest rates and dollar revaluation.

One might say that this will be the end of the present “dollar party” when carry-trades based on very short-term loans denominated in U.S.$ are financing all around the world purchases of risky assets denominated in dollars and particularly in other currencies- Brazilian stocks, U.S. stocks, Brazilian real, Australian dollar, oil, gold, sugar, etc. A party – but probably many bubbles.

Undoubtedly, new asset bubbles were formed in 2009 leading to economic policy dilemmas in many countries. As a matter of fact, in the U.S., another type of monetary policy of the Greenspan style (without rigid inflation targets) would certainly have already led to higher interest rates. In Brazil, paradoxically,  if you raise interest rates the real will appreciate even more, and if you lower interest rates the stock exchange will continue with the bubble. And so on.

This dollar party was somewhat unexpected, after the seriousness of the 2008 crisis. But bankers and traders do not lose time: they perceived the carry-trade opportunity, with dollars at zero interest rates, even if only for a few days, and additionally with the currency devaluation.

The mismatch between the U.S.$ loans and the long-term nature of the assets being purchased is dramatic, because after all – when things go wrong – liquidity disappears, particularly in countries (Brazil) where the exit doors are small and foreign exchange markets are thin( using the expression of Robert Mundell, another Nobel Prize).

Our recommendation is to keep an eye on what’s happening in the United States – as always. It is true that in cases like China (or even Brazil) the bubbles might burst before the U.S. interest rates go up and the dollar recovers for internal reasons and domestic policy mistakes, but in general the “negative” signs will come from the US.

And the curious thing is that such “negative” signs will be derived from very good news: The US will be growing again at a fine pace without inflationary pressures. Our guess estimate is that this will occur in the very beginning of 2010 – not too far from today – after fourth quarter figures in the U.S. But let us keep researching carefully because the bets are huge.