Tue, 3 Dec 2013
The costs associated with a full Fed taper would be astronomical, and investors seeking currency exposure should set their sights on the euro, says Merk Investments' president Axel Merk.
Anthony Dasaro: This is A.J. Dasaro for Morningstar, and with me here today is Axel Merk, founder of Merk Investments and manager of the Merk Funds. Axel, thank you so much for being here today.
Axel Merk: Great to be with you.
Dasaro: Axel, you've lived in various currency areas. You've invested in various currencies. What do you think U.S. investors who haven't had that exposure take for granted?
Merk: People think they're diversified because they invest in the S&P 500, not realizing that about 90% of the earnings of the S&P companies are hedged back into the U.S. They also don't realize that when they are told that the U.S. has the cleanest of the dirty shirts, that the euro is actually the best-performing currency this year, at least as of when we're talking. Last year, the euro beat the dollar by almost 2%.
When there is trouble somewhere in the world, that means there might also be some opportunities out there. There are some wonderful diversification opportunities because currencies are not correlated to the U.S. When people buy international stocks by the way, the only thing they've been getting in recent years is beta, more volatility. We tell them, "Why don't you zoom in on where the opportunity is, zoom in on that currency risk and potential."
Dasaro: What are some reasons that investors need to think about diversifying out of the U.S. dollar and the U.S. bond market?
Merk: Well, a couple of things. First of all, the bond market, I think most people would agree, has had for decades a bull run, and whether we're going to have taper or whatever it is, volatility is going to go up in the bond market. And with that, you might want to move out of that. The question is where do you flee to? One of the beauties about the currency space is that, we have all these arguments of what Fed chairman Ben Bernanke does or what the Europeans do. We may not like what our policymakers do, but we think they're predictable. And the best place to express those views might be the currency world.
If somebody prints more money than the other guy does, maybe that has implications for the currencies. If you have major regulatory changes, [that has implications, too]. And currencies move, and they move with much less volatility than the equity prices do. When the euro moves a full cent on a percentages basis, that's not all that much. So, with reduced risk you can zoom in on where the action is, and we think the currency market is where the action is and where the profit potential is.
Dasaro: What are U.S. policymakers doing right now, and how is that going to affect the U.S. dollar in the short term and the long term?
Merk: Great question because the Federal Reserve isn't doing a great deal. They don't know what they are up to, and the reason why they have no clue what they're doing is because they have taken their own gauges away. They have managed the yield curve so much that they don't know how healthy the economy is, so they are scrambling to overinterpret every single data point. So, they are just sitting down in the sandbox arguing. One of the most positive things about Janet Yellen coming in is that we're going to have some leadership. We're going to know where things are heading toward.
Now, the trajectory is that we're not going to head anywhere that's going to be a positive for the U.S. dollar. We don't think we can afford positive real interest rates, and we're going to have a Fed president who has indicated that she is going to use monetary policy to fix fiscal issues. That's basically what it means when you have an employment target: Let Congress have a mess--we're going to take care of things with monetary policy, which means we're going to print money, and with that we think good luck trying to contain the greenback.
Dasaro: Do you think we'll have to eventually exit this Fed balance sheet position, and is that going to be negative for the dollar?
Merk: Well, a couple of things. First of all, this taper talk has historically been associated with a strengthening dollar. Well, nothing could be further from the truth. The dollar has been weakening. Historically, when interest rates go up, if we were in a normal environment, the bond market goes into a bear market, foreigners are less inclined to buy U.S. Treasuries, and the dollar is actually going down.
We cannot afford an exit. First off, we can't sell the securities because we would have major losses at the Fed. If we pay interest on reserves or the reserve repos, we're going to be paying billions, if not tens or even hundreds of billions, in interest to banks. But more importantly, the cost of borrowing from the U.S. government is going to go up.
In 10 years from now, let us have a gangbuster economy; let us have historic levels of interest rates. We're going to be paying $1 trillion more a year in interest expense. We simply can't afford that. With that we're not going to have an exit, or at least we are just going to go a little bit in that direction, and then we have to backpedal right away.
Dasaro: This year we've seen the Japanese yen fall quite substantially and emerging-markets currencies have also fallen quite substantially, as well. Where do you think the best opportunities lie in the currency asset class?
Merk: The best opportunity might continue to be in the euro. We think the euro is going to be cursed to move higher. Everybody thinks that Europeans are printing a great deal of money; that's simply not true. The reason why they have these major issues is because they didn't print all this money, and then they had this EUR 1 trillion long-term refinancing facility in Europe--which by the is still a fraction of the multitrillions we've printed in the U.S.--but that money is being paid back by the banks. It's a more demand-driven system where banks are asking for liquidity when they don't want that liquidity. That doesn't mean the European economy is going to go gangbusters, but the euro will strengthen because they simply don't have the levers to push things forward on the printing press whereas the Japanese and the U.S. do.
With regard to emerging markets, these emerging markets are not very liquid, and the volatility is going to be there because of this taper talk, the back and forth at the Fed. So the weaker emerging markets are going to suffer a great deal. The more advanced economies in Asia in particular--China for example--I think they will do just fine because they're able to absorb those flows much better than others.
Dasaro: Thank you, Axel, for joining us today.
Merk: My pleasure.
Dasaro: From Morningstar, I'm A.J. Dasaro. Thanks for watching.