Dollar Ratios

My friend’s dad joked that kids are the most destructive force in the universe.

For stocks, the most powerful (and sometimes destructive) force is the movement of the dollar. The Federal Reserve and the Bank of Japan both meet today so it could soar or swoon. Since the buck holds sway, we should all of us in the capital markets from investors to issuers understand how and why.

Stocks react to the dollar because they’re opposite sides of the ledger. Debits and credits.  If money buys less, a debit, then what preserves value (stocks) increases in price, a credit.  So a “strong dollar” means more value resides in the currency and less in stocks.  A weak dollar is the opposite, and value transfers at higher risk into stocks to offset diminishing purchasing power – the quantity of things money buys.

It’s about ratios.  In the past, countries would scrounge around for a gob of gold. Then they could issue paper currency at a ratio. Played poker?  Chips are an asset-backed currency. Pay money, get chips.  Want more chips? Pay more money. The ratio is always the same so chips have fixed value and supply varies with the number of players.

Not so with money.  If Europe has spent more than it makes, its debts depressing the economy (like credit card debt constrains discretionary income), the European Central Bank can manufacture more money – bump up the chip stack without paying.  Remember our ratios?  Increase the supply of euros and prices of risk assets that preserve value, like stocks and bonds, rise to compensate.

Follow that reasoning. When money declines in value, stuff costs more. When stuff costs more, the revenues of the businesses supplying the stuff increase.  And since consumption – buying stuff – is the core way we count “economic growth” today, economies grow when prices rise.

Get it?  Yeah, it’s balderdash that selling the same unit at a higher price is growth. But that’s how governments now measure it. All central banks including the Federal Reserve thus have inflation targets. They are trying to create growth, without which most governments go broke.

Think I’m making this up?  Follow the math. You can’t print a batch of Benjamins. That’s counterfeiting. So how do central banks create money?  They issue money against the most widely available commodity in the world today:  Debt.

When you buy dinner on a credit card, the bank doesn’t reach into somebody’s savings account to pay the restaurant. It creates money. Pay the balance and that money vanishes.

Remember the ratios? Burn money and there are fewer dollars, which means the dollar rises in value, and prices fall, and economies contract (not really but that’s how we count now), and stocks swoon. Create money and the opposite occurs – everything rises.

Investor-relations people, you know the term “multiple-expansion?” It describes stocks that cost more without any change to underlying fundamentals.  This is a product of money-creation. In effect, central banks are trying to induce us all to pay more for things than they’re worth.  Value investment is the opposite: buying at a discount.

For perspective, JP Morgan is leveraged about 8 to 1.  Citigroup, about 7 to 1.  The Fed? With capital of $40 billion and liabilities of $4.54 trillion, its leverage ratio is 113 to 1.  Where money before depended on assets, like gold, now it’s backed by liabilities – debt.

The European Central Bank is buying eighty billion euros of debt a month to create money. What happens to debt? Its value skyrockets and interest rates plunge. It’s the opposite in the real world. You’re in hock, you pay the vig.  Bigger debts, more cost.

Japan is way beyond that, financing the government by directly trading yen for government debt, and now it’s buying exchange-traded funds, shifting to equities with infinite supply (ETFs can theoretically create as many shares as demand requires – but inevitably leverage increases). Japan is even contemplating paying banks and businesses to borrow. Why? Because debt creates money and more money keeps prices from falling.

The effort fails because consumers buy more when prices fall and less when they rise. So the very attempt to drive economic growth is in fact undermining it. Plus, the soundness of our currencies today depends on the capacity of governments to pay on their debts.

Summarizing, the world is indebted so it needs money. Central banks supply money by exchanging it for debt.  Creating money paradoxically reduces the capacity of consumers to buy things because prices rise. So they have to go into debt.  The cycle repeats like two parties munching opposite ends of a strand of spaghetti.

Back to stocks. When they vary inversely with the dollar it’s contraction or expansion of multiples, not real growth.  And that means consumers are losing purchasing power.  Since consumption drives economies now, it inevitably leads to slower growth.

And that’s what the planet’s got. Circular reasoning obfuscates facts.  The solution is a stable currency so all of us can understand fair value for stocks and everything else. But we’ll start with identifying the destructive force – and it’s not the kids.