The damage of the dollar glut

By Bill Fleckenstein

We're in the midst of a leveraged-buyout mania and a worldwide stock frenzy, running the gamut from just plain wild to completely out of control.

From time to time I find myself wondering: How did we get here? So today, I'm sharing my thoughts on that subject because if you don't know how you got to where you are, it's hard to be prepared for what may happen next.

In the beginning . . .

To make a long story short: The process was started by money printing in America to bail out the last bubble.

That induced money printing in much of the world because so many countries had linked their currencies to the dollar. More importantly, the very regions that were primed to grow -- think Asia, India and the Middle East -- exploded, in no small part, thanks to money printing. Thus, America's housing boom kept our economy growing. Growth in the other parts of the world I just mentioned, together with the attendant commodities boom, conspired to create the worldwide growth (and inflation) that we have experienced.

A lot of what's transpired has been a function of absurdly low interest rates, given the level of inflation around the world, and the collapse in risk premiums, aided by ratings-agency alchemy, which has allowed debt -- from moderately risky to total garbage -- to be spun into high-quality credit structures. In other words, the debt markets have acted as unindicted co-conspirators in the frenzy.

Stuffed to the gills with dollar bills

A major reason why our Treasurys market has traded as well as it has stems from the accumulation of dollars by the aforementioned regions and their desire to keep their currencies weak against the dollar. (China, Japan, South Korea, Taiwan and India have accumulated more than $2.5 trillion in less than 10 years, according to the May 23 Financial Times.)

The trillions of dollars printed "forced" those countries to print trillions of dollars' worth of their own currencies to keep them from appreciating too quickly. After they printed their currencies to buy ours, they wound up buying mostly Treasurys with those electronic greenbacks (that is, until recently).

Thus, currency-suppression techniques and blind reliance on formulas on the part of ratings agencies, combined with organic growth, plus the madness of the crowds, have brought us to where we are. But important changes are under way that at some point will derail the process I've just described.

First of all, Kuwait's dollar de-linking and China's sliding of the band (to pick the two most recent examples) will, at the margin, require less dollar buying and ultimately less Treasurys buying. Additionally, it appeared the Chinese were already spending fewer of their dollars on Treasurys and more on commodities, even before they took a flier on the Blackstone purchase. This is a roundabout way of saying that the world's bond markets might finally experience rising rates as the ranks of buyers thin out.

LBOs: Gorge now, regurgitate later

One of the unwritten beliefs of folks in the leveraged-buyout (LBO) crowd is that they'll be able to finance any wild idea they can come up with. So far, that has been the case. But we are going to hit a point where the cumulative effect of all this exchanging equity for debt will swamp the debt market, and the LBO party will be over. It's not possible to predict when speculative forces finally will choke the debt buyers, though that moment should be recognizable as it occurs.

Lastly, I believe that the world economy's growth will at the least be tested, if not completely undermined, because U.S. economic growth is in the process of slowing down. I think it will continue to slow as consumers are tapped.

The main engine that kept them going after the last stock bubble was the real-estate ATM, which is now broken. Further, the recent tightening of credit standards and increasing interest rates in the bond market -- not to mention the high price of gasoline -- will compound the problem.

A sanguine state of rationalization

In the meantime, it's been onward and upward for stocks, thanks to the blind faith in LBOs and a never-ending global boom, and a market that "acts well" (reinforcing the belief that market action never lies about what the future holds), factors that lull folks into a sanguine state of rationalization. Ultimately, I believe that market action will fool people. The one thing that I am most certain of is that there is going to be a dislocation -- because never have so many rationalized so much with so much leverage.