SON OF "A DAY LATE and A DOLLAR SHORT"
George J. Paulos of freebuck.com and
Sol Palha of tacticalinvestor.com
October 5, 2004
Roundtable authors George and Sol revisit their “dollar
short squeeze” theory.
spring of 2004 we published “A
Day Late and A Dollar Short” an analysis outlining the
risks of what we called a “dollar short squeeze” scenario
where we envisioned a rapid but short-lived deflation caused
primarily by the effects of excessive dollar-denominated
debt. The article caused quite a stir and inspired many
analysts to respond, both positively and negatively. We
thank all of the authors who took the time to reflect on our
thoughts and respond to them. Our goal was to spark a dialog
about a subject that was completely ignored by the
mainstream press and that goal was achieved. The “dollar
short” theory has since been endorsed by Richard Russell,
Bob Hoye, Rick Ackerman and others. Many other writers have
taken a strongly critical view of the theory and we respect
later, the dialog continues but we have noticed that our
original thesis is now being misrepresented as a
“deflationist” theory and one that is primarily concerned
with the forex (foreign exchange) value of the US dollar.
Reviewing our own work, we can understand how
misunderstandings could be gleaned from such a long and
complex article. In retrospect, we now see how we could have
presented the subject more clearly. Discussions of currency
value are difficult and prone to misunderstanding because of
the dual role of a currency as both an asset and benchmark
of value. We take this opportunity to restate and amplify
our views with respect to the current situation.
original thesis contained the following points:
the form of US dollars is a fundamentally weak asset
weakness is well known to almost all market participants
due to the long-standing trends of US indebtedness,
current account deficits, weakening manufacturing
sector, and chronic inflation.
majority of investors and consumers have taken on large
amounts of debt to capitalize on the belief that
inflation will continue uninterrupted into
the far future.
massive debt load is similar to, but not identical to a
“synthetic short” position on the dollar.
is similar to a short seller but one who is short cash
rather than another asset. A debtor can be ruined if the
cash value of collateral falls below the amount owed
just as a short seller can be ruined if cash margin
falls below net asset value.
short positions have consequences in markets, often
creating the conditions that cause weak assets to rise
quickly in value in a situation called a “short
squeeze”. These short squeezes are common in all markets
that allow short selling.
squeezes are rapid but short-lived events that can cause
investors with bearish short positions to be wiped out
due to a sudden rise in the asset value as other short
sellers make panic and buy back their short sales. This
can happen even if their fundamental bearish opinion of
the asset is correct. Short squeezes are counter-trend
short squeeze in the US dollar would be functionally
equivalent to a rapid but short-lived deflation where
general prices fall in response to a sudden collapse in
demand as cash and/or credit becomes temporarily scarce.
responses to a sudden deflation by rapidly increasing
money supply would take time to implement due to
administrative delay, political infighting, and the slow
speed of diffusion of new money into the economy.
Ultimately, reflationary policies from the central bank
and other authorities would gain traction and again
create the desired inflation but only after much damage
has been done.
original analysis we only briefly touched the topic of
foreign exchange and how the dollar would fare in relation
to other currencies. The article was already long and
honestly we did not fully analyze how such a scenario would
unfold in the forex markets.
In no way
did we imply that a short squeeze deflation would be
permanent. Our original article stated “In the aftermath
of such an event, it is quite likely that the dollar would
resume its decline due to the continued deterioration of the
fundamentals of the US economy. Remember, a short squeeze
does not indicate any change in the fundamentals of any
asset or security. In fact, it is a confirmation of its
weakness. The irony of the situation is that those who are
convinced that the dollar is slowly dying are probably right
but their collective action makes their investment positions
untenable.” In the long run, we assume that inflation
will continue and may even accelerate. Our point is that
inflation is not necessarily a straight line to oblivion but
can take a complex course, even reversing at times.
feel that the actual event itself would be short-lived,
damage from even a short bout of hard deflation could be
deep and long-lasting considering the huge overhang of debt
in the US. Highly leveraged investors could find themselves
wiped out even if their securities quickly recovered.
Consumers who fall behind on debt payments may find
themselves unable to catch up or may find they owe more than
their collateral is worth. Marginal businesses may fail if
demand and/or pricing temporarily collapse. Faith in
mainstay investments and assets would be broken.
In the time
since our original essay was published, there have been no
indications of dollar short squeeze phenomena. However,
there have been a number of developments that can be
interpreted as precursors to such an event:
Dollar appears to have put in an intermediate-term
bottom on forex trading
commodity sectors have fallen substantially including
some metals, agricultural, and other soft goods.
US interest rates have fallen.
measures of inflation have fallen.
indices have fallen.
supply growth has stalled.
inventory in national real estate is indicting topping
action in home prices.
consumer is showing signs of fatigue as indicated by
sluggish retail sales figures.
Implications of a Dollar Short Squeeze
temporarily fell within the US, how would the dollar fare in
foreign exchange markets (forex)?
the world has a trend and it’s well known that nothing will
simply trend in one direction forever. So even though the
dollar is technically shot to pieces and fundamentally
rotten, it will have a strong counter trend rally at some
point. When the dollar begins to rise these signs will start
to manifest themselves.
start to drop in price. This has already started to take
place and will keep accelerating for a while. Electronic
goods, now even many agricultural products are dropping
in price and what is even more interesting is that gas
prices are no longer rising even though oil keeps
setting new highs almost on a daily basis.
currencies that rallied while the dollar plunged will be
in the process of topping or putting in their final
will start to cut down on their spending; the latest
consumer spending figures seem to indicate that the
consumer is slowly tightening his or her belt.
The Feds won’t
sit still. They believe that the US cannot have deflation
take over under any circumstance, so they will start running
the printing press at full speed. In fact we believe the
recent rate hikes were implemented to confirm the illusion
that the economy is improving and that most likely next year
the Fed might have to reverse some of the rate hikes
implemented this year. If the Feds lower rates, then
investors won’t really want to hold dollars because most of
them are not speculators. Only speculators will then be
willing to play the rise in the dollar. The Feds will most
likely succeed in triggering of inflation and putting an end
to these initial deflationary forces. This could actually
back fire and bring on hyperinflation.
We need to
stop here for a while and explain something else. Currently
we have both deflationary and inflationary forces co
existing in almost perfect harmony. We have extreme
inflation in the energy sector and extreme deflation in the
manufacturing sector. Another thing to remember is that
deflation and inflation are nothing but cycles. In other
words they are nothing but trends, and when the trend breaks
in one it will trigger an up trend in the other. Example the
Feds could actually trigger hyperinflation as a result of
their fear of deflation by running the printing presses into
the ground. This will force everyone to try and cut down his
or her debts as soon as possible. In this case, a bout of
hyperinflation could bring about a cash short squeeze
because prices are rising faster than consumers can absorb.
theory is that you usually don’t pay your debts when one is
in inflationary times, because the future value of your
dollar keeps declining. There is one little problem, what if
you have no future dollars coming in or what if you future
dollars are not coming in as fast as inflation is rising. In
other words what if your income is not increasing enough to
pay rising bills? What if your income is declining? We are
already witnessing that in the health sector right now. A
big article was published on Yahoo stating that insurance
rates are rising at three times the levels of individual’s
salaries. This is equivalent to a reduction in salary
because health insurance premiums are deducted directly from
paychecks. In such a situation one would either look for
ways to cut down one’s debt or at the very least try to
spend less. Eventually such spending cuts will trigger
deflation as out of necessity business and individuals seek
to cut their discretionary spending.
John Tyler (www.trader007.com)
recently had the following to say as far as the dollar goes:
The G7 have
been meeting recently but have been keeping it very quiet.
“I suspect they are trying to create the impression of a
falling dollar so traders will be caught out”. Bush, Blair
and Howard are all getting together, they are all facing a
rather tight race and they want low oil prices so they will
team up to pump the dollar. It fits the BIS objective for
stability; which is political first and foremost so that
they can continue to operate, a Darwinian survival
How would a rising
dollar affect other currencies?
In a way this
question is really rather idiotic. We don’t have a constant
to measure any currency anymore so everything is just
arbitrary now. However if we look at a 10-year time period,
we see that several currencies increased in value while
several decreased in value. So when the dollar rises, some
currencies will pull back while others might actually rise
with it. What everyone is missing is that not one central
bank will allow its currency to simply keep appreciating.
This is because if one currency should be allowed to get too
strong, that nation will be priced out of the export
markets. Since we are a global economy and interdependent on
trade with each other, a very strong currency is something
no nation wants at this point. So we will actually enter the
stage of competitive currency devaluations, where
nations will start to devaluate their currencies just to be
able to stay competitive. This virtually assures us that the
Dollar will not be allowed to rise up in value indefinitely.
In some way these moves are being engineered as the current
value of the Euro is hurting the entire Euro zone and
benefiting Asia and the USA tremendously. It makes our
products more competitive.
So the real
question is what will happen once we enter this aggressive
stage of competitive currency devaluations? Gold will
finally start to shine as it will enter the true bull market
stage and rally in every currency. Currently Gold’s price is
based on what the dollar is doing, but there will come a day
when Gold will rally in the face of a so-called rising
dollar. I think those that waste too much time in analyzing
the rise of the dollar in terms of the forex value are
missing the big picture; that being the slow but sure
competitive currency devaluations that are currently taking
place. China has decided to take part in this by pegging the
Yuan to the dollar, other Asian countries are doing this by
selling their currencies and buying dollars and the list
goes on. We have not entered the fiercely competitive stage,
where the theme will be devalue or die. Once we get
into that stage, the only thing worth looking at will be
Gold. Yes eventually they will come out with a currency
scheme that will be partially backed by Gold, a point in
time, which will represent the peak of the gold bull market.
Austrian-school economist Marc Faber expresses a similar
view to ours:
“I should also
like to mention that if this scenario of a weak economy does
come into play, the dollar could surprise on the upside
simultaneously with the bond market. Why? Because weakness
in U.S. consumption will lead to an improvement of the U.S.
current account deficit as imports falter. I should like to
emphasize that this view of dollar and bond market strength
isn't a long-term call, but intermediate in nature, based on
the prevailing negative consensus about bonds and the U.S.
dollar and my expectation that the economy might suddenly
fall off a cliff.”
we believe that the US dollar would probably rise in forex
markets during a short squeeze event, but the rise would be
temporary and have limited upside.
George J. Paulos
and I acknowledge the possibility of a period of
hyperinflation, but a whiff of hyperinflation could actually
be the trigger for a cash short squeeze by diverting
precious income from discretionary consumption to
non-discretionary consumption and debt service. In fact, I
believe that we have already experienced that whiff of
hyperinflation and the damage has already been done to
consumers who have increased their non-discretionary
debt-service expenses while incomes have remained stagnant.
As a result, consumers are increasing their debt loads even
further to maintain lifestyles. This is not sustainable. The
debt service burden will soon reach a tipping point.
official response to these problems is always additional
monetary expansion. The end game of unlimited monetary
expansion is eventual currency collapse. Monetary expansion
and currency debasement are not just a US phenomenon. All
central banks are playing this game. This is why currency
collapse will probably include all of the major national
currencies due to their unstable fiat nature and their need
to maintain relative parity. If all major currencies
collapse together, then their relative value
may not change dramatically but buying power would be
severely reduced as inflation becomes globalized. The world
will be forced into a new global currency valuation model as
a result. Such a new model may be gold-based, but could also
be a novel system based on a basket of commodities. I
believe that the best way to play the currency debasement
game is via gold and silver.
currency collapse is not currently an imminent threat,
however collapse of other asset classes may be. This is
where the danger lies in the cash short squeeze scenario. A
rush out of some large asset class could create a shortage
of ready cash to settle transactions, causing massive
declines in those assets and resulting in deep recession.
Cash is like any other asset class: “You got to know
when to hold ‘em, know when to fold ‘em, know when to walk
away, and know when to run.”
“… the least
desirable asset today is cash. Therefore, a contrarian
investor should consider
holding above average cash positions.” – Marc Faber, Sept.
J. Paulos is Editor/Publisher of Freebuck.com, a website
devoted to wealth preservation and enhancement using
alternative investing approaches including precious metals.
He is also Associate Editor of The Gold Letter, a newsletter
covering junior mining and natural resource stocks.
The Gold Letter Website
summarize, the dollar short will result in deflationary
forces taking the lead for a while. Currently they are both
co existing pretty much in harmony. The Feds will come out
with an aggressive attack which could lead to
hyperinflation; this could in turn lead to consumers cutting
back on their expenditures simply because their salaries are
not keeping up with inflation and its going to take more of
the same old dollars to buy the basics that they need to
survive. This in turn will trigger deflation in full force
as we have mass bankruptcies across the board. The rise of
the dollar will trigger a drop in the value of some of the
now stronger currencies, however no nation will allow it
currency to get too strong. So we will enter the competitive
currency devaluation phase where one either devalues or
dies. In the end the death of the dollar will actually bring
about the end of fiat and possibly the implementation of
some Gold standard.
Palha is a market analyst and educator who uses Mass
Psychology, Technical Analysis and Esoteric Cycles to keep
you on the right side of the market. He and his partners are
on the web at
© 2004 George J. Paulos
and Sol Palha, All rights reserved.
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