The Yen and the Dollar Milkshake Theory

Back in April I wrote about the weakness in the Japanese Yen and how it can affect life and the economy here. Since then, I’ve noticed that in relation to the Pound and the Euro, the yen really hasn’t moved quite so much. In fact, both of those currencies have also dropped significantly against one other currency: the mighty US Dollar.

This reminded me of a term that keeps cropping up in my reading, and led me to take a closer look at the Dollar Milkshake Theory. Developed by Brent Johnson, AKA Santiago Capital, the theory envisages a scenario that appears to be playing out before our very eyes, whereby rapid USD appreciation sucks liquidity into the US and destabilizes world markets

This 6 minute Video provides a brilliantly simple explainer on what the Dollar Milkshake is and how it could play out.

A huge “milkshake” of liquidity has been created by global central banks, who have injected some $20 trillion in various currencies into the global economy since 2008. And everyone needs dollars. Whether it is to trade in commodities, shore up currency reserves, or to pay interest on USD debt: China needs dollars, Europe needs dollars, and Japan needs dollars. Despite significant money printing in America in the last decade there is still a shortage of dollars. Other countries have also been printing their own currencies in similar amounts. The demand for dollars is, quite simply, outstripping the supply.

More important even than the availability of dollars, is the rate of change in the level of the dollar. If that level rises too fast, then problems start popping up all over the world. That’s when countries like Sri Lanka and El Salvador start showing up in the news. When things get bad and the dollar rises rapidly, the rest of the world needs to print more and more of its own currency to convert to dollars to pay for goods and service its dollar debt. This means the dollar keeps on rising, forcing other countries to devalue their own currencies, which in turn makes the dollar rise further. And because in this environment the US looks like a safe haven, capital is sucked into the country which again pushes the dollar higher. Sooner or later we end up with a full on sovereign bond and currency crisis, which is bad news for the whole world, the US included.

Long periods of dollar strength have often ended with major financial dislocations, like the Asian crisis of 1997, so if the dollar continues to rise we could see some extreme volatility in markets.

So what does this mean for the Yen? Well, having just broken through a 40 year support line, things are looking pretty treacherous for JPY. We are probably near a point where, if the yen continues to fall against the dollar, we may see the first Japanese intervention in the currency markets in over a decade. You have to go back even further to find the last time Japan sold USD/JPY in order to support a weak yen, and guess what? It was in 1998 during the Asian Financial Crisis, when the USD/JPY was trading at 145. Note, we’re at 138 today…

As the title suggests, the Dollar Milkshake is just a theory. There is no guarantee that things actually play out this way, but there is a reasonable probability that we will witness what Raoul Pal calls a “dollar wrecking ball” scenario either now, or in the next few years. So how do you invest in an environment like this?

First and foremost, as I stressed in the Weak Yen Dilemma, know your base currency. Being in the wrong currency can sometimes hurt you more than a fall in investment value. On the other hand, if you hold dollars, but you are planning to spend the money in yen, you are looking at a golden opportunity to bring some money into Japan.

Secondly, remain diversified. With inflation still on the rise, this is not a good time to be sitting in cash, but it’s not a time for excessive risk either. If things get crazy that little bit of gold and silver (and maybe even Bitcoin) in your portfolio could come in handy.

If you want to be a little tactical, one area to avoid is emerging market debt. These are the countries that often issue dollar denominated debt, and are going to struggle to meet interest payments in a rising dollar environment. So maybe stay away from emerging market debt ETFs / funds for the time being.

Lastly, I think it’s key to stay patient. Extremes in markets do not last forever and reversion to the mean occurs eventually, milkshake or no milkshake.

Disclaimer: This should go without saying, but the information contained in this blog is not investment advice, or an incentive to invest, and should not be considered as such. This is for information only.

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