Merk: US Stock Bull Run Fading, Swedish Krona Attractive

March 31, 2015

Axel Merk is considered one of the top currency experts in the industry. He is president and chief investment officer of Merk Investments, based out of Palo Alto, California. Merk is the manager of the Merk mutual funds, including his flagship Merk Hard Currency Fund. He recently launched the Merk Gold Trust (OUNZ | B-100), a "deliverable gold" ETF. Merk is a regular on CNBC and Bloomberg TV, and the author of "Sustainable Wealth."

Merk recently sat down with to discuss the dollar and its positive correlation to risk assets in the U.S. He talks about the negative interest rates in Europe and why the Swedish krona is one of the better buys out there. Merk shares his views on China's currency and how recent reforms could spark an entrepreneurial boom there. It's been an amazing bull run for the dollar since last summer, but in the last few weeks, the greenback has retreated. Do you think this is a temporary correction, or a reversal of the bull trend?
Merk: The speculative positions that were long the dollar or short other currencies—most notably the euro—were at unprecedented extremes. When the Federal Reserve backpedaled a little bit earlier this month, it caused a ferocious short-covering. While that won't turn the dollar bulls into dollar bears, it does induce people to use less leverage. Volatility has come back and it requires less leverage. People have to cover, or at least significantly reduce, their shorts in other currencies, and that should be bad news for the dollar.

In addition, the stock market and the dollar have been rallying in tandem. That is something that's not supposed to be happening. The dollar is supposed to be rising when risk is off. Instead, it's been rallying when risk is on.

Finally—which is just a different way of looking at it—the market has been pricing in that everything is great in the U.S., and everything is horrible in the rest of the world. In reality, the world is more shades of gray, and at some point, it has to normalize. And so, I think, yes, the dollar rally had been overdone. Can you expand on this positive connection between the dollar and the rising U.S. markets?
Merk: My view is that the U.S. market rallying together with the dollar is a symptom of foreigners buying U.S. stocks and bonds. It is foreigners who are chasing yields in the U.S. And if I go back to 2007, it was foreigners buying the worst types of mortgage-backed securities. They're the ones who were late to the game. And so to me, this suggests that the equity bull market is in its final innings.

The one trade that's been working in this market is the momentum trade. And the momentum trade —be that in the equity markets, be it in the currency markets—encourages leverage and can unwind rather violently. So, I am concerned—it's not a healthy environment. Are there any other markets or assets on which you are particularly bullish or bearish at the moment?
Merk: Yes, the one currency we've gotten excited about of late is the Swedish krona—and we rarely get excited about a currency.

The Swedish krona has been one of the worst-performing currencies over the last 12 months versus the dollar, and the Swedish Central Bank recently lowered interest rates yet again. They're claiming that it is because they need to reach their inflation target, but they're really doing it because they're afraid of what's happening in the eurozone. They really don't have a deflation problem in their country. Unlike other European countries, the Swedish economy is actually doing very well. Their biggest export market is Germany, which is also doing well.

The main reason inflation is so low in Sweden is the drop in oil prices—which will eventually dissipate. As their inflation readings move up, the Swedish Central Bank will have to do a U-turn. Unlike other economies—like the U.S., for example—the Swedish economy can actually stomach higher rates and stronger currency. With this potential change in monetary policy, we think the Swedish krona is a good value at this point. Speaking of foreigners buying into the U.S. market, the incredibly low yields in other developed economies are clearly a big driver behind this. German bunds, for example, are now negative all the way to five years, and the 10-year bund is yielding about 20 basis points, which is even less than JGBs. Can these yields go any lower, and what are the implications?
Merk: Obviously, the reason these yields have come down so much is because of the QE that's been announced by ECB President Mario Draghi., because he is, what I would phrase, "convincingly irrational" and is working very hard to expand the balance sheet at the ECB. So, yes, those yields can be driven further down.

Now, will it help the European economy? QE is not what the European economy needs. They need structure reform. They need their banking system to be brought into shape. They need to get rid of sanctions against Russia if they want to boost their economy.

The one thing in which QE has been successful is weakening the currency. But pretty much the only country that benefits from that is Germany, because it's an export-driven economy. Indeed, the numbers coming out of there are very good, with some suggesting that the German economy may even be overheating. Let's talk about another country that's been affected by the strong dollar. China's export industry has suffered significantly since the dollar started rising. Chinese goods have become especially uncompetitive in Europe—its biggest trading partner. What are your thoughts on this and the Chinese economy in general?
Merk: The Chinese have probably been the most prudent in these currency wars, of all the players. They've worked too long and too hard to gain credibility to throw it all away overnight with a move for a short-term gain. What they might do is move away from the peg into a free float over time, but they are not going to have a kind of one-out devaluation. They are working hard to get rid of speculators. In that process, they have introduced some volatility. They're building liquidity in their currency, which ultimately is going to lead to an elimination of capital controls and then a free float. But that's really the last step in a long process.

Now, as far as the economy is concerned, clearly the Chinese economy is in transition. One reason I'm more optimistic on the Chinese economy than many others are is that I don't think it is quite as difficult as many people believe to get the Chinese economy in shape.

One of the key things that the Politburo is focused on is competition in the banking sector. What that means is not only that they can compete on getting deposits, but, more importantly, they can compete where they allocate credit. As China is moving from the state allocating credit to the free market allocating credit, you can unleash an entrepreneurial boom in China. Of course, none of that is going to happen overnight, and clearly there are going to be stumbling blocks, but I believe in China's potential. You're a known proponent of gold and its place in an investor's portfolio. The strong dollar has been a strong head wind for the yellow metal. What is your take on gold going forward?
Merk: Gold has been able to keep up despite the ferocious rally we've had in the dollar. One of the key reasons is that the Federal Reserve is all but promising to be behind the curve. They have said repeatedly that even if the economy and the inflation goes back to normal, monetary policy might be more accommodative, or rates might be lower than would otherwise be normal. So they promise to be behind the curve, meaning that real interest rates—interest rates after inflation—will continue to be near zero, if not negative. That's a clear positive for gold, which doesn't pay any dividend or interest. Something that doesn't pay anything is still better than cash, where you have a negative return after inflation. Thanks for your time.


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