Up until now, the dollar, in defiance of all expectations, has been strengthening against most world currencies. Even commodity prices had reversed their bullish trend. Maybe some of the long speculators on commodity reversed or deleveraged their positions to ride along side the US dollar reversal.
How could the dollar have risen in the face of overwhelmingly negative fundamentals? Some said the dollar had risen because Europe is following the US into recession. But, this proposition is ridiculous. No other nation has been as adversely affected by the credit crisis than America, where the mess had all began.
Some opine that Britain’s weakness is part reason for the US dollar’s strength. Yes, British economy is slowing and its property sector is facing a correction after years of bubble activity. But these are simply convenient reasons but hardly persuasive or convincing.
Since 2002, the US dollar has lost more than 25% in real terms on a trade-weighted basis (or 28% in nominal terms). One would think that it would have gone some way to reduce its current account deficit, i.e. more competitive exports, lower imports, and a shift in consumer behaviour etc.
Truth is, the current account deficit has barely moved and is still at the 5% level.
According to the International Monetary Fund, a 10% depreciation in the US dollar will improve US’ current account deficit by one full percentage point.
Going by that rationale, the current account deficit should have been halved! Instead, over the period where the dollar lost 25% in real value €“ the US economy had to contend with higher oil prices, stronger competition from emerging countries and persistent war-related expenses.
(PS: A clear example of the US dollar losing 25% in real terms: a Middle East nation selling oil at US$100/b today is equivalent to them selling the oil at US$75/b back in 2002)
Noteworthy is that the US has spent the last 7 years in a silly war. China spent the last 7 years building infrastructure and planning for the Olympics.
Which country do you think frittered away resources, and which one tried to add value to her underlying economy?
The real reason
My prognosis for the US dollar strength is that it’s being engineered by major central banks with the main objective of halting the commodity price uptrend.
The stubbornly rising commodity prices was doing a lot of damage to inflationary figures and curtailing demand.
The Fed and Treasury are fully aware that higher commodity prices will not only curb demand, but will also result in higher interest rates (used to rein in rising prices for goods and services.)
But both these institutions NEED to keep interest rates low to proceed to save the financial institutions in the US.
They need to deal with Fannie Mae and Freddie Mac, Washington Mutual, and a whole host of regional banks.
They need a flattish and low interest rate regime to resuscitate and restructure desperate mortgages. They also need more stability in property prices.
Coincidentally (and smartly enough), a stronger US dollar and the planned bailouts do the trick nicely.
The ECB seems amenable to that strategy as a weaker euro stems the drop in exports. If you were to do a survey, the majority of economists agree that the ECB will not reduce interest rates until the second half of 2009.
That’s because the underlying strength in Europe is still strong and it needs to fight inflationary pressures from the high commodity prices more than anything else.
The jobs market in Europe is also still relatively strong. That scenario does not require a weaker euro.
In contrast, the US economy, continues to worsen. This even after the Fed slashed interest rates and the massive bailout plans for Fannie Mae and Freddie Mac.
The US overnight loan rate is less than half that of the ECB €“ 225 basis points lower. The US has a US$750bil per year current account deficit and rising.
It has huge federal and state budget deficits. Americans save less and spend more than any other people on earth. The US economy has been losing ground especially on the manufacturing side to emerging nations, transferring vital industries to them.
Fed’s deteriorating state
The American banking system is under dire circumstances.
More recently, Lehman Brothers buckled under pressure and filed for bankruptcy. I’m expecting a whole bucket load of regional banks to follow suit.
The Fed has already tainted its balance sheet with US$450bil worth of default-prone mortgage-backed assets from its favoured institutions.
This junk now amounts to almost half of the Fed’s balance sheet, yes the very thing that is supposed to back the US dollar.
In the face of these fundamentals, the US dollar has paradoxically appreciated against the euro, ruble, rupee, yen, real, Singapore dollar and almost all other currencies. How can this happen?
While China has been forcing its commercial banks to hold more dollars, there has also been huge buying, by other foreign central banks, of American treasury bills.
In August, the increase in Treasury bill buying far exceeded that which is needed to offset the huge US trade deficit.
The Treasury bill binge happened right before the surge of the US dollar. Doesn’t this hint of a concerted effort by most major central bankers to cooperate with the US Treasury and Federal Reserve?
Prior to the intervention, most major American, European and Asian institutions held short positions in the dollar.
In order to kick off the dollar intervention, they needed a substantial initial pump. The first pump will be used to massively drain dollars from the world system, in order to forcibly raise its cross-currency value, above the first big stop-loss point.
These stop-loss points are well known to the Fed’s primary dealers.
Once the value was forced to the first major stop-loss point, a massive covering of shorts positions began. It was the biggest short squeeze in history.
The short position in the dollar was so enormous up until mid-July, that after the first stop-loss point was taken down, only minimal additional effort was needed to attack the next ones.
With a little added pressure, stop loss after stop loss is demolished, causing short sellers to desperately scramble to buy the dollar to cover what appears to be an impending catastrophic losses.
At some point, the dollar gained a momentum of its own. People who were previously short, and “stopped out”, decided that the wind was blowing in favour of the dollar.
These opportunists converted their funds to go long on the dollar and short on euros, yen, and so forth.
We are in the midst of this reversal right now, after the major part of the intervention has run its course. The powers-that-be are still intervening, to some extent, but they don’t need to use as much force, and have probably unloaded a lot of the long contracts already, at either a profit, or, at worst, a very small loss.
The carry trade
US Treasury chief Henry Paulson and the rest know that the yen carry trade has been fuelling commodity price spikes (borrowing in yen on low interest rates and investing in higher yielding assets).
They are aware that once the stop-loss levels have been triggered in an “unexpected rise in US dollar”, it would result in a domino-effect of investors closing out their yen carry trade positions.
Most of the funds in the yen carry trade were long in commodities, the euro, the Australian dollar and the New Zealand dollar. All spelt losses in those bets. However, the stronger US dollar also caused some of them to remain long instead in US dollar, even after the bashing they took in previous positions.
In the middle of the week, the dollar tumbled in Asian and European trading as a knee jerk reaction to news that the US credit crunch crisis is far from over, but climbed back up.
The markets have been very much herd-like for most of these twelve months, be it in oil or other commodity prices and similarly in the reversal of the US dollar. There is comfort in flying in flocks especially when the global financial markets are so tumultuous. This is not a period which rewards contrarian views.
Even those with contrarian views would be looking for better entry levels, after taking into account market psychology and sentiment. Now investors not only have to judge based on fundamentals and capital flows but also open interest in major futures contracts on various asset classes to get a gauge.
The dollar’s fundamentals are nothing to shout about. The fall of the dollar is a rational reaction to a massively mismanaged paper currency. When currency intervention ends, people will want out of the dollar.
Private manipulation of oil, silver or gold markets is a felony but government intervention in worldwide currency markets is perfectly legal.
The bill for the nationalisation of Freddie Mac and Fannie Mae will add about US$6tril to the Federal deficit.
The US government will be forced to print from US$250bil €“ US$500bil new dollars to offset losses in the next 2-3 years.
In addition, it is likely that another US$500bil or so will need to be printed to bail out the FDIC insurance fund.
According to Nouriel Roubini, about US$1tril-US$2tril worth of “value” will have been removed from the system by those who eventually default.
Prior to the credit crisis, the Federal Reserve balance sheet amounted to about US$940bil worth of treasury bills.
This was the fundamental support for the “Federal Reserve Note” or better known as the US dollar.
That is also now lumped with about US$450bil worth of default-prone mortgage backed securities, thanks to efforts to bail out big banks from their even bigger mistakes.
This leaves the US dollar with less than US$500bil in solid support. Each additional new Treasury bill to support printing more money will tarnish the balance sheet.
Soon, global investors will start shouting that the US dollar is not backed by anything at all. If you are not going to revamp and restructure the economy and consumption patterns yourself, the rest of the world will do that for you.
Nearing the end
It’s really quite simple. There are potential trigger catalysts €“ maybe when investors start to add up the mind boggling funds required to complete the bailouts, or when fellow central bankers decide enough is enough with regard to joint intervention, or when the Fed has to cut rates, or when some critical Mid-East nation(s) decides to drop the peg to the US dollar.
Ultimately, the reserve currency status will only get you so far. Finances need to be shored up. Lehman being allowed to go into bankruptcy and Merrill Lynch giving up trying to stay afloat independently, had probably ended the US dollar uptrend.
US dollar will be on a downward pressure with the Fed having to lower rates in the months ahead, and more significantly, the imminent collapse of many more regional banks in the US now that both Paulson and the Fed’s Ben Bernanke have drawn a line on bailouts (not going to happen anymore).
Investors eager to swoop in on US dollar denominated assets may want to bear this in mind, be it stocks, bonds or property.
photo: Crystal Liu Yifei