``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell
Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.
While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.
Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns
From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.
And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).
And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.
While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.
What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.
DEBT DEFLATION Dynamics In Progress
So what could be the forces behind such phenomenon?
``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.
``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”
This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.
How?
One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.
This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.
Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.
For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.
We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.
Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.
The US Dollar’s Hegemon and Threats To Its Dominion
Figure 6: Bill Gross: Going NuclearLastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.
PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.
From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”
``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”
Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).
Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).
The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.
Figure 7: finance.yahoo.com: South Korea Won-US dollarUnderstanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.
The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.
Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.
Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),
``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.
``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”
Conclusion
All these demonstrate the two basic factors on why US dollar has recently surged.
One, this reflects the US dollar’s principal function as international currency reserve and importantly,
Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”
Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).
We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.
Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.
Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.
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