This
post is a followup on the alleged US dollar shortage thesis as well as
further discussion of the Yuan, and the Yen.
Let's start with a recap of the US dollar debate, after which I will tie up
some loose ends.
US Dollar Margin Call Shortage Thesis
On March 8, ZeroHedge commented The Global Dollar Funding Shortage Is Back With A Vengeance
And "This Time It's Different".
ZeroHedge wrote "The last time the
world was sliding into a US dollar shortage as rapidly as it is right now,
was following the collapse of Lehman Brothers in 2008. As we discussed back
then, this systemic dollar shortage was primarily the result of imbalanced FX
funding at the global commercial banks, arising from first Japanese, and then
European banks' abuse of a USD-denominated asset-liability mismatch, in which
the dollar being the funding currency of choice, resulted in a massive
matched synthetic 'Dollar short' on the books of commercial bank desks around
the globe: a shortage which in the aftermath of the Lehman failure manifested
itself in what was the largest global USD margin call in history."
No Shortage Thesis
On March 11, I replied to the above idea with Is
There a US$ Shortage? Will it Sink the Global Economy? Again?
"I do not believe there is a dollar shortage or
even a synthetic dollar shortage. More importantly, a dollar shortage
certainly did not cause the crash in 2008. Excess debt and speculation caused
the crisis in 2008. Any alleged or apparent dollar shortage was a result, not
a cause of the crash."
Demand for Dollars
It's amusing to discuss currency shortages given all the central banks are or
have been flooding the markets with currency in an inane attempt to cure a
debt problem by forcing more debt into the system.
I discussed this on Monday in Draghi's Goal: Higher inflation and Negative Yields; ECB’s
Asset Purchases to Outstrip Supply 3-1; Is There a Catch?
That interest rates are negative in Germany for every duration from one month
through six years (only two basis points from seven) speaks for itself. There
is no demand for loans relative to supply of euros from the ECB.
Same as 2008 or Opposite?
The US dollar index is at roughly the same level as in 1998, also 1988 (not
shown). The peak in 1985 was 164.72. The peak in 2001 was 121.21.
Lehman Bankruptcy
On September 15, 2008, Lehman filed for bankruptcy. The dollar bottom was in
April of 2008, at 71.33.
At that time, anti-US$ sentiment was massively in vogue.
The Schiff's of the world were screaming hyperinflation. Today, US
hyperinflationists are thoroughly discredited and in hiding.
Today, nearly everyone loves dollars and hates gold. Dollar swaps that were
not in place then, are in place now. All things considered, conditions are
nearly the opposite of 2008.
Acting Man Chimes In
Pater Tenebrarum at the Acting Man blog contributed to my reply. Then on
March 12, Tenebrarum did his own followup: The Dollar Squeeze
– How Problematic Is It?
"The visible currency effects (such
as a soaring dollar exchange rate and funding gaps, see below) are usually
mainly a consequence, not a cause of crisis conditions. Of course, the recent
rise in the dollar was initially triggered by perceptions of monetary
policies between the US and other currency areas diverging – everybody
expects the Fed to hike rates, while rates are being lowered everywhere else.
It should be added to this that there are of course feedback loops at work:
the stronger the dollar becomes, the more difficult it will be for dollar
debtors abroad to service their debt, so any future crisis situation will
tend to feed on itself. Note in this context that if a debtor has hedged his
dollar exposure, the associated currency risk has not disappeared – it has
merely been shifted to his counterparty."
Tenebrarum provides many charts in his explanation. I caution that it's not
light reading to say the least. Then again, money in general is nearly always
a complex read.
$9 Trillion Stress Test
On March 11, Ambrose Evans-Pritchard at the Telegraph chimed in with Global Finance Faces $9 Trillion Stress Test as Dollar Soars.
Contrary to popular belief, the world is today more
dollarized than ever before. Foreigners have borrowed $9 trillion in US
currency outside American jurisdiction, and therefore without the protection
of a lender-of-last-resort able to issue unlimited dollars in extremis. This
is up from $2 trillion in 2000.
The result is that the world credit system is acutely sensitive to any shift
by the Fed. "Changes in the short-term policy rate are promptly
reflected in the cost of $5 trillion in US dollar bank loans," said the
BIS.
The BIS paper's ominous implications are already visible as the dollar
rises at a parabolic rate, smashing the Brazilian real, the Turkish lira, the
South African rand and the Malaysian Ringitt, and driving the euro to a
12-year low of $1.06.
The dollar index (DXY) has soared 24pc since July, and 40pc since mid-2011.
This is a bigger and steeper rise than the dollar rally in the mid-1990s -
also caused by a US recovery at a time of European weakness, and by Fed
tightening - which set off the East Asian crisis and Russia's default in
1998.
Emerging market governments learned the bitter lesson of that shock. They no
longer borrow in dollars. Companies have more than made up for them.
"The world is on a dollar standard, not a euro or a yen standard, and
that is why it matters so much what the Fed does," said Stephen Jen, a
former IMF official now at SLJ Macro Partners.
Mr Jen said Asian and Latin American companies are frantically trying to
hedge their dollar debts on the derivatives markets, which drives the dollar
even higher and feeds a vicious circle. "This is how avalanches
start," he said.
BIS data show that the dollar debts of Chinese companies have jumped fivefold
to $1.1 trillion since 2008, and are almost certainly higher if disguised
sources are included. Among the flow is a $900bn "carry trade" -
mostly through Hong Kong - that amounts to a huge collective bet on a falling
dollar. Woe betide them if China starts to drive down the yuan to keep growth
alive.
I have no problems with the above. However, close
scrutiny shows conditions are opposite of the conditions ahead of the
Lehman crisis. In 2007-2008 there was a flight out of dollars. Now everyone
seems to want them. How times change.
Tightening More Urgent?
Pritchard continues ...
The most recent Fed minutes cited worries that the
flood of capital coming into the US on the back of the stronger dollar is
holding down long-term borrowing rates in the US and effectively loosening
monetary policy. This makes Fed tightening even more urgent, in their view,
implying a "higher path" for coming rate rises.
That last paragraph
makes no sense to me. But rather than plant the same idea in anyone's head, I
simply asked Tenebrarum what he made of it.
Tenebrarum replied ""It can't be
right. It has things the wrong way round. A stronger dollar is akin to a
tightening, not a loosening of policy, in the sense that it will pressure
import prices and that prices in the economy at large will adjust to that
with a lag - precisely what usually happens when monetary policy becomes less
accommodating. If you look at short term rates, you will see they keep
hitting new highs for the move (1, 2, 3, 5 year yields). It is actually the
market perception that tightening is underway that causes the dollar to move
higher.""
Speculator Dollar Shorts
Let's now take a look at speculator positions on US dollar bets. On the
futures market, for every long there is a short, but let's look at who is
long and who is short, and by how much.
Charts are courtesy of SentimenTrader.
Hedgers are the commercial traders including market makers like of JP Morgan.
The market makers take the opposite side of speculators such as hedge funds.
The number of contracts in numerous currencies is at all time high levels.
US Dollar Hedgers
Euro Hedger Positions
Canadian Dollar Hedgers
Yen Hedgers
Extreme Opposite of Conditions in 2007
Not only are the positions opposite that of the start of the crisis in 2007,
the magnitude of the bets is enormous. The motto appears to be bet with
leverage. Hedge funds that win on such bets win big. If they lose, well, it's
typically OPM (other people's money).
That does not mean a reversal is guaranteed. Hedgers after all, hedge (and
that is why JP Morgan never was hurt being allegedly short silver all the way
up to its high near $46).
But given that speculators and hedge funds (in spite of their name) don't
often hedge, the above charts show there is fuel for a massive reversal.
Five Reasons for Dollar Strength
- ECB and Bank of Japan are now QE king and Queen
- Nearly everyone believes the Fed will hike
- US 10-Year interest rates are close to 2%,
elsewhere they are close to zero percent
- US stock market has been a one way bet
- Currency speculators (shown in the above
charts), have a huge bet on the dollar
If any of those conditions change, and especially if there is a cascade of
reasons, a reversal in the fate of the US dollar will be enormous.
This is not a timing mechanism, but rather an observation there is potential
for this alleged "dollar shortage"
thesis to start looking like a "euro
shortage" event.
And that is not all that far-fetched. Events in Greece or Spain can change
things in a hurry. Investors who believe the ECB has everything under
control,may find out otherwise.
In fact, I guarantee you things are not under control anywhere: Not in the US,
not in Europe, not in China, not in Japan.
Is Japan Zimbabwe?
Having discussed the dollar and euro in depth, let's turn the spotlight on
the Yen for a moment. Axel Merk asks Is Japan Zimbabwe?
The other day, when I was on a panel discussing
unsustainable deficits in the U.S., Eurozone and Japan, the risk of inflation
and Zimbabwe style hyperinflation came up. When asked about the difference
about Japan and Zimbabwe, I quipped that there isn’t any. My co-panelists
were all over me, arguing Japan is different. Notably that Japan could not
possibly go broke because, unlike Zimbabwe, it’s an advanced economy. The
argument being that Japan produces goods the world wants.
To be clear: Zimbabwe and Japan are not the same. But are they really that
different? Zimbabwe not only had a much weaker economy, but also much weaker
institutions. But the old adage that something unsustainable won’t last
forever may still hold.
The difference between Zimbabwe and Japan – and Europe and the U.S. for that
matter – is that advanced economies have more control over their destiny.
However, all these regions have made commitments they cannot keep by
continuing business as usual. A weak country may simply implode. A strong
country has choices. The preferred choice these days appears to be to kick
the proverbial can down the road.
The path an advanced economy with unsustainable finances takes is in many
ways a cultural and political question. Unsustainable government finances
tend to be accompanied with unsatisfied citizens that have seen their
standard of living erode, either because inflation has eaten away their
purchasing power or because the government has taken away benefits. Such an
environment is fertile ground for populist politicians to be elected. In the
U.S., this may be the rise of the Occupy Wall Street or Tea Party movements.
In Japan, a populist prime minister is in power.
What officials have in common is that they rarely blame themselves, but seek
to shift blame on the wealthy, a minority group or foreigners. It’s no
co-incidence that Abe wants to abandon Japan’s pacifist constitution; if
Japan were able to balance its books, I allege that odds of such a discussion
would be much lower. Similarly, by the way, Ukraine would not be in its
current mess if it were able to balance its books. Japan unlike Ukraine,
though, has well functioning government institutions.
Inflation is a slow motion form of default. The “advantage” of inflation, as
long as it doesn’t turn into hyperinflation, is that it is less prone to the
so-called “contagion.” In a default the risk is that many solvent players are
drawn into insolvency as a house of cards implodes.
The reason why a government default tends to start out as a slow motion
locomotive before it falls off a cliff is because stakeholders want to buy
time. In the Eurozone debt crisis, for example, risk-averse investors were
caught off guard when they realized their peripheral Eurozone debt was not
risk free. By now, everyone should know these securities are not risk free
which reduces the risk of contagion, as these assets have mostly moved away
from financial institutions to those that can bear the risk. No one is going
to cry if a hedge fund loses money; similarly, if the International Monetary
Fund (IMF) loses money, the losses are ‘socialized’.
Back to Japan: Japan can continue on its current course as long as the market
lets it. It’s impossible to predict if and when the market might lose
confidence. The Eurozone debt crisis has shown that sentiment can switch
rather suddenly, even for countries with fairly prudent long-term debt
management, such as Portugal or Spain. It may be naïve at best to think that
there will be plenty of warning should market sentiment shift.
What we do know is that central bank actions have masked risks. Risky assets
don’t appear risky anymore. But of course they are still risky. So when
volatility surges – for whatever reason, investors might flee with a vengeance.
A default, by the way, is not the end of the world. While the socio-economic
impact on a country may be severe and a default may cause institutions to
fail, especially those that own debt of the defaulting country, the reset
button of default doesn’t affect everything. Government institutions may
survive and so may many manufacturers. Japan induced hyperinflation to hit
the reset button after World War II. Who says this can’t happen again?
Yen
Shortage?
A curious thing happens in hyperinflations. It actually appears to leaders of
countries in such circumstances that there is a shortage of currency. After
all, money doesn't buy anything. They need to print more and more of it to
purchase anything, with obvious results.
The current COT position is such there could be a different kind of demand
for Yen. Which comes first? I don't know and neither does anybody else.
That said, way back in 2005 I made a couple of statements that seemed absurd
at the time.
- The US would experience deflation, not hyperinflation
- Japan would go into hyperinflation before the
US
The US did go into deflation, depending on how one measures it. My definition
is credit marked to market. On a CPI basis (a very flawed but widely used
measure) the US also went into deflation.
My many times stated proposal still holds: The US will go in and out of
deflation a number of times over the next decade.
I discussed deflation at length in 2008, in Humpty
Dumpty On Inflation
I remember that title well because I have referred to it many times.
Curiously, that post started with a discussion by Axel Merk.
Here we go again, this time with a discussion on the Yen.
Who's in Control?
Hopefully the answer to that question is obvious. No one. This is clearly
uncharted territory with competitive currency debasement ending (for now) in
the US but taken over by the ECB and Bank of Japan.
Odds of a Greece default are huge, and in my opinion rising. Is the ECB and
eurozone prepared? They say they are, I think they are mistaken. With 691
Trillion Dollars of Derivative Bets,
how can anyone believe any central bank is in control of anything?
US GDP is not quite 18 trillion. Derivatives are roughly 38 times US GDP.
Imagination Sets In
These numbers defy my imagination. Yet ...
- ECB president Mario Draghi thinks we need more
euros.
- Prime Minsiter Shinzo Abe and the Bank of Japan
think we need more Yen
- Janet Yellen and the Fed have concluded the
world does not need more dollars (at least for now).
And people are dumping gold for dollars because the Fed is
"tightening"
It's truly a world gone mad.
