Friday, 21 November 2008

Dollar Strength Sustainability

Coincident with the passage of the Paulson Plan in early October, the top prime brokers (MS, GS, JPM) issued margin calls on hedge funds which raised the average margin required from about 15 percent to about 35 percent. At a time of fragility in global markets and global confidence, this was equivalent to the sudden contraction of global market liquidity by a trillion dollars or so. A huge sell off in quality assets followed as hedge fund managers struggled to meet the margin calls.

Because hedge funds are unregulated, and prime brokerage credit isn’t well reported for aggregation, there is no obvious way to compile exact data. Nonetheless, it would be rational to assume that simultaneous global margin calls on a vast cross-section of hedge funds would have a dramatic effect on global markets. Hedge funds accounted for well over half of all market transactions in 2007, so are a huge driver of maket trading and liquidity.

Trillions of dollars of value were wiped off the balance sheets of the world’s investors over the next few weeks as forced selling forced prices lower and lower. Adding to the selling pressure, many hedge funds were simultaneously raising cash for redemption demands of investors also squeezed by margin calls by their creditors.

I’m sure none of this was intentional (wink, wink). I’m sure there was no coordination among the prime brokers (nudge, nudge). I’m sure it would never occur to anyone in the Wall Street prime brokerage banks that manipulation of leverage could create profitable trading opportunities (cough, cough).

The result was a collapse in global prices for equities, debt and commodities. FIRE SALE! Everything must go!

As the margin calls got met, the dollar strengthened. It strengthened hugely against the pound. From $2 to the pound earlier this year, Sterling has slid to below $1.50. This is likely because there are such a lot of hedge funds and private equity funds here in London, all struggling to meet their margin calls in New York.

At the same time, we observed a huge expansion in the monetary base as the Fed doubled its balance sheet and Paulson doled out taxpayer largesse to Wall Street. The banks began to accumulate massive reserves and Treasury yields crashed lower, especially at the short end. Treasuries gained value as the prime brokers parked the incoming margin cash in the safest, most liquid asset - the primary collateral for all interbank obligations too. These reserves and Treasuries are just sitting in the Fed and not contributing one iota to the stimulation of the economy.

All of this is interesting recent history. Now what happens when some of these trends reverse?

What happens to the global markets when the deleveraging stops? What happens when there are no more global margin calls on the surviving hedge funds? Will anyone want to buy dollars when they don’t need them to repay dollar debt?

Will there still be inflows to US Treasuries when few need a place to park cash for short term liquidity? What will prop up demand for the Treasuries then?

What happens when banks begin to use reserves to lend or speculate in the now crashed assets available globally at fire sale prices?

With most of the growth still projected to occur outside the USA, will some of those Treasuries be sold to take advantage of the many equity investment deals on offer? How will that affect the dollar?

We are observing huge swings in asset markets. We are observing huge swings in foreign exchange markets.

I’m not going to make any recommendations, but I predict we haven’t seen the end of volatility. The rapid rise of the dollar, the massive demand for Treasuries, are hugely convenient for the US Treasury as it finances the expansion of the Fed balance sheet and the giveaways to the corporate welfare queens on Wall Street and elsewhere in the last days of the Bush administration. It seems unlikely, however, that the conditions can be long sustained.

When they reverse, we may see a fair sized bounce in global equity markets, a loosening of credit conditions in global debt markets, a revaluation of commodities, and a revaluation of the mighty dollar. Many will call the bottom and pile back in.

I wonder how long that will last . . .

Hat tip to FTAlphaVille where the team gives me much to think about every day and the analysis of trends is superb. Picks for this week include:

M3, where are thou?

Fill your boots!

Dollar *danger* ahead


Knute Rife said...

Did you notice Wednesday when a group of Japanese economists suggested that US treasuries be issued in yen? I think it's basically a statement that Japan does not believe the US can meet its obligations in any acceptable form if there were a general unwinding. And that means the natives are getting restless. An actual default would be unlikely, but a monetization of the debt by printing a boatload of greenbacks would be just about a certainty, and that's effectively the same thing. Japan is expecting the dollar to head back south sharply once the current repatriation of dollars is done. Eisuke Sakakibara, who used to be Japan's top currency official, came right out and said it at a conference in Tokyo last Sunday. Once that happens, look out.

RGE reader of LB said...

There was an interesting Peter interview with Peter Schiff on CNBC yesterday where he argues for a collapse of the dollar.

(sorry for tainting the high quality of your blog by including a link to CNBC)

MR said...

What did you mean with :
When they reverse, we may see a fair sized bounce in global equity markets, a loosening of credit conditions in global debt markets, a revaluation of commodities, and a revaluation of the mighty dollar. Many will call the bottom and pile back in.

A Revaluation of Dollar ? Shouldn't it be devaluation ?

Devil's Advocate said...

LB, great post. However, to play devils advocate:

Why do you not see the U.S dollar to be the world's dominant reserve currency or assets being priced at U.S dollar? What other alternatives are out there? Euro, Sterling, Yen have been diminshed in this crisis.

The U.S. has a more flexible economy than many of the proposed alternatives to the USD. It is doubtful that many East Asian nations would want to see their currencies used as a major reserve currency (not to say they would have a choice). I believe this because they mainly run a Mercantilist economic policy in an attempt to boost employment first.

Economies will always see issues come up, be it of their own making, or an external shock. My views, and in many ways, my confidence is based on the view that flexible economies succeed, that bubbles are necessarily a bad thing in the long run, that defaults will not go on forever, and that income just can't collapse entirely. The U.S. in a sense runs a higher risk version of capitalism than many of its peers, but I think in the long run that is good. That's why some of the proposals being batted around capital hill right now scare me. Even with those fears, it's not like we're going to move towards the centre-left policies of Europe.

Last, the thing is that my views on economics have little to do with watching imports/exports, savings/investment, or currency fluctuations. I tend to ask "which economies have the most incentives to become productive?", "Which countries have their demographic houses in order?", Which countries are most able to respond to shocks (be it a credit crisis, or supply side shock)?". In which countries, does governments not hinder business formation?"

OuterBeltway said...

LB, how do you account for the fate of the WS Welfare Queen's stock prices? Even GS has halved in value since the election.

That puzzle piece doesn't seem to fit smoothly into your otherwise perfectly credible theory. Does the WSWQ stock-price drop mean that:

a. WS welfare recips are going to use the (remaining) hedge funds as the vehicle for playing the equity bounce

b. WS welfare recips are taking their money from Wall Street and doing direct and/or equity-market investments in the developing world, and giving up on the U.S. market altogether?

And finally, I think I see the outlines of the "decoupling" arguments re-emerging from the dust and debris of the WS debacle.

We'll know the decoupling is truly underway when WS is allowed to fail.

Independent Accountant said...

The dollar is finished. Long live the dollar!

artichoke said...

Is it too impolite to say, that we want a weaker dollar so our debts aren't so large?

Anyway I said it and I believe it. Quite honestly if the dollar doesn't weaken, life in the USA could get tough -- taxes too high to pay foreign debt, etc. If it gets tough, I will go elsewhere.

This blowup isn't my fault and I won't pay for it. Count on it.

ndk said...

Let me add a few more things that make me fear a collapse of the dollar:

#1: The U.S. issued a lot of USD debt to buy foreign equity. The enormous out-performance of international equity relative to U.S. debt made NIIP look reasonable for years. Equity has not done very well lately, but debt has. See old Setser for more.

#2: Many U.S. based banks have international deposits(64% for Citigroup). Even worse, some of these deposits may be matched by domestic liabilities. See Iceland and South Korea, respectively.

#3: Geithner.

#4: Summers tipped to replace Bernanke. Even worse, it's not 2010.

#5: Trade deficit still exists.

#6: Fed has lots of junk on its balance sheet. The solvency of the national bank matters and can be reasonably consolidated with the Treasury. See Buiter.

#7: Budget deficit approaching 10% of GDP.

I'm fleeing anything USD-denominated as fast as I possibly can.

ndk said...

Mr. Advocate, if I might be your own devil for a moment:

Why do you not see the U.S dollar to be the world's dominant reserve currency or assets being priced at U.S dollar? What other alternatives are out there?

I don't view the absence of a suitable replacement as important when discussing the possibility of collapse. It's an endogenous kind of thing that happens in crises. There's always an alternative to flee to; commodities, gold, and current-account surplus currencies smell ripe to me here. The world can tape itself back together under a new banner later.

The U.S. has a more flexible economy than many of the proposed alternatives to the USD.

We've gone very far out of our way in this debacle to avoid any adjustment. Detroit, the financial sector, real estate(preventing mobility of workers to boot), and other heavy federal intervention. By contrast, China's allowing unprofitable sectors and people to get dismembered.

I believe this because they mainly run a Mercantilist economic policy in an attempt to boost employment first.

The U.S. has not intervened above the table beyond jawboning to keep its currency strong. In this way, we're very different from countries like Soros' Britain or 1997/98 Asia and Russia.

However, there has been plenty of intervention to keep the dollar artificially strong. The oil exporters, China, Japan, and other peggers did it for us. The major difference is only who loses savings in the resulting misalignment, not the impact that has on the real economy in the preceding time.

The other points you make I'd agree with.

Dr. Crow said...

Thanks for sleuthing things out for us, LB! You've confirmed my suspicions about the trustworthiness of prime brokers.

Knute- I read that "suggestion" the same way. Its not like they don't trust our currency down the road, they're just trying to be helpful...

Hymns to the Lord said...


You say:

"We've gone very far out of our way in this debacle to avoid any adjustment."

If we give Bernanke the benefit of the doubt, adjustment is being allowed - the only constraint is that the powers that be are trying to ensure it occurs in an orderly manner.

50% off equity prices in a year, corporate bond yields at 2-300% of what they were a year ago, Treasuries yields close to 0% ... this surely can't be characterized as an absence of adjustment.

Anonymous said...

Quite extraordinary that you can discuss a collapse of the dollar without mentioning gold.

Physical gold is getting scarce. Even Alan Greenspan admitted "it is still the ultimate forma of payment"

No ones liability.

ndk said...

Mr. Hymns,

If we give Bernanke the benefit of the doubt, adjustment is being allowed - the only constraint is that the powers that be are trying to ensure it occurs in an orderly manner.

I think this doubt is justified. I just think the scope for orderly adjustment here is very small. China has much more room, with their personal savings rates and general lack of debt.

50% off equity prices in a year, corporate bond yields at 2-300% of what they were a year ago, Treasuries yields close to 0% ... this surely can't be characterized as an absence of adjustment.

You're absolutely right: in the financial markets, we've seen plenty of adjustment. I was speaking more of the real economy, though. We've seen very few major bankruptcies, not many layoffs relative to the crisis scale, and most people can't move due to negative home equity.

Anonymous said...

Taser International stock price jumps on massive order From the UK for 10,000 units.

Expecting trouble?


I'm Not POTUS said...

Perth Mint in Australia announced today that they were halting acceptance of new orders until January.

One client in the EU took 33,000 ounces in one order.

But this is not news.

Deflated said...

HISTORY (mostly from London Banker – the man who UNDERSTANDS what is happening):
1.Margin calls on hedge funds
2.Sudden contraction of global market liquidity
3.Huge sales to meet margin calls
4.Trillions of dollars of value wiped off balance sheets
5.High levels of hedgie redemptions
6.More sales of assets
7.Collapse in global prices for equities, debt and commodities.
8.Dollar stronger because lots of funds in London struggling to meet their margin calls in New York.
9.Fed doubles balance sheet
10.Taxpayer largesse doled out to Wall Street
11.Bailouts of autos, airlines, etc. wherever (and ONLY wherever) Wall Street is at risk from CDS liabilities
12.Huge expansion in the monetary base
13.Banks begin to accumulate massive reserves
14.Incoming margin cash (and a lot of other cash) parked in Treasuries
15.Treasury prices up; yields down.
16.25 November: Bloomberg reports US bailout totals 7.7 trillion

FUTURE (partly from London Banker)
17.Margin calls end
18.Deleveraging stops
19.Reduced demand for dollars
20.Reduced need to park cash in US Treasuries
21.US domestic demand very low and imports greatly reduced
22.US trade deficit declines quickly
23.Exporters to US don’t need to need to buy so many US Treasuries
24.Bank reserves used to buy crashed assets, many outside the US
25.Banks start to sell US Treasuries to finance these purchases
26.Net sales of US Treasuries – prices falter then fall
27.US can’t sell enough Treasuries and starts to monetize debt
28.Dollar starts to fall
29.Global equity markets rise
30.Commodity prices rise
31.Supply-side shock in the US leads to shortages
32.US prices rise and US govt. can’t fudge inflation numbers enough
33.US citizens panic
34.Hyperinflation of prices of consumption goods in the USA
35.Dollar falls
36.IMF overwhelmed
37.Exports to USA reduced even further
38.Global economy shrinks again, worse than ever
39.Global depression

Seems to me that steps 25 to 39 play out in the UK in rather similar fashion to the USA, except we are more like Iceland.

London Banker said...

@ Deflated

Wow. I said all that?

It certainly could play that way, but there's always a few surprises. You've left out a destabilised and angry Russia, a contracting China, a deflating Arabian Gulf, food riots in the developing world, and a lot else that can spur a crisis.

Deflated said...

@ London Banker
I do like your thought that other events might 'spur a crisis'. I thought THIS was the crisis - but of course this could be the hors d'oeuvres course.

I look forward to your writings every week. Please keep them coming. I promise never to post such a lengthy comment again.

Knute Rife said...

"Crisis" is rapidly becoming a cheapened term. If this is a crisis, what shall we call the Hobbesian nightmare we could, and parts of the world will, fall into?

Anonymous said...

On the currency theme, though wandering slightly off the dollar strength focus.

I wonder if I might ask a question of LB - and other knowledgeable commenters....

What is the likelihood that the UK will begin to seriously (re)examine the idea of adopting the Euro? I realize the political considerations, and the implied lack of maneuvering room when a member of the Eurozone, and of course that accounts for a large part of the rejection to date....
It seems to me - definitely not an economist or working in the financial field in any capacity - that conditions may have arrived that accidentally suit the Euro proponents perfectly, and the country too.
Surely now more than ever there are reasons to join. The currency would be less likely to come under speculative attack, and the Eurozone appears to have demonstrated surprising stability (contrary to the stated expectations of many).

In the (untrained) view of this reader, it just seems to make sense at this time in history.

I'd appreciate LB's views in general on the feasibility (and advisability) of UK Euro adoption.
1. Not British
2. Not resident in the UK
3. Absent any partisan feelings vis-a-vis UK political parties

Norman Ball said...


I read your blog religiously and in fact quote you in a recent article in the Potomac.

Keep up the insightful commentary.

kristiina said...

Serfdom revisited:
"A few months ago, Cambodia’s Prime Minister, Hun Sen, publicly announced the leasing of Khmer paddy fields to Qatar and Kuwait, so that they can produce their own rice. Though the area involved was not specified, it must be fairly large, as the government is getting almost US$600m in loans in return. At the same time, however, the World Food Programme has had to start shipping US$35m-worth of food aid to relieve the hunger plaguing Cambodia’s countryside." from

Seems some dollar holders are figuring out they can't eat paper. And not feeling quite safe with the free market providing for their needs.

Deflated said...

I hope it is permissible to suggest topics for future attention on this blog by our kind host. This is my suggestion, from Peston's BBC blog today:

Some analysts see this as the start of the money printing-presses being turned on with a vengeance, a deliberate attempt to stoke up inflation to reduce the real value of all those excess debts. I'm not sure we are there yet - though it's probably only a matter of time.

Anonymous said...


EVERYONE needs to think about whether or not the announcements of the last few days are indeed just BS. Will these programs come to fruition? Will they print for sure? Or are they just stalling since they can't sterilize anymore?

Remember the old adage MONEY talks and BS walks. Is the .gov going to put the money to to talk?

Anonymous said...

recall, when Japan cut interest rates in the 1990s to zero %, they were a creditor nation, the US will cut interest rates to zero as a debtor nation - a dollar collapse is inevitable and coming soon, hyperinflation will not be the way out this time

ndk said...

Again, to everyone who keeps saying printing is around the corner, there's no such thing as "just printing money." The Fed must purchase a security or perform a repo agreement to get the money into the system. Because its favorite food, short-dated treasuries, are already so strongly bid, it can't use those. It has to buy something else, which inevitably exposes the Fed to some risk. This might be credit risk; this might be term risk; this might just be a plain negative spread. The negatives associated with this risk are so severe that the consequences probably outweigh the benefits if done on a scale that matters. Like, greater than the $600b just sitting there already through stealth quantitative easing to this point. Quantitative easing failed in Japan too.

The ability to print money at will is just a ruse. A very useful ruse, but a ruse nonetheless.

EDC said...

you play the hand your delt.

There could be a lot of changes if foreigners refused to buy usa debt.

usa is the innovator when it comes to the world, also the manipulator.

If the state of affairs does not allow them to keep all the entitlement programs, then some of those programs must go.

Look at california, they will see massive cuts of state spending.

USD is the reserve currency, China and it's three sum trillion gdp is not going to get reserve status.

as long as the citizens of the usa are tricked into spending all they have the world will continue to support the consumer...

if not we all go back to the stone ages... which could very well happen.

a lot of these assumptions only assume that the USA maintains it's status quo. which could happen but there could be a GAME changer like a new technology... uhmm... i don't know cold fusion or something like a miracle.

you never know... we all could only assume.

Either way it was a great post by the LB..

good work.