Monday, October 19, 2009
Is David Bloom Wrong About the Dollar?
As I have previously noted, HSBC currency chief David Bloom doesn't think that the dollar will rally when the stock market next tanks:
The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off].
Is he right?
I have argued that the new dollar carry trade could very well unwind during the next crash, which could create an enormous need for dollars.
Now, Tyler Durden has written a must-read summary of a new report by BIS which shows that the real liquidity crisis last year was among European banks, which were hugely overexposed to the dollar (in amounts many times greater than their GDPs, in some cases), and so they were desperate to raise dollars last year when the market crashed.
The Fed became the world's lender of last resort, extending huge swap lines to foreign central banks so they would have dollars to be able to cover their currency positions.
Durden quotes from the BIS report:
The severity of the US dollar shortage among banks outside the United States called for an international policy response. While European central banks adopted measures to alleviate banks’ funding pressures in their domestic currencies, they could not provide sufficient US dollar liquidity. Thus they entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (Figure 7). Swap lines with the ECB and the Swiss National Bank were announced as early as December 2007. Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion. As the funding disruptions spread to banks around the world, swap arrangements were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network (Figure 7). Various central banks also entered regional swap arrangements to distribute their respective currencies across borders.
...
The analysis shows that between 2000 and mid-2007, the major European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by interbank borrowing, borrowing from central banks and FX swaps. We argue that this greater transformation across counterparties in fact reflected greater maturity transformation across these banks’ balance sheets, exposing them to considerable funding risk. When heightened credit risk compromised sources of short-term funding during the crisis, the chronic US dollar funding needs became acute, particularly in the wake of the Lehman Brothers bankruptcy.
Durden notes that this same currency imbalance may be rebuilding:
We are now back at a time when the only gains in the stock market are at the expense of dollar destruction, with a concomitant funding for dollar denominated assets. In one short year since the collapse of Lehman we have gone back to the same dollar funding risk exposure as was on the books in these days before Dick Fuld's empire unraveled. While whether or not the Federal Reserve stepped beyond its bounds in practically bailing out not just Goldman Sachs, but as this paper has proven, virtually the entire world, is not up to us to decide. However, a critical topic is have we learned anything from the implications of an unprecedented dollar funding gap, which is likely back to record levels once again.
As the H.4.1 discloses weekly, the Fed's liquidity swaps are now back to almost zero. This means that foreign Central Banks believe that have the FX swap and dollar maturity situation under control. They thought the same before Lehman blew up. And they were wrong. As the DXY continue tumbling every lower to fresh 2009 lows, the trade de jour is once again the dollar funding one, although unlike before when the Yen was the carry currency of choice, this time it is the dollar itself, positioning banks for the double whammy of not just a dollar funding shock, but one coupled with a potential massive short squeeze. If and when an exogenous event occurs, not even a trillion in Fed swap lines will be sufficient to bail out the world economy. It is time someone in Congress asks the Chairman all the pertinent questions that evolve from this analysis and how he is prepared to handle its next, much more vicious, and likely terminal, iteration.
I asked Durden whether he thinks the BIS report proves that Bloom is wrong, and whether he thinks the dollar will rally at the next market crash.
He responded:
Depends where in the circular argument you catch the dollar. I think the take home message from the above article is actually simple: if the global CB system nearly collapsed due to dollar funding concerns when the dollar was not the carry currency, imagine what will happen when you have a dual quest for funding: 1) from structural asset/currency mismatch and the FX swap's propensity to evaporate when most needed; and 2) from the need to cover the shorts that themselves are allowing the funding of US denominated assets (it takes a while to filter through). What has happened is that we are doubly on the hook now to the Fed to provide perpetual dollar funding to anyone who needs it.
As to a direct answer, I think the next market crash will be critical whether it is a liquidity, counterparty or simply driven by momentum with everyone unwinding at the same time (Oct 19, 1987). If it is a combination of all three, the Fed will be unable to restore the system, absent it printing several dozens of trillions of dollars overnight which would devalue the entire dollar denominated asset base (which accounts for roughly 400% of Europe's GDP).
I have written to David Bloom, but am still waiting for a response.
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Thanks for these fresh insights into how a fundamentally worthless dollar could paradoxically become extremely scarce, causing it to soar in value. The prospect of a dollar short-squeeze is something I first wrote about in the mid-1990s. At the time, international-finance professors whom I interviewed on the topic didn't understand what I was talking about (although the authors of "The Incredible Eurodollar," a 1983 book by Hogan & Pearce, allowed that the idea was pretty sexy). I still see a short squeeze as possible, if not quite likely. To avoid it, the Fed would need to deliberately hyperinflate during the relatively short (i.e., a day or less) period in which the short squeeze would play out. I doubt they would succeed, however, since the effort would entail monetizing not only all Treasury paper, but munis, corporates and all else.
ReplyDelete-- Rick Ackerman
It so ironic. How can the worthless fiat US currency be considered a 'safe haven'. The day of reckoning will come soon for USA. Be patient.
ReplyDeleteIf there is a USD short squeeze, this would be a good opportunity for China and Russia to put their money where their mouths are and convert their USD to Euros, Yen and Sterling (which by then I hope will be managed by a new and competent administration).
ReplyDeleteThe sudden shortage of US dollars is caused by exporting based countries buying US dollars to force their own currency lower in order to preserve their export trade in the worlds reserve currency.
ReplyDeleteAnyone (eg China) who has pegged its currency against the US dollar does not have this problem.
In such an environment suddenly many countries must buy US dollars, hence the shortage. This has been building for 20+ years and can only be solved by all countries floating their currencies. China is now big enough to cause a major imbalance (much like Japan did in the early 70s). China must float their currency or everyone peg against the yuan until they do. If nothing happens, the yuan will end up as the reserve currency as the US did against the pound. China understands this and is storing gold to back their currency. The Dragon is about to strike back.
We have reached the point where the US dollar is falling rapidly against a basket of currencies and those countries then try to peg against the dollar by buying more dollars. The banking world then runs out of dollars to pay short term debt and hence a sudden squeeze of up to a weeks duration while central bankers sort out the shortage.
The carry trade has inflated the world stockmarkets. This is a different problem. Its caused by close to zero interest rates and greed. The only cure is to raise interest rates, very, very slowly. A fast hike will cause a US lead depression and we all know there is only one cure for that and everyone now has nukes.
Geoff Croker Melbourne, Oz