What's Up Now with the U.S. Dollar?

The above chart is the US Dollar Index for about the past 9 years. From its high of about 120 in 2000 the US Dollar Index recently hit an intermediate-term low around 72 just about 6 months ago. The Dollar stabilized for a few months, and, in the past 3 months has gone screaming higher, although the chart above places the recent move up in perspective.

With the U.S economy weakening, the banking system in crisis, interest rates low and going lower, and the Federal Reserve creating money like crazy to fill the void of now-worthless debt, one would think the US Dollar would be in free fall and gold would be going through the roof.

Wrong. The G7 appears to have decided, along with a little help from their friends in other central banks, to bid up the dollar. Others have discussed this in detail. The relative strength in the US Dollar occurs in the context of a downtrend, and is only a 10 to 15% upward move from the lows. But the consequences appear to have been dramatic.

Mega-leveraged hedge funds may have been crushed leaning the wrong way against the dollar. Given the leverage inherent in currency trading, combined with leverage employed by hedge funds, one can only speculate about their large currency trading losses.

Coincident with the "surprise" rally in the dollar has been the collapse of commodity prices almost across the board. Here too, one suspects that hedge funds were leaning the wrong way. Of course, many hedge funds and mutual funds were leaning the wrong way on commodity based stocks, and these too have been crushed.

Thus, the short-dollar long-commodity trade has imploded in just a few months, after being a slam dunk for about 5 years. As I wrote this, Hank Paulson was giving a speech on CNBC at about 8 PM, on October 21st, 2008. I'll bet Dollars to Euros Hank and Friends have been giving the dollar a little nudge the past few months, which may have triggered currency losses amongst hedge funds, leading to the unwinding of the commodity trade, triggering more losses in the commodity and stock markets.

Certainly it's been a running joke of Todd Harrison's on Minyanville that if you're short the US Dollar, or long commodities, you're "trading against Hank."

Here's the really important part. Now that a Euro only costs $1.30 instead of $1.60, and a US Dollar is worth $1.21 Canadian Dollars instead of $1.00, or an Australian Dollar is only worth 68 cents instead of a full US Dollar, most of the run may be done. What happens when Hank and Friends take their pedal off the metal of the US Dollar?

Given the fundamentals, once Hank takes his foot off the hedge funds' throats and lets the US Dollar continue its inexorable journey to zero, gold and perhaps other commodities are likely to explode. Simultaneously, other currencies such as the Yen, the Swiss Franc or the Australian Dollar may provide a nice alternative to the US Dollar.

Oddly enough, with the resumption of inflation, emerging market stocks should once again take off, and we may repeat portions of the previous cycle from 2002 to 2008.

Positions: All my assets are in US Dollars, except for shares in the Reserve Fund's Government Money Market Fund, frozen over a month to redemptions and counting.

Comments

[User 143167:]

Hank is dumb if he really did so. He single-handed worsen this credit crisis by pumping up the dollar to ballon the whole losses in the financial system into multi-trillions. It requires the government to print money like crazy to stempede the blooding and risk all of us a hyperinflation 2 years from now.

2008 Oct 22 11:53 AM

[Dr. O:]

I do admit I'm conspiratorially minded, especially when markets become "harmful" to the US or world economy. With oil at $140 plus, some believe the US Dollar was goosed up by Governments, to burst the oil/commodity bubble.

$140 Dollar oil was bad for everyone but a few companies who didn't need THAT much money, and enemy-states like Iran, Venezuela, and a newly hostile Russia, etc. $140 oil was bad for China, and Japan, and the US, who could intervene in the currency markets.

I'm just an average Joe the Plumber, but others have speculated about other factors temporarily driving the US Dollar higher besides Central Bank Intervention: big unwinds of the "carry trade" (borrowing in US Dollars or Japanese Yen to buy higher yielding currencies or assets), or unwinding of other positions that require settlement in US Dollars.

It's way too complex for me.

But a higher dollar was needed to burst the commodity bubble and, this is important, to satisfy our Creditors. The US has trillions in outstanding Debt (bonds). The holders of those bonds (denominated in US Dollars), were, no doubt, none too happy to be watching the value of their assets decline with the Dollar.

Let's say you're China. You hold, by some accounts, over one Trillion Dollars in US Debt. Over the past decade, or so, the value of the US Dollar has declined about 50% against the Euro. That kind of sucks. You're holding bonds yielding, what, 5% or less, and if you wanted to sell them and convert the cash into Euros, or Swiss Francs, you can only buy half of what you could have bought ten years ago?

Or if you wanted to convert your dollars into Gold you could only buy one third the gold you could have bought ten years ago?

That's one crappy bond. Would you buy more US Bonds? Not likely. Then what happens? US Interest rates shoot up, the US economy slows even more, and your exports (remember, you're pretending to be China), take a dive.

Now you go into recession and those millions of people who need work making goods have no jobs. That can't happen if you're China.

So, you have to support the US Bond market, keep US interest rates reasonably low to support the US Consumer, and, help drive up the value of the US Dollar so you're not losing so much money on your Trillions in US Bonds.

And that is precisely what has happened. The markets hit a "pain threshold" over the summer of high commodity/weak dollar, central banks put their heads together, and starting intervening, the dollar rose, commodities fell, and, our creditors were less unhappy.

But what do I know. I'm just a Joe the Plumber.

2008 Oct 23 07:24 AM

[Dr. O:]

Dollar index now at 86, up another 4% since I wrote the article. Wild goings on in the forex arena.

2008 Oct 24 12:39 PM