Death of the Dollar Still Inevitable: The Dead Cat Bounce Explained

I've been writing a lot recently about the dollar vs gold trade, with the emphasis of the discussion being on gold analysis. The problem is that there are a lot more individuals who care more about dollar FX markets than they do about gold. This has been the case regarding the network of people I work and converse with on a daily basis, and this has definitely been the case with main stream media.

The latter subject is the actual reason I decided to sit down and write up a piece regarding the U.S. dollar. More specifically, on CNBC this past Friday and Monday, I've heard several times dollar bulls claiming dollar doomsayers have once and for all been proven wrong. They claim the dollar correction to be done and behind us, meanwhile the greenback is repositioning itself as the reserve currency in the world. Well, I've just about had enough of that talk and I am here today to debunk that farce while explaining just how the dollar rally has taken place

Wall Street's Demise Driving the Dollar?

Let's start this discussion in a fitting place: credit markets. The turmoil in credit markets has been widely covered with most of the emphasis on that coverage being in the wrong places.

The first part to understanding how the short term credit tightness resulted in a dollar rally is understanding that almost ALL credit derivatives are valued in U.S. dollars.

Let's look at the Lehman Brothers CDS trigger for an example. Lehman had corporate bond volume of $160 billion. Tied to that $160 billion was $400 billion in credit default swaps that were triggered. Of that $400 billion, it appears that around $300 billion of those CDSs have been settled through payment. That means $300 billion U.S. dollars needed to be secured through the FX markets and transferred to the counter party. This is obviously dollar bullish in the immediate short term.

Although the numbers differ, this scenario is essentially identical for AIG and the rest of the CDSs that have triggered. It's also important to note the conflict of interest here. Understanding that there are several shoes to drop and corporate bankruptcies to ensue, there are still several large CDS triggers to come. The holders of these swaps must secure dollars to settle these contracts. The stronger the dollar is, the more stress it puts on the parties to meet their obligations. I promise you that the U.S. government and the Federal Reserve understand this and will act accordingly in order to limit some of the stress this will put on credit markets. That is very dollar bearish in the long term and should be noted.

Credit Spreads Unwinding

In continuing this discussion, we are going to stay within the realm of credit markets, but look at it from a different perspective. If you watch or read any financial media you're most likely familiar with the notion of credit spreads. Analysts use credit spreads in all markets to analyze a number of different items ranging from inflation to credit default risks.

That's all great, but what you hear about less is the trillions of dollars that trade these spreads. The aggregate positions between career traders, hedge funds, and other investment funds that trade inter-market credit spreads are truly massive.

The problem, similar to many of the historical trends that were considered to be set in stone, is that the trend changed. We've seen this with the crack spread, and the unwinding of the carry trade as they deviate from their historic norms. What had been the norm, no longer is. Understanding that there was a global liquidity glut in these things and the lack of a counter party, meaning the trade was essentially one sided, when the worm turned, it was very difficult for these positions to be liquidated.

One of those spreads that was over utilized was the spread between short government debt and long private sector debt. Obviously this spread has been destroyed and had you traded the exact opposite position, you would most likely be retired and extremely wealthy by now.

So what does this have to do with the U.S. dollar? The trillions of dollars that was short government debt and long private debt was forced into margin call and massive puking of positions ensued. Similar to the situation with the Lehman CDSs, to cover the government debts shorts, the funds must secure U.S. dollars. This short covering resulted in massive unintended dollar buying and was a main driver behind the dollar strength.

The two issues discussed in this article aren't the ONLY drivers of the recent dollar strength, but they are the MAIN drivers. The most common reason for the dollar strength that you hear of is the cash is king theory. This is true, but is NOT the main reason for the dollar strength. Understanding these notions on a very basic level is TRULY ESSENTIAL in understanding the current relationships driving capital flows, and therefore driving ALL FINANCIAL MARKETS. Most importantly, we must realize that the same factors that are driving the dollar up in the short term are actually BEARISH in the long term. THE DOLLAR IS TERMINALLY ILL.

Disclosure: The author and publisher do not hold positions in the securities mentioned.

Comments

[A Lewis:]

Typing in caps does not strengthen your point...

2008 Oct 29 09:08 AM

[igggy:]

What's the point of saying the USD is weak if no other alternative is suggested. What's going to be the strong currency? The Yen? I doubt. The Euro? Unlikely. Ultimately gold should prevail but until then it's the dollar.

2008 Oct 29 10:59 AM

[Greg Pinelli:]

The dollar is dead/dying/finished scenario has been beaten like two dead horses for many years. There's no doubt it's worth less every decade..however, a currency's value is measured against one of two things..another currency (paper) or a metal like gold or silver. It's hard to look at the current financial mess and point to ANY paper currency more valued or able to take the dollars place. The alternatives, gold predominantly, would need some kind of nation state endorsement to start trading as real money in the market..instead of a proxy measuring rod.
As long as massive amounts of paper (electronic and otherwise) move across the financial landscape at the speed of light the world will flock to US Dollars EVERY time there is a crisis...like it or not.

2008 Oct 29 11:05 AM

[Chris B:]

Gold is a volatile commodity with violent and unpredictable price moves that are not tied to any particular set of fundamentals. Worse still, as investment in the commodity has been transformed from delivery contracts to ETF's, the metal's price is increasingly determined by how well the rest of the stock, bond, commodity, and derivitives markets are doing. If Goldman Sachs loses a billion in any one of these areas, gold will tank as they sell out their ETF position to cover the losses.

If you're of the "physical gold" camp, tell me why you should pay 25% over spot metal prices for a collector coin, then pay for insurance and perhaps secure storage?

GLD shares are essentially that gold-backed currency that goldbugs always wished for, yet they are just another volatile short-term Wall Street commodity ETF. What exactly, is the rationale for such an investment, whose rate of return and risk we cannot even have an educated guess about.

2008 Oct 29 01:29 PM

[Here's a th...:]

Time to get long the barter system

2008 Oct 30 11:07 AM

[WATCHMAN of...:]

So where are you putting your money, Nicholas? The last several days on Seeking Alpha there have been numerous articles on how Europe is on the brink of a severe credit crisis that dwarfs the U.S. The Euro will collapse also. Japan is too export dependent to survive a long downturn, so there goes the Yen. So what is your solution? Russia? Brazil? India? Wal-Mart does not take gold for food and clothing.

2008 Oct 30 12:04 PM

[wallyjm:]

the dollar is based on faith alone just like the mark after ww1. barter economy may be in the future. i do hope we can stumble through as we usually do.

2008 Oct 30 01:26 PM

[Chris B:]

OK, you accumulate jewelry and junk in the yard to prepare for a barter economy.

I'll spend my money on an education, get an MBA, learn a couple languages.

We'll see who ends up with the best outcome.

2008 Oct 30 03:26 PM

[CLH:]

Yes the dollar is going down in the long run but its the only money of any value. Gold has failed to be anything but a loser.

During deflation (now) it can only go down .

2008 Oct 30 05:21 PM

[PainfullyAware:]

Who knows how long it will last? Certainly an unprecedented amount of Freak-Out going on world wide.

Dollar still has the biggest military and a bunch of nukes behind it.

The rest of the world has been a bit terse with the Good ol US of A roaming the world and muscling them for quite some time. Now the consensus, whether right or wrong, is that America started this calamity.

Been seeing quite a bit of chatter from world leaders that leans to reducing their exposure in the future.

If or When the rest of the world decides that the dollar is not such a hot ticket we will see some amazing changes. I hope they are not as catastrophic as the rumblings suggest.

We have a long way to go before stability.

Prepare for the worst; Pray for the best.

2008 Oct 30 08:23 PM

[OctoberFaith:]

What freak out? We have a perfect exchange as far as I'm concerned.

2008 Nov 01 12:32 AM

[nmelendez:]

i am still quite curious how all this will turn out. On the one side you have the deflationaries , where everything goes down in price, causing mass layoffs to prop up company gains, which in turn makes things less expensive due to demand. In this scenario the US would go broke, bankrupt.
Then you have the inflationary scenario. Oil would go to 250 US dollars while other currencies remain strong. This would make US goods cheaper causing a boom in the US growth and the US capitalizing, paying off its debt. Dow 28000, S&P 3200, Gold at 4300.
Talk about confusing. I guess in the end it will depend on which direction the world wants to go. Me, i am betting on inflation, no one wants to ruin the world economy with deflation.

2008 Nov 08 08:53 PM