Currency Consternation

Currency Consternation
This week I had discussed how my blog's readership was down. From what I could gather it seems many are just tired of the games and tired of the same old, same old in the markets (or maybe my writing). Well, there may be something very different in the works that is worth some attention.

The discussion about the future of the dollar is still raging full force after a big kickoff this week. The dollar of course does not exist alone, and currencies are entwined in ways I really cannot comprehend.

To start, currency debacles tend to have outsized effects, even if their relative scale is not such that one would think so. Consider:
1994 Mexican Peso Crisis
While swiftly addressed, it had all the markings of a serious problem.

1997 Asian Financial Crisis
The floating of the Thai baht caused widespread damage across the globe

1998 Russian financial crisis
The Russian debt default not only sealed the doom of Long Term Capital Management, but almost caused the first "systemic risk" meltdown which was delayed until 2008.

From these three examples I take away that currency problems can be the cause of serious market dislocations across the globe. With an eye towards that angle, let's take a look at this weeks developments.

This nonchalant piece really dismisses the news as something that's not going to happen soon. I wonder what the headlines about the Thai baht were like the day before:

Latvia on the brink
LONDON (MarketWatch) -- It's never good news when a government bond auction fails. It's particularly bad news when an auction fails for a note maturing in just six months. And it's really bad news when there isn't any bid at all.
Were Latvia to devalue, that would hit economies in neighboring countries like Lithuania, and Swedish banks would rack up additional losses on the loans they have made throughout the region. The real nightmare scenario would be the Swedish banks then pulling down other European banks, and then triggering Credit Crunch: Part 2.
There is, of course, a long way before that unwieldy scenario comes to pass. Latvia hasn't devalued -- yet - and, even if it does, that doesn't mean it would drag the Swedish banks under.

Fair enough I guess, but of course we have no idea what exposure these banks have.

Adding to this is another subtle wrinkle that I think has importance on a much grander scale (FT, via Naked Capitalism):

Latvia denies plan to devalue currency
...Riga announced tentative plans on Tuesday to cap the amount that banks would be allowed to collect from mortgage holders in a move that analysts said would make it easier for Latvia to devalue....
...The Latvian proposals would allow banks to collect only the current value of a property rather than the original value of the mortgage, insulating homeowners from the 70 per cent drop in property prices since their peak.

And so a ripple near a coast spreads across the world.

To me, this is huge. One of the most vexing issues on the table right now is the "Delay and Pretend they will Pay" game being played by the banks. Banks hold many mortgage backed assets (both residential and commercial) at near par values. They refuse to take marks against them. They will willingly roll over commercial debt or allow residents to remain in a home indefinitely rather than force a foreclosure and take a hit to the value of the loan.

We have seen that mortgage "cramdowns" have not become viable yet, due mainly to the push back of the banks. They fall back on the delay plan.

If the lower tranche holder is 100% sure by government (think US state to extrapolate) proclamation that they will never see their money, then this game is up. The banks can pretend all they want, but they will be out of time and out of new money investors.

I am not saying this WILL happen, only that in desperation I would not be shocked to see entities resort to such a thing. Just like mortgage holders just "walking away", the banking system is arrogant beyond belief that people will pay their debts no matter what. Ivory tower and all that. Try living in a poor city and then get back to me.

Sticking to the currency theme, the falling dollar is causing many countries to try and protect their competitive edge. This is draining reserves of those countries and again, we know currency problems can go a long way. Consider (via Zero Hedge):
Asian tigers roar back at US Dollar

I advise reading the whole thing, but this is the take away point:

Overnight, we witnessed intervention by various Asian central banks to suppress their own currencies against the Dollar. The banks of South Korea, Taiwan, the Philippines and Thailand all intervened to prevent appreciation of their currencies. The Bank of Korea bought $1billion. The Bank of Indonesia bought $350 million. The Phillipines' central bank bought $100 million. The Hong Kong monetary authority sold $3.88 billion Hong Kong Dollars to support its dollar-peg. The Yen is at 88.24, but there was no intervention by the BOJ, at least none that we could confirm.
These are serious moves. Why is this not front page news? It is difficult to tell whether these are simply more dramatic fluctuations on the world markets, or the start of a new phase in the crisis. What will be imperative is to pay close attention to the actions of global central banks in the days ahead. Currency is key. The next four weeks should be quite interesting indeed.

Scrambling to keep pace with the US dollar fall is sure to cause some kind of imbalance as those funds (large on a relative scale) are committed to currency moves.

From Clusterstock, another angle:

Asia Will Ambush Dollar Shorts Over And Over
Thursday's coordinated currency intervention by South Korea, Taiwan, the Philippines, and Thailand is just the start of what will happen should the dollar keep sliding.
Most export-heavy countries around the world are far from ready to address the hard changes at home required to deal with a weak-dollar world.
Their economies are growing fast. Yet for many leaders, this speedy growth is the only real legitimacy they have with their citizens, without which they could be in deep trouble.
Thus they'll fight tooth and nail to forestall any change from the status quo whereby Americans consume, while they produce and grow...
...While dollar shorts probably have long-term trends in their favor, many will be made into unfortunate examples by aggressive central banks along the way. Traders beware.

Another "the dollar will never fall" call.

I would submit that if the dollar keeps declining, the export countries (China excluded) simply do not have enough ammo to fight back. This is how a currency crisis happens. History shows us how serious this can be.

In closing (warning, more of the same old, same old) the one drawback of fiat currencies is that they are built entirely on confidence. Fiat currency can do all the "stupid pet tricks" the central banks want as long as confidence that the pet will perform holds.

Why is devaluation so disruptive? The same reason mortgage defaults are so disruptive, lenders/creditors just cannot believe you are going to stiff them. In their mind they are doing YOU a favor by loaning you more money than you can pay back, and at onerous terms, so you should do what you have to do for full payment.

When this does not happen by revolt (through devaluation or default) the system loses confidence because their bluff was called.

The world has seen devaluation many times in the last 100 years (US in the '30s still on the gold standard, US in the '70s walking away from the gold standard, Argentina 2 times, the three examples above, and Latvia maybe in the next month), so why the shock and awe? This is because it attacks the very premise of fiat currency.

I am moving to a stance that world money moves bear watching, and as the US markets seem as boring and predictable as can be for months, maybe you will watch too.

Comments

[Roger Knights:]

"This week I had discussed how my blog's readership was down."

Does SA keep count of readership of your articles here? If so, how are the numbers holding up?

"The dollar of course does not exist alone, and currencies are entwined in ways I really cannot comprehend."

The basic problem is debt and default and downwind dominos. It's hard to know where and how the cookie will crumble, but given the stress on the system, "something's gotta give," and it most likely will happen suddenly and "out of the blue," like the Credit Anstaldt default in 1931. Latvia could be the pebble that starts the avalanche this time.

Oct 09 06:36 AM

[Economic Di...:]

Roger,
I am not sure if SA tracks read numbers, but I have a stat counter on my host blog and the trend from August to now is down about 50%. Maybe I am slipping or like I said maybe people are just tired of this kind of thing.

Thanks for reading, you have not dropped off!

Oct 09 08:25 AM

[john s. gordon:]

'banksters arrogant beyond belief" - you got that right.
> jack

Oct 09 09:09 AM

[Robert Mart...:]

Econ Disconnect:

I always enjoy your work, so don't fret about blog readership stats. Perhaps it reflects reader fatigue.

I think that folks are tired of hearing the same old issues. After all, there isn't much new to say: Fundamentals haven't improved, yet the market goes up. It's as if this part of the crisis is playing out in slow motion, and it will bore us into apathy and inaction. After all, if the market hasn't crashed already, why would it now?

Nevertheless, the U.S. dollar is getting more and more attention. When it gets pushed over the edge is impossible to predict, so we just have to position ourselves and our investors accordingly.

Patience is the key right now.
Rob

Oct 09 11:55 AM

[Economic Di...:]

Robert,
Thanks so much for the kind words. I am not too put off, I think you are right about the fatigue issue.

Weird day today with a stronger dollar AND higher stock prices. Maybe a one day thing, but you never know.

On my blog site I always feature Friday Night Entertainment, so if anyone is interested in film clips and music, take a look.

Oct 09 05:43 PM

[Roger Knights:]

David Fry's comment on his SPY chart was that the end-of-day runup on Friday to the old high indicated that someone wanted there to be headline news to this effect over the weekend.

Clever--and yet it indicates weakness and desperation. The market is so fragile that the only thing sustaining it is momentum. If the market stalls, people will start to figure the rally's over, and sell, which will cause more selling, which will lead to a perception of a resumption of the bear market, which will lead to more selling, which will be hard (expensive) to turn around, etc.

Oct 10 04:45 PM

[manya05:]

I am still reading, don't worry, but I have my theory of SA readership. The site seems to be overpopulated by the "sky is falling" investment crowd that sees how fragile the US economy is. A lot of people have been predicting a stock market crash, a crash and burn of the US economy, the end of the world as we know it (I am guilty of that too). Yet, despite all the negativism, the market keeps levitating, no big bank has failed, either by themselves or through manipulation currencies have held more or less steady. So, you have to admit that the ruling class has done a good job of keeping the party going, if not as rowdy as before, at least the music is still playing, and there is plenty of booze left. So, I can see how reader fatigue can st in at SA.

Oct 12 03:05 AM

[dragonpaw:]

Yes, there is a burn-out factor involved here, ED. Too many of us investors have become traders. Nibbling at the edges and beginning to feel too confident at 10% monthly gains is surely playing with fire.Doing this for 35+years,I can't believe another down-leg won't come. The more they pump, the quicker they'll dump. And dump on all of the peons they will. Just keep re-setting those stop-loss limits!
As the old song laments ".. nowhere to run , nowhere to hide, nowhere to run to baby...."

Oct 12 11:44 PM