Dollar Bear Trade Looks Dangerously Crowded

A bearish frenzy has developed in the US dollar, and is probably the strongest consensus I've seen since the bullish stampede in oil futures crashed last Summer. With publicity hungry commentators from historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories weighing in with their economic insights, and hedge funds leveraging up aggressively again on the global carry trade using the dollar as a 'free' funding currency, it's time for a reality check. There is no alternative to the dollar as the global reserve currency for the foreseeable future; while the dollar's share of CB reserves has declined from 72% to just over 62% this decade, this is the result of the Euro's emergence, with the Yen still a paltry 3% of global forex holdings.

Total dollar holdings have steadily risen, and even this year, China has continued to accumulate dollar assets, while grumbling about US economic policy. It will be at least a decade before Yuan convertibility is a real prospect, and only then if China can radically overhaul its financial markets in the meantime, developing deep capital markets and hedging mechanisms and gradually opening its capital account. At the moment, even in Hong Kong, less than 2% of trade is conducted in Yuan. As for that complex proposed IMF basket currency, which dollar bears offer as a real alternative, call me when a Colombian drug smuggler is caught with a suitcase full of the things.

The structural nature of America's trade deficit has been demonstrated this year by the fact it still remained at 3% of GDP in Q2, in the depths of the recession (from 7% at the peak of the boom in 2007, when its funding was soaking up 70% of global excess reserves). In fact, the US hasn't run a trade surplus since the early 1990's recession, and that constant funding requirement places ongoing pressure on the dollar. I've commented at length on the dangers of current Fed policy, which does little to alleviate deflation in real assets while stoking hyperinflation in financial ones, and to the extent it is spiking commodity prices, undermining a real recovery. If it was down to me, I'd immediately place the $870bn in excess commercial bank reserves at the Fed at a negative interest rate (ie charge them for the privilege of parking their cash, as the Swedes have already done) and simultaneously hike rates by 50bps. This would correct the current dangerous distortion of the monetary base.

Those reserves, applying the typical 7-8x deposit to loan multiplier over the last couple of decades, would translate into a credit surge equivalent to 40-50% of US GDP, underwriting a cyclical recovery, and closing the divergence between the Fed's $1.2trn of quantitative easing and the $110bn rise in M2 money supply as stymied by commercial bank capital hoarding.

By hiking rates now, you offset the inflationary implications on expectations, while underpinning the dollar and supporting foreign capital flows while the US economy rebalances after a decade of excess consumption and underinvestment. Ben Bernanke and Tim Geithner may talk the talk on the need for higher US household savings, but a zero interest rate policy is punishing thrift. The Fed's emergency response to last year's financial panic was appropriate and decisive in tackling a deflationary threat, but it now needs urgent adjustment, before the law of unintended consequences results in a new bout of economic turbulence and a fatal loss of credibility. Even without a radical rethink, such is the bearish extreme we have now reached (reflected in the sense of panic at central banks from Europe to Brazil) that a snapback rally of 15-20% is likely imminent, leaving the consensus confounded.

Disclosure: Long USD/Yen

Comments

[Dave Wrixon:]

Reserve currency?. At the current rate of decline it will be worth virtually nothing within a decade.

Oct 23 02:14 PM

[junkyarddog:]

You shared some thought-provoking information.

Like many, I'm frustrated with our government lack of fiscal discipline, and seeing congress spend money like there is no tomorrow. If I had a huge amount of dollars, I'd be very nervous too: I'd simply dump the US dollar! However, in exchange for what? Definitely not for yuans.

I trust the Chinese government as much as I trust monkeys to safeguard bananas. So, the author's assessment on the bearishness of the dollar made me think, if anything, simply because of lack of many other alternatives as world reserve currencies in the short-run. Still, if our Congress doesn't reign in its spending, the dollar will be dead -- and maybe that's exactly what our leaders want.

Oct 23 02:22 PM

[cyclingscholar:]

Raising short term rates to .50% or even 1% would

(1) convince financial markets the FED understands a TARP exit strategy, thus deflating asset bubbles...

(2) reduce long term inflation expectations and thus longer term interest rates....

(3) reward savers and frugal consumers while punishing the profligate and financially promiscuous...and

(4) stabilize the dollar, thus increasing foreign direct investment in the US.

Oct 23 02:48 PM

[Shocksink:]

Dollar is like an unfaithful wife/husband........ once the trust is breached, it´s hard to believe in. Dump it and go on with your life.

Oct 23 03:44 PM

[Angel Martin:]

I don't think any Fed tightening moves are credible until we see some sustainable employment growth. The markets just would not believe they would stick with it in the face of an continued recession/deflation spiral.


On Oct 23 02:48 PM cyclingscholar wrote:

> Raising short term rates to .50% or even 1% would
>
> (1) convince financial markets the FED understands a TARP exit strategy,
> thus deflating asset bubbles...
>
> (2) reduce long term inflation expectations and thus longer term
> interest rates....
>
> (3) reward savers and frugal consumers while punishing the profligate
> and financially promiscuous...and
>
> (4) stabilize the dollar, thus increasing foreign direct investment
> in the US.

Oct 23 05:22 PM

[aussiereader4:]

Another interesting comment;

'historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories'

Attack the mental faculties of anyone who espouses a future that is not rosy for the USA. It is quite clear that his argument is quite persuasive.

Oct 23 06:26 PM

[Swashbuckler:]

(5) kill any chance of economic recovery
(6) stab the stock market

On Oct 23 02:48 PM cyclingscholar wrote:

> Raising short term rates to .50% or even 1% would
>
> (1) convince financial markets the FED understands a TARP exit strategy,
> thus deflating asset bubbles...
>
> (2) reduce long term inflation expectations and thus longer term
> interest rates....
>
> (3) reward savers and frugal consumers while punishing the profligate
> and financially promiscuous...and
>
> (4) stabilize the dollar, thus increasing foreign direct investment
> in the US.

Oct 23 08:42 PM

[untrusting ...:]

Good summary and points. Thanks for posting it.

On the Fed negative interest rates on Fed deposits. Not so sure that "forced withdrawls" really would go into much lending. Maybe most would go into purchase of treasuries, bonds, stocks as much of excess liquiidty already has. Espcecially with the hugh issues of new treasury debt.

Banks have to maintain liquidity and captial in order to offset the hugh coming losses on CRE, mortgages, etc. They don't want to lend and they won't with the loss issues on the horizon.

Oct 23 11:05 PM

[driftwood2:]

Good catch on the divergence.

Oct 24 02:46 AM

[Dave Wrixon:]

The difference is that we may have doubts that the Chinese would not behave like your guardian monkeys. We have proof that the Americans will.


On Oct 23 02:22 PM junkyarddog wrote:

> You shared some thought-provoking information.
>
> Like many, I'm frustrated with our government lack of fiscal discipline,
> and seeing congress spend money like there is no tomorrow. If I had
> a huge amount of dollars, I'd be very nervous too: I'd simply dump
> the US dollar! However, in exchange for what? Definitely not for
> yuans.
>
> I trust the Chinese government as much as I trust monkeys to safeguard
> bananas. So, the author's assessment on the bearishness of the dollar
> made me think, if anything, simply because of lack of many other
> alternatives as world reserve currencies in the short-run. Still,
> if our Congress doesn't reign in its spending, the dollar will be
> dead -- and maybe that's exactly what our leaders want.

Oct 24 04:36 AM

[Michael Clark:]

Sean: We should have begun to gently raise interest rates in 1999. We should tighten now, in that we are 10 years late -- and need to begin taking care of our currency. We've inflated the world since 1983. Now we need to deflate the world a bit, so we can achieve some stability and relief from the Inflationists creed which has built bubble after bubble, thinking that an expanding economy and a consumer bubble are the same thing.

Oct 24 07:46 AM

[popey:]

Sure the dollar can rally, and it probably will in various convulsions over the next 12 months. But the systemic weakness of the US economy will soon push real interest rates into negative territory. When that happens, the bond market and USD will simultaneously implode. The US economy, currency, and even the Union itself is at risk. Any discussion of the USD must analyse the systemic cancer of the US economy and govt balance sheets. Medium to long term, the dollar is complete cactus.

Oct 24 08:36 AM

[Steven Vincent:]

I agree. A rally in USD is imminent and it will be more powerful than many are expecting. The first phase will be initiated by an intermediate term pullback in equities markets which will throw the bull rally into question. The second phase (if there is to be one) will be occasioned by a shift in "the story" from the inflation/liquidity trade to a growth trade as the world economy shows signs of takeoff.

Both the dollar crash and the "world depression" hypothesis are sentiment extremes that stand a pretty good chance of being turned on their heads in dramatic fashion. It's what markets do.

Oct 24 03:53 PM

[LilBob:]

"Those reserves, applying the typical 7-8x deposit to loan multiplier over the last couple of decades, would translate into a credit surge equivalent to 40-50% of US GDP, underwriting a cyclical recovery..."

I feel you are falling prey to the fallacy of the "omnipresent consumer". It doesn't do any good to have businesses hiring new employees or opening new store locations when no one has any money left in their pockets to spend. The consumer base in this country is seeing a decline in wages, we aren't seeing any substantial or successful efforts to enhance domestic capacity or create new jobs, and we don't have any really hopeful examples of transformative technologies-other than alternative energy-on the table to justify taking out all of those new loans. Just giving out loans so Americans can go back to buying cheap imported crap on credit isn't going to do a thing for this economy but set us up for another, even deeper recession.

Oct 24 08:56 PM

[Mr. Big:]

A sustained rally in USD can only occur when the Federal Reserve becomes hawkish on interest rates. Under the current state of the economy, interest rates are not going up anytime soon. Housing is barely stabilized by the artificially depressed mortgage rates and corporate borrowing costs have come back (more-or-less) to pre-crisis levels.....but again....only with the support of artificially depressed short and long term rates. This stabilization in the economy has been the catalyst for the big run-up in the stock markets since March. If interest rates were to rise today, the housing market will quickly turn from a recovery to a spiraling free fall (again) and the unemployment rate will skyrocket as corporations cut even more jobs to make up for higher debt service payments. Say bye-bye to any recovery whatsoever. And bid your farewells to the Dow 10,000...for good.

At least for another year or so, we will likely see a continuing weakening trend in the US dollar as the Fed attempts to hold the line on interest rates. Foreign investors will continue to lose more and more confidence in the government's ability to get their fiscal act together and the ultra low borrowing rates will induce further shorting of the greenback to feed the carry trade.

But something tells me that we might not even have a year....as the Federal Reserve is now that buyer of perhaps 70% of all US treasury issues because foreign (and domestic) investors are jumping ship in groves. That percentage is steadily climbing and eventually, the Fed's ability to hold rates will crumble. When that happens, the treasury bond market will crash sending investors scurrying for an alternative safe haven (maybe gold, commodities or some other currency). Then we will witness the crash of the US dollar in typical third-world style and the foundations of hyperinflation will set in very quickly. Weeks? Months? Years? Who knows? But it really is just a matter of time.

Oct 24 09:43 PM

[Tony Daltorio:]

The author is in dream land.....

When will the Fed raise rates? The answer is NEVER! Within a year, they will actually move to negative interest rates.

Oct 25 09:58 AM