Are We Lining Up for Another Dollar Shortage?

Includes: DIA, GLD, QQQ, SPY, UDN, UUP
by: Kristjan Velbri

Now that the Federal Reserve dollar liquidity swaps are out of the way, there is no buffer left holding the market together.

In 2008, amidst one of the worst financial crises, the US dollar became very sought after. In the preceding years, non-US banks had accumulated hundreds of billions worth US dollar denominated claims. Their dollar claims grew at a much faster pace than their dollar deposits.

Murphy's Law dictates that if something bad can happen, it most certainly will. Case in point: During the financial crisis, the market prices of banks' dollar claims fell much faster than banks could come up with new dollar deposits to back their leveraged positions. The Fed ran to the rescue, throwing billions of dollars at foreign central banks so they could assure their members banks had the necessary liquidity. Of course, this did nothing to solve the underlying problem of too much risk and imperfect information (derivatives, anyone?).

Which brings us to today. As is evident, the dollar swaps did everything they were supposed to do. But now that they're gone, there is a possibility that the dollar shortage will return. The dollar has been gathering momentum for quite some time. Those that look at charts had to have seen the massive divergence between the price action and most of the indicators (MACD is a good example) that first appeared in the spring. Now that the dollar is back in an uptrend with negative news from the Eurozone supporting it, we are looking at what could possibly be the second phase of the dollar shortage. It's on the brink already and it only needs one little push.

Where could the push come from? A number of sources, really:

1. Higher interest rates
2. Negative news that would dismiss the validity of the recently published GDP gain of 5.7%
3. Second wave of home mortgage resets
4. Commercial real estate

Any one of these would have the effect of plunging asset prices. Given the huge amount of dollar claims amassed by the European and other non-US banks, it does not seem reasonable to assume that they have managed to sell those assets or hedge away their risk completely. The situation is quite a bit different from what it was in 2008, but there are a number of disturbing similarities. The Libor-OIS and TED spreads are both looking calm right now (this was not the case in 2008), but volatility is starting to pick up. Derivatives also pose a problem as there were $604 trillion worth of derivatives as of June 2009, according to the Bank for International Settlements. This is $79 trillion less compared to June 2008, but $57 trillion more compared to December 2008.

If the dollar shortage were to return, equities as well as futures would get hammered just like they did in 2008. Some claim that gold is a safe haven during a liquidity crisis but there is no proof to back up that claim*. During a liquidity crisis, all assets get sold. Even if gold and gold equities were to hold up for a while, which they haven't up to now, they would be sold soon enough just because they could. Don't be fooled into thinking that fully funded clients are different from those on margin -- a plunging asset loses value regardless of leverage, some just get wiped out earlier than others.

*Gold is definitely a safe haven in the long term, but there is nothing to protect short term holders in case of a fire sale.

Disclosure: Long physical gold and silver (long term)