Dollar Chaos?

by: The Nattering Naybob


Discussion of the potential effects on equity, bond, commodity, capital and asset markets regarding:

GC Repo Rate; Yen Cross Currency Basis Swaps.

The Dollar Rally; China's Forward Dollar Swaps.

Nikkei Selloff; Japan's Interbank Lending.

Ran (乱?, Chinese and Japanese for "chaos", "rebellion", or "revolt", or to mean "disturbed" or "confused") is a 1985 Japanese-French jidaigeki epic film directed and co-written by Akira Kurosawa. In this cinematic masterpiece, an aging Sengoku-era warlord decides to abdicate as ruler in favor of his three sons. The story is based on legends of the daimyo Mōri Motonari, as well as on the Shakespearean tragedy King Lear. If you have never seen Kurosawa's last epic, you are truly missing something in life. A must see, one of the best films ever made, and should be required higher educational subject matter, IMHO.

GC Repo Spike

"Despite the below-zero interest rate and the possibility of further easing, investors piled into the yen, continuing the Japanese currency's more than 6.5 percent increase since the day after the rates were announced following its January meeting. Tina Byles Williams, Chief Executive Officer and Chief Investment Officer at FIS Group in Philadelphia. "There's anticipation of a risk-off moment and the yen is the protection against that."" Weak U.S. data, BOJ outlook push dollar down vs. yen - Reuters

Utter MSM nonsense which in the quote "the yen is the protection" is being parroted yet again. We previously discussed this commonly held misconception, the tsunami of dollars being lent into the market, and the perils of Japanese banking in China, in some recommended reading A Yen For Yuan?

Above note, With the banks parking in RRP overnight for Q-end window dressing, GC (general collateral) repo rate spiked to 1.75% on March 31st, the highest since 2008. I suspect next week things might get tight with China possibly rolling over their forward dollar swaps est. $150 - 300B. TBD. Something is wrong and its not just Q-end dollar liquidity related.

Negative "cross currency basis swap", lending USD for JPY or EUR or CHF says it all. A uber premium that entices me to lend my "spare dollars" into the market in a swap for Yen, Euro, Franc which get parked in negative yield bonds, driving bond yields lower and prices higher. Anyone needing dollars to transact or for funding; bond sales or buybacks; global corporate (finding cheaper dollar funding by starting in Euro or Yen, then swapping back to USD); EM, China and Japanese banks.

To review, i.e. I lend "spare dollars" for Yen, said dollars hit the market, dollar float rises, dollar weakens. On the other end, park swapped Yen in safe negative JGB, yen get pulled out of market, lower yen float, yen rises. The negative bond yield? No problem, a cost of doing business, still making a killing on the negative basis or spread for my lent out dollars, which have flooded the market. There is only a shortage, if you need them.

The negative cross currency swap basis and sovereign bond yields confirm the level of "dollar" funding activity and an increasing systemic liquidity strain for "dollars". Now you know why KING DOLLAR has gone from 100 to 94 since Feb 11 while the Yen, Euro and Swiss Franc gained, those carry trade's for dollars are alive and well.

Don't forget, what goes up, must come down and in this case, vice versa. At maturity, the transaction posted at the front end of the swap reverses, completing the swap and reversing the currency pair FX effect. TBD.

The Dollar Rally

Now, Morgan Stanley thinks the dollar is setting up for one "final leg higher,"aided by macro developments outside of the US. Specifically, MS says the dollar rally will be driven by "EM currency weakness and related US capital inflows." The bank believes EM must eliminate its output gap, or the difference between the actual output of an economy and its potential output. Since the US has already eliminated its output gap and unemployment is at or near the non-accelerating inflation rate of unemployment (also known as NAIRU), or the level of unemployment below which an economy sees inflation increase, these factors should provide support for the dollar as they're likely to result in a tighter labor market and higher US wages. So how far can the dollar run? Morgan Stanley thinks the trade-weighted dollar will hit 135 by the end of 2017, good for another 10.7% rally from current levels."

There are two thin shreds of potential truth in the above narrative. One, the trade weighted dollar could easily hit 135. Two, the dollar rally will be driven by "EM currency weakness and related US capital inflows." But not for the reasons they posit, EM and US output gap, along with Nairu are a misdirect based upon MSM narrative.

As the global economy slows further, less petro and euro dollars will prop up the dollar vs EM currencies. That will be counterbalanced by furtherance of the Yen, Euro and CHF dollar carry trades which will concomitantly weaken the dollar. Any selling of UST's is being offset by secondary market demand for that "quality" collateral or what is considered "money".


You can pay me now, or pay me later... all forward dollar swaps and cross currency basis swaps have something in common, they kick the can forward, avoiding the real issue. In the end if you want to dance, the "dollar" piper must be paid and BS econometrics, speculator positions and MSM media spin, be damned.

Over the period, as part of the income stream, and at rolling or maturity, DOLLARS must be payed to satisfy those positions. Those dollars have to come from somewhere, they will be at a premium, and when they get paid or swapped back, the dollar float lowers and the dollar potentially goes up, affecting commodities prices, amongst other things.

The big kahuna or "can to kick" is China, their synthetic FX - forward dollar swap position - is est. $150 - $300B. Putting this in perspective, in 2009, ALL of the banks in Europe totaled a known synthetic FX position of $310B. Even deeper, Japanese Banks have made $360B in overseas loans since 2012, most of those, you guessed it, were to provide "dollars" to Chinese business concerns.

Again, those dollars have to come from somewhere vis. when you lend dollars, you either already possess them, liquidate something to obtain them, or you borrow them by selling bonds. Mega Japanese banks Mitsubishi; Sumitomo Mitsui; and Mizuho can raise dollar funds by selling bonds overseas. Japanese banks who lent out borrowed dollars, are straddling those cross currency swaps by being "short" on their borrowed dollars.

That could be disturbing, as the basis or spread becomes more negative, those "market makers" have to pay higher costs on the dollars they lend out. Higher costs, lower margins means some of those trades could blow up in those banks faces.

Japanese Side Effects

I suspect something is going on with either/or Japanese banks supplying China "dollars" or Chinese banks swapping to get "dollars. Cross currency basis swaps USD for JPY going sour might have those banks liquidating to come up with USD to cover interim, rolling or maturity costs. Perhaps that's why the Nikkei has tanked the last three days? Just sayin.

"The lending balance in the call market dropped to 2.97 trillion yen ($26.5 billion) at the end of March, the lowest since October of 1980. The figure has shrunk to just one-seventh of the January level, and is down more than 40% since the end of February." - Nikkei

Japanese interbank lending or "flow of funds" has contracted to a 36 year low. A 40% contraction in March, with a seven fold contraction since January. Continued contraction of interbank transactions at this rate, would be much like an aortic stenois (a narrowing of the aortic valve, impeding delivery of blood from the heart to the body) leading to turmoil, chaos and potential financial system failure.

Speaking of chaos, at some point when margins erode, Japanese banks which are currently "making" that market, might rebel, pull back, exit and create a void. Now where do the Chinese get those dollars? In that event, watch the last resort, Central Bank Liquidity Swaps held at the Fed.

It is speculated, pun intended, that China rolled their forward dollar swaps in August and again in December. Remember the chaos, disturbance and confusion in global markets in both of those months? When China roll's again, early to mid April, many might know it and wished they had taken the money and Ran? TBD.

With regard to the above, we examined the FX and macro concepts involved in: In The Toilet?, Rally Dance?, Need For Speed?, In Time? and The Balance?

Would like to thank you folks fer kindly droppin in. You're all invited back again to this locality. To have a heapin helpin of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

This is the 25th in a series of thematically related missives which will attempt to identify the macroeconomic forces with potential to adversely effect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence in not masticating and spoon feeding the baby ducks, as in learning the hard way by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard


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Market Plays

As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this could tie into any list of investments or assets. Those listed below happen to influence the indices more than most.

There are many macroeconomic cross sector and market asset correlations involved that affect your investments. Economic conditions, the eurodollar, global dollar debt and monetary policy all influence the valuation of the above and market plays below, via King Dollar's value, credit spreads, swap spread pricing, market making, liquidity, monetary supply and velocity, just to name a few. For a complete missive series listing covering those subject and more, click here.

The potential global economic developments discussed in this missive could affect numerous capital and asset markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.

A List of 17 Potential Market Plays (Long or Short?): Apple Computer (NASDAQ:AAPL); Google (NASDAQ:GOOG); Facebook (NASDAQ:FB); Microsoft (NASDAQ:MSFT); Citigroup (NYSE:C); General Electric (NYSE:GE); Cisco (NASDAQ:CSCO); Bank of America (NYSE:BAC); Amazon (NASDAQ:AMZN); Tesla (NASDAQ:TSLA); SP 500 Trust ETF (NYSEARCA:SPY); Ford (NYSE:F); Starbucks (NASDAQ:SBUX); Intel (NASDAQ:INTC); ATT (NYSE:T); IBM (NYSE:IBM); Exxon/Mobil (NYSE:XOM)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.