The Currency Race To The Bottom Just Got A Lot Steeper

Summary

• The Fed's most recent 50bps rate cut has made it unprofitable for FX swap traders to sell the euro and buy the dollar.
• For the first time ever, the overnight Federal Funds rate is higher than the entire yield curve from 1 month all the way out to 30 years!
• This will most likely force the Fed to cut even more at the next FOMC meeting on March 18th.
• In order to keep other rates above the Fed Funds rate, 50bps will not be sufficient.
• The next cut is more likely to be 75bps, and that will clobber the dollar index. The euro may have to follow. Hence, the slope downward has steepened.

All fiat currencies exist within the plane of a rigged slope downward against all goods and services. All central banks, with the exception of those that maintain currency pegs, explicitly target a 2% general price inflation rate, which means that the explicit goal is for currencies to lose value over time. As each central bank tries to balance the rate of decay of its own currency against others, we have what is known colloquially as the “race to the bottom” with central banks the world over trying to manage the rates of inflation of each national money.

The key to managing this race to the bottom is to make sure that no single player in this race gets too far ahead of the others. The destruction of the value of currencies must be slow, methodical, insidious and coordinated. As Austrian School Economist Murray Rothbard writes in his book What has Government Done to Our Money? (page 68):

What governments want, after all, is not simply inflation, but inflation completely controlled and directed by themselves. There must be no danger of the banks running the show. And so, a far subtler, smoother, more permanent method was devised, and sold to the public as a hallmark of civilization itself - Central Banking.

Subtler and smoother yes, until now. I believe that due to significant developments in the bond markets and what will most likely be a recession ahead, thanks to the paralysis caused by the global reaction to the coronavirus, central banks may soon lose control of this race for good.

The two most important runners in this race to the bottom are the US dollar and the euro. In order to keep forex markets basically stable, these two currencies must disintegrate against other goods and services at similar rates. Up until now, this has been working just fine, gradually impoverishing the middle class that depends on purchasing power on both continents. However, the economic slowdown precipitated by the reaction to the coronavirus has thrown a monkey wrench into the system, and now it looks like the downward slope for the US dollar specifically against all other goods and services has just gotten steeper. If the euro does not match, then the dollar index could be about to seriously decline, and fast. In fact, it already is, and continues to decline strongly today, March 9.

This is happening because up until the Fed’s most recent 50-basis point rate cut, the interest rate differential on overnight rates between the dollar and the euro was about 158 basis points. Euro area overnight rates are zero, and the overnight Federal Funds had been 1.58%. Obviously, this creates an incentive for creditors to sell the euro and buy the dollar, profiting from the arbitrage. This puts downward pressure on the euro and upward pressure on the dollar on forex markets.

The Fed’s most recent emergency rate cut slammed that arbitrage profit rate down by 32%. On the basis of pure differentials, the incentive to buy dollars and sell euros is still there, but there are other costs involved here that need to be factored in. If those institutions principally fueling this trade have been doing so as a safe or defensive play, then they are almost certainly hedging currency risk with their positioning. That insurance costs money and cuts into the arbitrage profits.

Euro Pacific Capital CEO Peter Schiff noted this problem in his latest podcast. I have transcribed the relevant parts below:

... [The United States government must] finance our deficits by borrowing from abroad. And so we have to reward foreign creditors for lending us money. Historically, the yields on US Treasuries have been higher than yields on sovereigns of other quality countries like Germany, Japan or Switzerland, and so we have been able to entice foreigners to lend us money by offering them a higher yield on sovereign credit... If you’re living in Europe and all your costs are in euros and you’re a euro-based investor, if you’re buying Treasuries as a safe haven, then you have to hedge currency risks...

The problem is the yields on the 10Y US Treasury are now so low that it is impossible for anybody anywhere in the world to lend us money by buying Treasuries and hedge out the currency risk. Because by the time you subtract the cost of hedging from the pathetically low yield, you end up with a negative number... They might as well just settle for the negative yields they have in their own country rather than getting an even more negative yield by lending to the US.

Schiff was referring to foreign demand for Treasuries specifically for the purposes of financing federal budget deficits, the implication being that foreign demand for Treasuries should seriously decline now, putting more pressure on the Fed to monetize the remaining supply to plug the deficit. However, the same logic applies to hedge funds engaging in more short-term EUR/USD FX swap trades on the arbitrage between the Fed Funds rate and rates set by the ECB across the pond.

That the dollar index has collapsed 4.6% in 11 trading days is evidence that the short-euro long-dollar forex swap trade may now be unwinding. Most of the losses in the dollar index (UUP) since February 20 are from declines against the euro (FXE), up 4.8% against the dollar in the same time frame. Looking at a long-term history of the dollar index, this past week was the 67^th worst week for the index out of 2,565 weeks since the gold window was closed in 1971. That puts it in the 97^th percentile of worst weeks for the dollar index ever.

If there still remains any arbitrage profit in the long-dollar-short-euro FX swap trade, it won’t last much longer. On March 18, the Federal Open Market Committee is scheduled to meet again. According to the CME Fedwatch tool, the chances of yet another 50-basis point rate cut down to a target range of 0.50-0.75% are 71.6%. The remaining 28.4% is betting on an even more extreme cut of 75 basis points down to a target range of just 0.25-0.50%.

If there is still any potential profit in an arbitrage trade going short the euro and long the dollar, then that profit is likely to completely evaporate come March 18^th at the next FOMC meeting There is little chance, in my view, that the Fed will risk seriously upsetting the equities markets and not deliver at least another 50-basis point rate cut to the Fed Funds rate. Stocks are already freaking out as it is. The dash out of dollars and back into euros may be reflecting forex traders trying to front the Fed’s move in about 10 days.

There is another reason why the Fed will almost certainly cut, and in my opinion, 75 basis points is actually more likely than 50, notwithstanding the Fedwatch probabilities above. The reason is that adding to the immense pressure to cut overnight rates fast is the fact that the entire yield curve all the way from 1 month to 30 years is currently yielding below the Fed Funds rate. This makes it completely unprofitable for prime brokers to buy any Treasuries at all by borrowing at the Fed Funds rate and profiting on the arbitrage. That trade is completely gone. The Fed has to fix this fast if it doesn’t want to end up being the only institution buying Treasuries at all, since it of course couldn’t care less about arbitrage profits. In order to restore some semblance of balance here, a 50bp cut in the Federal Funds rate amazingly would not be enough to push overnight rates lower than anything but the 30Y bond. This, in my opinion, makes the prospect of a 75bp cut, in fact, the Fed’s most likely move from here, and perhaps even a full percentage point to bring rates back down to zero!

Back to the euro. As for the European Central Bank, according to Trading Economics, markets are expecting only a 10bps rate cut to the bank's deposit facility during the next ECB meeting on March 12^th. Compared to a likely 75-basis point cut on the Fed Funds rate, this is chump change. The short-euro-long-dollar FX swap trade will still be unprofitable with only a 10bp cut on the euro side.

If the ECB surprises and delivers a very deep cut rather than just a shallow 10bp adjustment, then the dollar index might recover, but at great cost to the euro. Push negative rates any deeper than they are, with a stalling economy frozen by major coronavirus quarantines, and there could be a serious backlash from banks already suffering under negative nominal yields. The effect of such a move could very easily be a dash to real assets to preserve capital away from the economic corrosion of negative interest rates. That would translate into severe and sudden euro-denominated consumer price inflation.

You can see where this is going. The slope downward in the race to the bottom between currencies looks like it just got a lot steeper. Central banks can control rates when the slope is shallow, but when it tips for reasons out of the control of central banks, controlling inflation rates becomes impossible. All currencies must follow this same angled slope down and maintain their relative exchange rates with one another or the forex markets are going to be disrupted. In order to maintain stable exchange rates, or at least generally stable exchange rates, now central banks are going to have to sacrifice purchasing power. They are going to have to let all currencies slide against real assets even faster. There is no other option.

Therefore, I would not be at all surprised if we were to see coordinated central bank action very soon - an explosion of liquidity in all currencies that should serve to push real asset prices much higher in terms of the currencies now being sucked into what looks to be the growing event horizon of a fiat black hole.

Hold on to your gold (GLD) and silver (SLV), folks. Real assets could be about to go haywire, and the precious metals will most likely lead. It looks like things are about to get really crazy.

Analyst’s Disclosure: I am/we are long GLD, SLV. 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.