US Dollar Rally: Not So Unexpected

Time for a little pat on the back — my own.

When I first published Financial Armageddon in March 2007, one of my more controversial calls — aside from predicting, among other things, the kind of systemic crisis we now see unfolding — was that the dollar would stage a short-to-medium term rally during the early stages of the unraveling, contrary to the expectations of other prognosticators who correctly foresaw troubled times ahead.

Here, for example, is an excerpt from Chapter 6, ”Systemic Crisis”:

Initially, those who are exposed will seek to unload the largest, most dangerous, or least valuable positions. As the loss-cutting crowd expands, the upheaval will seep through into more liquid markets. Mostly, the pressure will be felt on the downside. Nonetheless, following the dramatic expansion of complex arbitrage, derivative, and relative value positions accumulated over several years, many markets will also see abrupt and violent squeezes to the upside. Firms with massive bets on a fall in the greenback, for example, could be stung by a widespread scramble to unwind similar positions. This will likely be spurred by a short-term rush for traditional safe-haven investments, an unusually unaccommodating Fed, and a scramble to raise U.S. currency as bankers hurriedly call in outstanding dollar-denominated loans.

And below is a passage from Chapter 12, “Geopolitical”:

Still, while little doubt exists about the longer term outlook for the greenback, especially given that U.S. officials will eventually be forced to turn on the monetary spigot full blast, the dollar may well swing noticeably higher versus other currencies in the short run. The combination of massive speculative bets against the currency; widespread margin calls at major financial intermediaries as volatile markets boost collateral requirements; unexpectedly tight monetary policy; and frantic efforts to convert assets of all kinds into cash to service trillions in dollar-denominated loans, bonds, and other obligations will likely trigger a short-term boost in demand.

This move will ultimately prove unsustainable, however, as the wholesale destruction of purchasing power amid a hyperactive increase in the supply of the currency proves overwhelming. With the Fed eventually seeking to monetize anything and everything in sight, those who can will do their utmost to bail out of American currency. Dollar-denominated assets of all kinds, including former safe-haven investments such as Treasury bills and the debts of Fannie Mae and Freddie Mac, belatedly recognized as unbacked by government guarantee, will come under relentless selling pressure.

In “Dollar Surges Amid Hustle For Supplies Overseas,” the Wall Street Journal brings us up-to-date on a dramatic move that has caught a lot of people — except those who read my book, of course – seriously off guard:

As global markets slide, the dollar has become a hot commodity.

The dollar surged again Monday against a swath of currencies, with the exception of the Japanese yen, which drew strength as fear swept through markets.

The latest advance follows a record-breaking performance last week that saw the dollar post its biggest weekly gain against the euro since the European currency’s inception in 1999. Late in New York, one euro bought $1.3519, its lowest level since August of last year, down from $1.3806 late Friday.

The buck’s rise is unfolding despite grim data out of the U.S. It is being fueled, many experts believe, by a frantic search for dollars by foreign banks from Switzerland to South Korea.

That scramble is also producing highly unusual situations in short-term money markets, with foreign banks, particularly from Europe, seeking dollars early each day while U.S. players hoard them. Many European banks are paying interest rates that are at least twice as high as what their U.S. counterparts are paying to borrow dollars overnight.

The dollar is in demand because many foreign banks engaged in short-term borrowing in dollars to fund various activities in recent years. Now, one normal channel for getting those funds or rolling over such debt — borrowing from U.S.-based banks — is gummed up, as banks are leery of lending to one another.

At the same time, banks world-wide are also looking to reduce their overall borrowing as part of a race to clean up their balance sheets. Where that borrowing was in dollars, they need dollars in order to repay it.

“There is a pyramid of leverage” in the financial system built up over years, says Mark Astley, CEO of Millennium Global Investments, a U.K. currency manager with $15 billion in assets. “This isn’t going to be over in a couple of weeks.”

The global demand for dollars pushed the U.S. Federal Reserve to announce a major expansion of its “swap” lines with other central banks, which allow them to provide liquidity in dollars to their local commercial banks. The Fed now has arrangements with nine other central banks, which together provide access to a total of $620 billion.

Still, that hasn’t been enough to ease the squeeze. Some of the demand for dollars has spilled over into the currency markets. There, participants can buy dollars outright, or use derivatives known as currency swaps to exchange one currency for another at two different points in time.

Some investors say the appetite for dollars is akin to the demand for the yen. The yen surged against the dollar and the euro Monday; late in New York one dollar bought 101.61 yen, down sharply from 105.14 Friday.

The yen’s ability to thrive stems from the fact that in better times, investors borrow in yen to take advantage of Japan’s ultralow interest rates. But when volatility rises or investors need to cover losses elsewhere, they undo these maneuvers — known as carry trades — and buy back yen, boosting Japan’s currency.

Meanwhile, by borrowing so much in dollars, foreign banks may have created “the biggest carry trade of all time,” says Hans-Guenter Redeker, a currency strategist at BNP Paribas in London.

The U.K. pound was at $1.7465 from $1.7752, and the dollar was at 1.1476 Swiss francs from 1.1274 francs Friday.

European banks appear particularly affected by the dollar squeeze. In a June report, the Bank for International Settlements noted that in recent years European banks had borrowed short-term in dollars from other banks and channeled those funds into longer-term credit for nonbanks — one such example could be mortgage-related investments in the U.S. The net liabilities to all banks grew to more than $800 billion by the end of last year.

Since the collapse of Lehman Brothers Holdings, it has become very difficult for European banks to raise dollars in the U.S. money markets. In particular, money-market mutual funds that are large providers of cash have turned cautious. Many will only part with their cash for a day at a time and restrict their lending to the strongest companies and large U.S. banks.

Several mornings over the past few weeks, traders reported that some European banks that needed to borrow U.S. dollars had difficulty finding investors to lend them cash overnight, even if the banks paid rates of more than 6%. When evenings came, money-market funds would rush to invest billions of dollars in overnight dollar deposits with large U.S. banks, in some cases accepting interest rates of as low as 0.01%.

Subscribe by RSS Subscribe by Email