A Thought on the Dollar

Posted by urbandigs

Sun Aug 10th, 2008 03:22 PM

In late February, I wrote a piece titled, "Sometimes We Get Lost in the Dark", as a change-of-pace discussion on what I thought described the state of our economy at the time. Thinking back now (when Bear Stearns was still alive), February was certainly a very dark and mysterious time for our markets as they navigated through unchartered terrain. weak-dollar-strong-dollar.jpgI mean, who expected Bear was going to die of that quickly!

Today, I want to temporarily embrace an idea of what I think is going on with the recent dollar rally, seemingly sparked by a concerned Trichet in the Eurozone. It does have an orchestrated tone to it, and that's fine as long as you all know that I am not a conspiracy theorist or paranoid about such theories. However, I am a believer that there is a co-ordinated effort going on between our federal reserve and overseas central bankers to attempt an orderly unwind of global holdings of toxic waste. It is in nobody's interest that the system fail, and because of this very unique environment, I think the idea that specific markets (credit markets, currency markets, commodity markets, equity markets) are being targeted for orchestration to allow the mass unwind to proceed with minimal event-causing disruptions, is worthy of discussion.

Off the top of my head, I see the following interventions for the following markets:

Equity Markets

a) Paulson's backstop plan for GSE's allowing the treasury to buy preferred shares of stock for Fannie Mae & Freddie Mac, thereby placing uncertainty and more risk for those holding, and thinking of holding, short positions. It's hard to raise capital if your stock is below $5/share!
b) the temporary restriction of naked short selling for a selected number of companies

Credit Markets (rate cuts & facilities offered by fed)

a) 325 bps of fed funds rate cuts, 350 bps to discount window
b) $30 Billion for rescue of Bear Stearns
c) PDCF
d) TSLF
e) TAF & repos

Commodity Markets

a) talk of lifting moratorium on offshore drilling
b) talk of windfalls profit tax on oil companies that will limit research & development
c) US Senate proposal designed to curb commodity speculation (The Stop Excessive Speculation Act, recently blocked by Republicans)

Currency Markets (central bank dissenters & rhetoric)

a) dissenting votes on rate decisions
b) 'tough guy' act in issued statement
c) Trichet's recent comments on concerns over Eurozone growth

us-dollar-index-rally.jpgThats what I want to discuss, that last one. The recent dollar rally (30-Day US Dollar Index chart on the right courtesy of FXstreet.com) seems to be sparked by comments from Trichet over risks of slowing growth. That statement changed the view that Trichet will hike rates another 1/4 point, and instead now gives the impression that rates are on hold and may go lower in the future. Massive short covering and new positions are being taken on the dollar, resulting in lower commodities across the board; which is what we wanted anyway right?

Lets put ourselves in their shoes? HOW DO WE STOP RISING COMMODITIES? As I said April 22nd, ANYTHING THAT WILL SUPPORT THE US DOLLAR:

I've said this so many damn times on this site: commodity inflation + housing deflation is NOT A GOOD MIX! Pipeline inflation is bubbling and we can expect future inflation data to be very troubling indeed.

The fix? Here's a thought: ANYTHING THAT WILL SUPPORT THE US DOLLAR! We MUST remove the speculative currency trade that has driven commodity prices higher; arguably there could be $30/barrel in speculative trade in oil as an example. Even if this means the fed changes verbiage to put their bias into the fight against inflation, then so be it! That would be interpreted by traders that future rate cuts are in serious doubt, the US dollar will be supported, and it would remove a good portion of the speculative trade in most commodities. It doesn't fix the supply problem that has resulted from fast growing economies like China & India, but it will help by removing the bets made simply on the premise of a weakening US dollar.
There is speculation in commodities, I have always stated that, and it wasn't only supply/demand forces driving oil to $145; speculation helped and a weakening dollar drove that as commodities were the only asset class working for the past few years. The $30 of speculative oil I discussed 4 months ago, is where we are right now with oil down about $30 from its high in only the past three weeks. Obviously this proves that speculative trading exists in the price of crude oil.

Thing is, I think we still have big problems ahead of us and a few big institutions that are going to fail. If that turns out to be true, the fed will have to cut rates to calm the tradable markets, probably before they re-open for trading again. If the US dollar was in the dumps, requiring $1.60 to buy one Euro, and with oil at $145 and gold at $975, there was absolutely no way the fed could afford to cut rates to deal with such an event. That would have driven oil closer to $175, gold closer to $1200, and the Euro closer to $1.75 against the dollar; think about that environment. That would have also made foreign holders of our debt very unhappy, and we do not need to deal with ramifications of that dynamic right now.

Things that make you go hmmm. So what do we do? Lets have a chat with Trichet and co-ordinate a change in public bias (lets not do anything about!), to fix some of the major macro problems that may come from surging commodity prices and a continued imbalance of currency valuations. If we, the fed, act tough on inflation, and you, Trichet, mention a blurb about slowing growth (which is happening so credibility won't be hurt), that could buy us a cushion!

It has a two pronged effect:

1) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will appease foreign holders of US debt

2) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will reduce speculative bets on commodities, and cause a correction in the price of commodities priced in US dollars

These are both welcomed events. But a third effect can be the bulls-eye accomplishment!

By giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will give our fed MORE FREEDOM TO CUT RATES should our economy continue to deteriorate down the road. To me, this is the ideal situation for Ben Bernanke and it is this exact reason that I think a co-ordinated effort to cushion the dollar may be in place right now. Call me paranoid, but to slow down commodity inflation, or at least the perception of inflation expectations, without hiking rates is a major ingredient to soothe some of the problems we face! Ben wants to inflate, and in my opinion will not hike rates as long as there is housing/credit deflation, unemployment is rising, and the financial sector remains under distress. Hiking rates now will be counter-productive to fixing the financials/credit markets (which is so crucial for a housing recovery to take place) and an orderly unwind of toxic securities.

An outcome supported by this way of thinking, is if our fed does indeed cut rates as their next move (who knows when), and if Trichet holds rates at 4.25% for the foreseeable future. Should this happen, then the fed orchestrated it wonderfully; that is, if there was a stealth co-ordination in the first place (I have to assume these guys are talking to each other, on the same team, and working together on the problems both face). Clearly, traders are covering dollar shorts and selling Euro longs, and pricing in either a US rate hike or a Euro rate cut. Lets see what happens next!

In conclusion, I think the fed knows that it needs bullets if unemployment continues to rise, the economy goes into a deeper slowdown, the credit crisis claims a big institution or two, or if housing/debt problems continue to accelerate and spread to higher quality classes. To be able to cut rates, the dollar needed some resuscitation and commodities had to correct. If the fed was forced to cut rates with $150 oil, and the Euro at its high against the dollar, the problems would be compounded and fed ammo wasted. With the dollar strengthening and commodities selling off, the fed has more legroom to do what they might have to do to invigorate growth and calm any spikes in distress in the credit markets. Time will tell if this scenario plays out, or if the US is really leading the world out of this mess (helped by tons of fiscal/ monetary stimulus) setting up a sustainable recovery for the US dollar and the proven burst of the commodities bubble. You know where I stand.

Related Currency Read from March 11th, 2008, discussing the impact of a more dovish ECB on our dollar:
That means the US dollar may not become as weak as expected and commodities priced in dollars may lose a dose of steroids (rate cuts) that they were betting on. If you want to get real crazy, what if we assume that international markets are lagging the US and they are about to enter a period of financial distress similar to what we have been through for past 4-6 months? Our currency could bounce further if foreign cb's start easing at a time when our fed found a way to limit future rate cuts. Ehh, just a thought with many if's.

Add a comment

13 comments

CAPTCHA Image