27 October 2009

The US Dollar Rally of 2008: The Consequence of a Bull Market in Fraud

The theory of a short squeeze in Eurodollars which we had first put forward last year "The Dollar Rally and Deflationary Imbalances in the US Dollar Holdings of Overseas Banks" seems to be confirmed by this paper from the NY Federal Reserve bank, and the latest figures on cross border currency transactions from the BIS.

"Highlighting the international dimensions of the financial crisis that began in the fall of 2007, authors Niall Coffey, Warren B. Hrung, Hoai-Luu Nguyen and Asani Sarkar examine the difficulties international firms encountered obtaining U.S. dollars and the ensuing effects on the foreign exchange (FX) swap market. Analysis shows that as firms increasingly turned to the FX swap market to obtain funding, the dollar “basis”—the premium paid for dollar funding—became persistently large and positive, primarily as a result of higher funding costs paid by smaller firms and non-U.S. banks." The Global Financial Crisis and Offshore Dollar Markets

Further, the latest data from BIS shows that the dollar rally tracked the acquisition of eurodollars with a significant correlation. This is shown on the chart at the right.

After the Federal Reserve alleviated the short squeeze through dollar forex swaps "The Fed's Currency Swaps" with the central banks in the affected regions, the dollar squeeze dissipated and the dollar fairly quickly resumed its downward trend. There is a case to be made that some of the big US money center banks were using the dollar shortage to reap windfall profits, but this could have also been a side effect of the seizing in the short term credit markets.

But much of the European outrage, as least, was in feeling that they had been 'set up' by the very banks that had sold them the foully rated instruments in the first place. A classic face ripping, as they say at Wall and Broad. And this similar to the reason is why the Chinese government declared that its own institutions could walk away from derivatives arrangements that had been sold to them by the Wall Street wiseguys under false pretenses. US towns and states are not so fortunate it appears.

What does this mean? It implies rather strongly that those looking for a repeat of the sharp dollar rally from last year are very likely to be sadly disappointed.

This was no flight to safety; this was the consequence of a massive fraud in dollar denominated financial assets having been sold to gullible foreign investors and their banks. Note too that the eurodollar positions do NOT account for the dollar rally in 2006. This is what was expected, because there was no corresponding spike in LIBOR to indicate a squeeze. Rather, that earlier dollar rally was due to foreign investment in US equities and financial assets at the height of the post tech crash Dollar Assets Bubble.

Here is a brief piece on The Backwardation in LIBOR and Its Divergence from Effective Fed Funds which shows the signs of the 'eurodollar squeeze' as opposed to net foreign investment in financial assets.

The foreign banks have now unwound a significant amount of the dodgy US dollar financial assets that caused the short squeeze through their fraudulent valuations.

Yes, there will be more rallies in the ongoing decline in the US dollar. There always are countertrends in every long term trend. This is how traders make and lose their gains, as the market makers skin them slowly but surely. We can only wonder for now how much money has come into the US equity and bond bubble in the past six months, and how much is leveraged via the dollar carry trade.

But we ought not to see such a large rally in the dollar again unless there is a precipitous decline in stocks that forces a painful unwinding of the dollar carry trade. Foreign banks ought to be on the lookout for this development, because it is in their regions that the short squeezes have most of their effect. The Fed is awash in dollars and does own a printing press, and is not afraid to use it.

And for those desperately waiting for a free ride and easy money from a synthetic dollar short on debt, they should be reminded that the chief monetarist himself, Milton Friedman, also reminded that "There Ain't No Such Thing As a Free Lunch."

Or more civilly perhaps, "even fraud has its limits in conferring more value upon that which has less."