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Monday, May 17, 2010

Bigger Fish to Fry, and update to Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

This is an update to the original post that I wrote in the beginning of April: Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

I am going to stick with my intro from last time because it sets the stage:

I am bearish on the US Dollar Long Term. This is no secret and I have been an outspoken critic of US monetary policy for a long time. Will we get a continued rally in the Dollar for the short term (next few months)? Yes, I think that is likely. But even a few months is short term in the bigger environment.

Here is an in-depth macro analysis of the Dollar that I wrote months ago: Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog. Aside from the fundamentals, I think the technicals also paint a bleak long term picture for the Dollar:

And we are getting the continued rally in the dollar like I was saying a month and a half ago. I am a long term dollar bear, but I am certainly not short it at the moment.

But you ask:

"What about deflation"
"What about inflation"
"What about hyper-inflation", etc.

If anybody is subscribing to an "either/or" philosophy here with regard to the monetary outcome, they don't know what they are talking about. It will be a combination.

There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes. But before I start veering way off topic, I lay out the case for a simultaneous deflationary and inflationary (stagflation) outcome here: Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428

In addition, see the link at the top of the page for a dollar / equity correlation chart that disproves the blanket statement that "inflation / a weak dollar helps stocks go up".

Dollar Swaps

I spent a lot of time in my last post discussing Dollar Swaps and the role that they play in the deleveraging crisis of 2008-2009. Here was what I wrote last time:

But we also have a very steep drop in LIBOR during the deleveraging crisis. Why is that? If everybody, most especially financials are scared, because there is a deleveraging and liquidity crisis, why would LIBOR go down?

Because the Fed was pumping the system with Dollar Swaps!!

**If you want the real reason for the "bottom" in March 2009, there it is.**

All arguments for compelling valuations are BS, or "once in a lifetime buying opportunities" are BS. We stopped the freefall NOT because the market said "no mas", but because the Fed stuck an inflatable pool halfway underneath the cliff divers trajectory. It forced liquidity into the system as it was seizing up. If you really want to understand this issue, read Kristjan Velbri's excellent post Dollar Liquidity Swaps & The Financial Crisis.

And in the context of Bigger Fish, the Fed after sucking up all of the open Dollar Swaps from the last crisis just rolled out a fresh batch of brand spanking new Dollar Swaps: http://www.federalreserve.gov/newsevents/press/monetary/20100509a.htm

n response to the reemergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the reestablishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

Basically the idea behind the Fed is to head the next crisis off at the pass. The last crisis was a deleveraging and liquidity crisis. And the Fed wants to make sure that the crisis in Europe does not get amplified by a lack of liquidity in the reserve currency. And I am not faulting the Fed for this move. It makes a lot of sense. In fact, if I were in charge of the Fed I would fire myself... errr, I mean I would probably do the same thing.

But before everybody gets all ga-ga bullish about guaranteed liquidity, lets consider the context. The Fed stuck an inflatable pool halfway underneath the cliff divers trajectory when it forced liquidity into the system as it was seizing up during the last go around. That was a reactive move that prompted to the market to bounce off its oversold conditions. This is a proactive move, that while can be addressed as an act of prudence, speaks more like an act of desperation. The Fed is trying to stave off debt contagion. And since this crisis is sparked by sovereign debt worries and the the US debt sustainability issue resembles Greece more than it does Germany, the Fed and the Treasury have a very real reason to be afraid.

While this development is not immediately bearish, it is certainly in no way bullish.


Here is the LIBOR / Dollar picture from my April 6 post. Read the notes carefully:

And what does the picture look like today? Something very bearish. LIBOR is rising and accelerating. Fear is coming back en vogue. Contagion is the new 9-letter 4-letter word (...?!?!). A lot of people are saying "debt issues are overblown, buy the dip on the Euro". ... I am not so sure about that. Please see this EUR/USD analysis and projection that I put together back in March: Thoughts on the Euro, the Dollar, and a Long Term EUR/USD Count. The current EUR/USD is 1.23 which is about halfway down to my target from that post. So LIBOR, TED, the Dollar, Dollar Swaps, etc. are all saying it is time to be very cautious.

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