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Cheap dollars and the next financial crisis
Sunday, September 13, 2009
Liam Halligan writes in the Telegraph of the grave danger posed by a world awash in cheap (and getting cheaper by the day) U.S. dollars, a condition that doesn't look as though it will change anytime soon given the likelihood of U.S. interest rates staying low for quite a while.
Hmmm... A snap back in the dollar that causes a financial crisis that, in turn, spurs more dollar buying in a flight to safety and an even stronger dollar - that does sound dangerous.The dollar is now being used as a "carry" currency. Traders are using low Fed rates to take out cheap dollar loans, then converting the money into currencies generating higher yields.
"Carrying" credit in this way is currently the source of huge gains. No one knows the true scale, but the world has, of course, been flooded with cheap dollars.
This presents serious systemic danger. A dollar weighed down by Chinese divestment, then suppressed further by carry-trading, could easily spring back. Those who had borrowed in dollars would owe more, while their dollar-funded investments would be worth less. This "unwinding" could send financial shock around the globe.
This is what happened in 1998, when yen carry-trades went wrong, causing the collapse of Long-Term Capital Management and sparking a global slowdown.
So even if the Western world manages to fix its banking system, the Fed's money printing could well be stoking up the next financial crisis. The dollar carry-trade. You heard it here first.
ooo
7 comments:
" The dollar carry trade. You herad it here first."
Stephanie Pomboy of Macro Mavens and Randall Forsyth of Barron's, who has been quoting her, have been on this theme for many, many months.
I'm glad you mentioned LTCM. The problem then was/is that big Wall Street firms were told to "chip in" and fix the problem (pay off LTCM's counterparties). That established the precedent that all problems can be and should be fixed. One of America's strengths is the belief that evey problem has a solution. Unfortunately that reinforces the idea that every crisis should be "solved". In this case, the "crisis" (credit crunch, failure of banks en masse) IS THE SOLUTION to the problem of too much debt. Unfortunately, not enough banks (esp the big ones) have been allowed to die. Yet. Sure it will be tough when they do implode, but only after excess debt is defaulted can we move forward in a sustainable way. Printing money and borrowing at an insane rate is not sustainable, by the way.
Ebola is a horrible disease, but one reason it's never gone worldwide is that - thankfully- it kills its victims so quickly that outbreaks peter out. If we could extend the lives of doomed Ebola patients by a few months, it could wreak havoc on the world. Same thing with trying to help zombie banks limp along. Helping them will eventually bring about our sovereign financial demise.
Everything we have been doing is wrong, even if it seems (temporarily) to be working. All of the bailouts and gov't guarantees are the wrong approach. The debt level was/is too high. Bad debt should default - not be made whole by the government. Who's going to backstop the US government?
Cricket...cricket...
Hi Tim,
Long time no see.
Hey, I must be missing something in Halligan's piece. How exactly would this cause the dollar to rise? Seems to me an oversupply of dollars leads to nothing but one conclusion: Dollar depreciation.
And Chinese "divesment"? Sure, they want to switch to SDR's but aren't they still buying up DDA's like crazy? I think if anything the Chinese are still buoying the dollar. Isn't that the case?
Please forgive me if you're being ironic with us and I didn't catch it.
Regarding the dollar carry trade, Dennis Gartman of The Gartman Letter, has been discussing this for months.
Vespucian,
Currencies used for the carry trade are artificially weak, similar to the Japanese yen a few years ago when it was trading at 125 per dollar (now it's at 90). When the carry trade "unwinds", the carry trade currency strengthens since borrowers are selling the higher yielding currency/asset to pay back the "carry trade currency denominated" debt.
What Halligan is saying is that there is currently a dollar carry trade that is making the dollar artificially weak and nowhwer does this seem more clear than against the British pound.
Thanks Tim.
If there is such a carry trade occuring AND there is a surplus of dollars around to boot (allowing the carry trade in the first place) then what on Earth is holding up the dollar? Why isn't it plummeting? Is it just that the alternatives (Euro, Yen) look crappy too? Then why not gold if all the currencies are bad investments for sustaining value?
I mean, if there is an oversupply of all currencies, and that seems to be the case, why isn't gold picking up the slack more?
I think the mainstream investment community still poo-poos gold. Ask around. Do any of your friends and family own gold (i.e., ones that you haven't already twisted their arm to do so)?
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