Deleveraging Pushes Up the U.S. Dollar

St Louis, Missouri- Good day… Wow, another unbelievable day/night in the currency markets. The dollar continued to run up versus most of the currencies yesterday and last night, as investors brought money back into the United States. We continue to get calls from WorldMarket investors asking us what was pushing this dollar up, as all of the data seems to be negative for the U.S. dollar. The only explanation that seems to make sense is the global deleveraging of investors.

Here is as good an explanation as I can give: Over the past several years, money was extremely cheap, and investors took advantage of these cheap loans. Hedge funds, corporate investors, and even some individuals borrowed funds and placed them into higher yielding investments to earn the ‘carry’. This occurred not only in the currency markets, but across the entire spectrum of asset classes. These investors were rewarded with incremental yields over ‘cash’ investors, and banks were more than willing to lend, so the amount of leverage continued to increase to absolutely absurd levels. Everything was fine until the housing market here in the United States turned, and losses started to show up on the books of some investors.

These investors had to sell some of their higher yielding assets to make up for the losses, and a move toward deleveraging started to emerge. As these first investors sold these assets, their price dropped, forcing still others to sell. The credit crisis, and the lockup of the credit markets was a final straw in the leveraged carry trades. Even investors who wanted to stay in the trades could no longer get the loans to keep these trades alive. They were forced to deleverage, selling their investments to pay back the loans.

So the benefactors of this deleveraging of the financial system? The Japanese yen (JPY) and the U.S. dollar, currencies which were used to funds these carry trades. The United States and Japan have some of the world’s largest banks, and extremely low interest rates, making them the perfect funding currencies for the carry trades. As the deleveraging has occurred, investors have purchased back these currencies to pay back loans. Also, a majority of the investors participating in these trades were based in the United States, so the deleveraging meant a move back to the U.S. dollar. U.S. investors purchased nearly $1 trillion in foreign stocks and bonds since 2003, many of which are now being sold with the proceeds moving back to the U.S. dollar.

The dollar has also benefited from other factors, including the printing presses at the Treasury – which have been running overtime. Bernanke and Paulson have increased the money supply at an incredible pace. Some of these dollars the U.S. Treasury Department is creating are being used by foreign central banks in ‘swaps’. These swap contracts allow the foreign central banks to swap their local currency (a majority are in euros (EUR)) into U.S. dollars to lend to their institutions who are offsetting losses in their dollar-based investments. And even investors who don’t have the ability to enter into ‘swaps’ with the U.S. Fed, still have a need to offset losses that have piled up on mortgages and other dollar-based investments. The choice for these investors is to sell these assets, which have dropped to fire sale levels, or borrow their home currencies (in this case euros) to buy dollars (this would be a reverse carry trade).

So the deleveraging of the global financial system, at least to me, certainly seems to be one of the primary factors propping up the U.S. dollar. But where will it end? These are some extraordinary times, and the markets are anything but normal. Anyone who thinks they can tell individuals what is going to happen in the markets over the short-term are on something. Ty Keough said it best in responding to a caller’s request to have him try and predict what was going to occur in the markets over the next few weeks. Ty told the caller, “The only prediction I will make is that the next thing to happen will be something we have never seen before. Expect the unexpected!” But over time, markets will settle back to the underlying fundamentals, and the current fundamentals don’t support a stronger dollar.

Chuck is spending the rest of the week at the EverBank headquarters down in Jacksonville. He sent me these thoughts to share with readers this morning:

“Here I am in Jacksonville after having a wonderful dinner with some of the great folks here. I came back to my room and checked the currencies to see that the euro had lost another 2 cents to the dollar. UGH! As I said a couple of weeks ago, I’ve risen the white flag. This is just crazy, all this dollar strength… But it is what it is, and again, I’m going to stick to my fundamentals, as they have never let me down before…

“I’ve told the crowds that this reminds me of 2005 so much… The dollar gained, and gained all the way to 1.18/euro, and the dollar bulls were dancing in the streets, saying that the dollar’s bear market had come to an end, only to find out the dollar had been propped up by the Tax Amnesty for U.S. Corporations doing business overseas. Once that Tax Amnesty ended, the fundamentals for the dollar returned to push the dollar down over the next two and a half years.

“Now, we have this financial sector meltdown pushing the dollar up once again. The worldwide demand for dollar funding is driving the dollar higher every day. It’s amazing to see that everyone wants dollars to fund their capital requirements, etc. I’m feeling very overwhelmed, to say the least, regarding this dollar strength… But, it is what it is…

“Speaking of being what it is… Let’s talk money supply… I had a go with someone the other day regarding the current money supply being put into banks. He said that this money supply was not going to cause inflation… But I said, ‘the true definition of inflation is money supply increasing.’ He said that this money supply was not going to the banks to stimulate the economy; it was going shore up the bank’s books… So I said, ‘well, it’s still money supply, and you can’t tell me that this isn’t going to eventually enter into the economy and stimulate inflation.’ Then I went on to say, ‘Banks can’t stay in business, or survive without making loans, so they may need to shore up their books now, but eventually, they are going to have to put that money to use!’ But for now… I have to take my lumps…”

Yes, the dollar strength is pretty overwhelming for all of us here on the trade desk.

The pound sterling (GBP) slid to the lowest level in more than five years against the dollar after BOE Governor, Mervyn King, said that Britain’s worst banking crisis since World War I is likely to push the economy into a recession. King’s comments came after the Bank of England released minutes from their October 8th meeting, when they voted unanimously to lower their benchmark rates 50 bps. Yesterday’s decline of the pound was the steepest intraday decline in 16 years. And the short-term outlook continues to be bearish, as weekly and monthly stochastic and trend indicators show a target for the pound of $1.60.

The Bank of Canada reduced its main interest rate by a quarter of a point – less than economists predicted. But central bank Governor, Mark Carney, said that they would probably need to act again to fend off the effects of the global recession. The Canadian dollar (CAD) joined most of the other currencies and slid versus the U.S. dollar yesterday after the rate announcement. Canadian exporters will be hobbled by a U.S. recession, and the free fall in commodity prices. But policy makers stopped short of saying that Canada’s economy is headed for a recession. This month, the World Economic Forum rated Canadian banks as the soundest in the world – but these banks are still reluctant to lend. A further cut in rates, and falling commodity prices will keep the loonie under pressure.

Emerging market currencies were the biggest losers overnight, as Argentina’s planned seizure of private pension funds stoked concerns that the nation faces its second default this decade. South Africa’s rand (ZAR) fell to a 6.5-year low against the dollar, joining the Brazilian real (BRL) and Mexican peso (MXN) as the worst performing currencies. The rand moved above 11 rand per dollar for the first time since April 2002, as the move away from emerging markets combined with another fall in the price of gold to put downward pressure on the currency. South Africa’s economy is similar to that of the United States in that they rely heavily on portfolio inflows to fund their current account deficits. These portfolio inflows aren’t going to be forthcoming in the current environment of risk aversion.

Brazil’s currency continued to fall despite government efforts to shore it up. Brazil has spent $22.9 billion in the past month in an attempt to slow the fall of the real. Sales of reserves to buy reals in the spot market totaled $3.2 billion from October 8th through October 20th, central bank President Henrique Meirelles said in testimony before congress late yesterday. But Brazil is not alone in trying to prop up their currency. Mexico, which has a smaller economy, spent even more on currency intervention during the same period. Mexico’s central bank bought $6.4 billion worth of pesos on October 10th alone to shore up the currency.

Brazil is getting somewhat of a bum rap by the currency markets, as their economy is doing fairly well amid the global credit crisis. The government’s debt as a percentage of gross domestic product fell because the country is a net dollar creditor. Capital levels at Brazilian banks exceed the minimum amount required under international guidelines. And while Brazil is known for commodity exports, only 13% of their GDP comes from exports. They depend more on domestic demand than foreign markets, so they should be somewhat protected from a reduction in global trade.

In other emerging market news, Hungary’s central bank raised interest rates 300 bps today after a series of earlier measures to prop up the forint failed to halt the flight of investors. The first emergency increase in five years came after policy makers left rates unchanged at their scheduled meeting two days ago. Investors should continue to monitor the situation here, as Hungary continues its attempts to avoid further falls in their currency.

To end on a positive note, the Japanese yen has benefited from all of the deleveraging, and traded back down below 100 overnight. The yen continues to be the only bright spot in the currency markets over the past 3 months, as it has gained 8.2% versus the U.S. dollar.

Currencies today 10/22/08: A$ .6713, kiwi .5951, C$ .8044, euro 1.2842, sterling 1.6324, Swiss .8579, ISK (No Quote), rand 11.017, krone 7.0117, SEK 7.881, forint 214.73, zloty 2.9390, koruna 19.876, yen 98.51, baht 34.54, sing 1.4985, HKD 7.7527, INR 49.34, China 6.8342, pesos 13.7438, BRL 2.3465, dollar index 85.49, Oil $69.31, Silver $9.7699, and Gold… $753.63

That’s it for today… I wanted to wish my father a happy birthday today. He has been suffering from Parkinson’s diseases for several years, and my mother had to make the difficult decision to move him into a home last year. But he is receiving tremendous care in his new home, and we they are hosting a big birthday dinner for him tonight. Hope everyone has a Wonderful Wednesday! Happy Birthday DAD!!

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Chris Gaffney
October 22, 2008