How Much Capital Does it Take to Lift a Dollar?

On March 18, 2010 the Gold Anti-Trust Action Committee (GATA) wrote CFTC Chairman Gary Gensler a letter calling to his attention evidence that suggests an anti-gold cartel consisting of the U.S. Treasury, the Fed, and the bullion banks has been suppressing the gold price, and that this action is coordinated to further the “strong dollar” policy established by former U.S. Treasury Secretary Lawrence Summers.

If indeed this is the case, since all interventions end badly, a valuable question to answer is whether there are signs that the intervention has gotten long in the tooth. The most obvious would be that the capital required to rescue the ailing buck would be significantly higher than it was prior to the meltdown of the credit markets in 2008. Indeed, Peter Schiff speculated the dollar rally would end badly just three days before the GATA letter was published.

An increasingly less efficacious intervention also might explain why gold is the only asset that is close to new highs, whereas other commodities and equities generally have not completely recovered from that shock. Moreover, we know that the Fed has had to devote resources prop up the market for Treasury securities and the mortgage market. The party line is that due to the recovery such assistance is no longer needed. By historical analogy, a tightening to defend the dollar and to raise interest rates was seen in 1931, shortly before the wheels began to come off the world economy.

When the financial system collapsed in 2008, where did we turn to keep the ball rolling? First the Fed injected reserves into zombie banks, and shortly thereafter it resorted to quantitative easing. Since banks in the U.S. may be all loaned out and consumers are busy paying down debt, that effort may not have produced much benefit. Eight million jobs have been lost, foreclosures are in the millions, and bank failures continue. The broad money supply has flatlined, and loans are falling year-over-year.

Instead, credit expanded dramatically in developing nations such as China and India. The dollar remains the reserve currency, so other countries pyramid their money upon the reserves we export to them from running a gigantic trade deficit. In the orbit of the core supply of dollars here in the United States is a greater amount of Euros and a rapidly expanding pool of other fiat currencies. Collectively, the motion at the wide end of the money pyramid has the greatest effect upon the world economy.

Emerging nations such as China and India were encouraged to print yuans and rupees prodigiously. If you ran the Chinese money system and you were accused by Fed-subsidized economists of having manipulated your currency to be undervalued, would you revalue it and shut down your export industries, particularly if they were owned by key communist cadres? Or would you print at 20% to 30% annually – an amount sufficient to double your money supply within about three years – and then tell your citizens to exchange this newly created paper for gold and silver? You would also order your corporate sector to acquire hard assets, which would also lock in your newly printed wealth. If you successfully pulled that one off, wouldn’t you be twice as rich as you were before – just as long as you didn’t trigger much higher inflation in your country? (Some evidence of that is beginning to mount).

You would especially want to do this and direct your purchases to the gold market if, as GATA has documented, there exists a cartel which is suppressing the gold price for you. The Chinese may be swinging at this pitch, but we may not know for some time to come, judging by their disclosure of reserve accumulation over the last few years. If they did, it would be easy for them to hit the ball out of the park, financially speaking. But the more troubling question is why have we left in the relief pitcher who gave up a grand slam after Greenspan loaded the bases? Not only is he likely to cough up another couple of homers for the “away” team and increase the already horrendous earned run average of our central bank, there doesn’t appear to be any promising talent in a bull pen filled with arms more suitable to amateur ball.

In the early 1930s, governments competed to resuscitate economic growth amid a mega-cycle credit contraction by pursuing a “beggar-thy-neighbor” policy. One by one they devalued their currencies in terms of gold, and the outcome for each that did was temporarily higher output and trade accounts. The U.S. did not devalue until 1934, which caused its industrial production to plunge some 50% before it cried “uncle” and followed suit, negating the temporary advantage achieved by other nations.

Since currencies are freely floating today, that tactic is not an option, unless some countries opt to reset their currency to gold at high prices, an eventuality discussed in my book, Endless Money (John Wiley, 2010). Instead we are seeing the same competition for survival amid a credit collapse, but it is being addressed with a different set of policy tools. The BRIC countries are printing money in astonishing quantities, which makes U.S. debt increasingly valuable – and more unable to be repaid. We are once again flatfooted while the rest of the world runs circles around us. As our policy makers read from their Keynesian and monetarist playbooks, they misguidedly cheer our competitors on.

When the U.S. dollar’s declining trend was broken last December, more than a few technicians and gurus noticed the change and declared that the greenback was poised to rise. Did the Australian meeting of central bankers outline a globally coordinated exit plan that would start with a surprise discount rate hike by the Fed, continuing the Larry Summers “strong dollar” policy of shorting paper ounces of gold and goosing up the dollar? With the Greek crisis boiling over in the second week of February, there emerged right on cue a fundamental reason to support the bull case for the greenback. If the credit bubble spawned from 20% to 30% money supply expansion in emerging markets collapses, then there could be more reason to hoard dollars. Would the strengthening dollar cut short the U.S. recovery?

Like stacking the batting lineup with left-handed hitters, the Chinese have neutralized the Fed’s right-handed curveball pitches. A strong dollar has no effect on the yuan or other pegged currencies. It may help the Treasury sell bonds at a more advantageous price to certain foreign nations which aren’t as directly on the receiving end of U.S. import demand. China still collects lots of dollars, and it may or may have not reinvested them in full recently. But the Japanese economy is on red alert, having collapsed by mid-double digits in 4Q08 and 1Q09, and its government has exhausted its ability to borrow from its own citizens. Like a giant hedge fund, it has borrowed massively in yen and speculated in dollars.

Supposedly, the Fed’s program of “Quantitative Easing” is over. The exit plan has begun. But who will buy U.S. debt? Is not the Fed’s raising of rates eerily similar to the tightening of September 1931, which began in response to a weakening dollar consensus? Here is a quotation from Ben Bernanke’s 2002 speech honoring Milton Friedman that describes how juicing the dollar in 1931 was one of the key policy mistakes alleged in the famous Friedman-Schwartz Monetary History of the United States:

“On October 9 [1931], the Reserve Bank of New York raised its rediscount rate to 2-1/2 per cent, and on October 16, to 3-1/2 per cent–the sharpest rise within so brief a period in the whole history of the System, before or since (p. 317). This action stemmed the outflow of gold but contributed to what Friedman and Schwartz called a “spectacular” increase in bank failures and bank runs, with 522 commercial banks closing their doors in October alone. The policy tightening and the ongoing collapse of the banking system caused the money supply to fall precipitously, and the declines in output and prices became even more virulent. Again, the logic is that a monetary policy change related to objectives other than the domestic economy–in this case, defense of the dollar against external attack–were followed by changes in domestic output and prices in the predicted direction.”

It may be years before a Fed audit or Freedom of Information Act filings reveal the extent of capital market manipulation that is occurring. Even if it were known, economists would be apt to cite “seen” over “unseen” effects. We can simply point to anecdotal evidence. It would be convenient to know if the intervention is nearing an end, sinking of its own weight. Here is one clue that might support the case that manipulation of our currency has become a Sisyphean task: Trading volume in the U.S. dollar ETFs, which necessarily captures a small percentage of foreign exchange trading volume, is exhibiting a huge imbalance.

When there was a strong consensus in 2009 that the buck was burning, trading volume in the UDN derivative, which is short the U.S. dollar, picked up and averaged just fewer than 2 million shares weekly. In some weeks, volume got close to 6 million.

Figure 1: UDN ETF 3-Year Chart. Courtesy

In contrast, once the dollar rally began, volume in the UUP, which is long the U.S. dollar, suddenly jumped from levels similar to the UDN to 20 million or more shares weekly. Moreover, its underlying assets have swelled to ten times that of the UDN, weighing in at over $2 billion compared to UDN’s slight excess over $200 million. So nearly ten times as much money has been spent to send the dollar up about 10% as was placed to make it fall by some 25%.

Figure 2: UUP ETF 3-Year Chart. Courtesy

All this has happened even though arguably there was somewhat more unanimity of opinion that the dollar would weaken in 2009 than there is it should strengthen now. Naysayers will claim that what is happening in this small pocket of foreign exchange trading is not terribly relevant. Or they might say it only reflects retail investor sentiment. But more than a few hedge funds participate in the ETF market, so there is an institutional presence there, and arbitrage is possible.

If the theoretical case being built by GATA is correct, then we may be witnessing reduced effectiveness of Fed and Treasury intervention, with the result being Mudville’s aging relief pitchers are certain to get pounded again. We may not be in the final innings yet, because we have not yet seen a series of rate hikes – which are sure to be a drawn out affair of meaningless 25 basis point increments – and simply because the counter rally in the dollar has only gone on for a few months. When you are dealing with irrationality, whether it is trading exuberance or the modern day application of busted economic theories, calling an inflection point is more an art than a science.


Bill Baker,
for The Daily Reckoning

[For more of William W. Baker’s financial commentary you can visit his website here: The Conservative Economist.]