Synthetic Shorts, the Senior Currency and a System Saturated with Credit
Yesterday, I gave a potential reason why the dollar might be due for a rally in the coming weeks and months. That reason had to do with increasing international uncertainty that could cause a migration of assets out of speculative markets and into the global reserve currency, which at present remains the US Dollar. Yesterday's example was just one potential scenario. I received many comments on the article, (and I welcome more), and was somewhat surprised to find that many readers out there share the same opinion.
The idea of a rising dollar in a deflationary depression is certainly not a new one. Several analysts -- Richard Russell, Bob Hoye, and Robert Prechter among them -- share the opinion. An overview of the basic theory:
Russell has written that the massive amounts of dollar denominated debt in the global financial system amount to a massive "synthetic short position" against the dollar. From an April 2004 article at Gold Eagle:
What does [the synthetic short position] really mean? It means that to pay off debt you need dollars. Much of the US debt (thanks to the Fed's 1% short rates) has been built on a structure of low rates. But now, with rates rising, we're beginning to see a squeeze on debt, particularly on variable-rate mortgages. This is setting off a rush to raise dollars.
You can't print dollars the way the Fed does. So to raise dollars what do you do? To raise dollars you've got to borrow more or you've got to sell something, and by something I mean "anything" of value. So I believe what we're seeing now is the very beginning of a LIQUIDATION of assets. If it's got a market, it's being sold. We're seeing the early beginning of a move to raise dollars - to raise dollars to carry, to finance, and to pay off debt. Debt's "short position" against dollars is beginning to operate. Commodities, stocks, bonds, anything that is liquid is being sold to raise dollars.
Russell's comments came when rates were just starting to go up. We've now seen the Fed hike rates 17 times in a row. If we were starting to see a squeeze on debt in April 2004, that squeeze has only increased over the last 2 years.
Hoye, in an interview with Jay Taylor, echoes these sentiments in at article at Safehaven, February 2005, referring to the "senior currency" - i.e. the US dollar.
TAYLOR: ...Could this be next? Might the dollar fool everyone and get strong now?
HOYE: Quite likely. Back in previous bubbles, the financial capital was in London. Underwriters went around to places like Bolivia, Turkey, Chile, and Egyptian banks and everywhere else, because the demand for such paper seemed endless. So they floated a whole lot of "junk." Then, once the party is over, the debt becomes a burden.
TAYLOR: In the old days, their debt obligations were in sterling, which was the senior currency; whereas now, with New York being the financial center, the dollar is the senior currency?
HOYE: Yes. And all you need for this recipe to work is a bare majority of all the debt that is floated in the bubble to be contracted in U.S. dollars. Once the party is over, everyone then has to get their hands on U.S. dollars to service their obligations in New York.
Hoye was right on that call, made in February 2005, as the dollar rallied for most of the year. The logic remains in place.
Most recently, in the June 16 Issue of the Elliott Wave Theorist (Full issue available free, from July 12 - July 19) Prechter puts it this way:
The problem today is that not some individuals or corporations or governments, but the entire system is saturated with credit. Worse, much of that credit is propping up other credit, and this nth-generation credit is propping up the financial markets. When the financial markets go down, IOUs will come due. Conversely, when IOUs come due, markets will go down. People who must finance debt to maintain their standard of living will soon be selling everything and anything to stay afloat. When people on the edge are strapped, they will sell their investments to pay the interest on their debts. If they won't do it themselves, their creditors will do it for them. Banks are already repossessing homes at a furious pace. In Georgia, April foreclosures were up 300% from April 2005. This is only the beginning. . .
...Pundits tell us "We are in a hyperinflation, like 1920s Germany." No, we are not. In the early 1920s, the Allies told Germany to pay reparations that Germany couldn't afford. It found a practical solution in printing marks. The inflation of the past 73 years in not primarily currency inflation, but credit inflation. Credit can implode in a deflationary depression; currency cannot. Once currency is printed, it's out there for good. Some people argue that the Fed will print currency at a hyperinflationary rate, but that's a guess at best, and so far all we have seen is the same old game of facilitating credit. . .After it is obvious that credit stimulation has failed, hyperinflation may be a "last resort," but I stress the word may. In the 1930's it was no resort at all; the Fed opted to stay healthy instead. So before hyperinflation even might become a threat, you should be able to get wealthy betting on the downside. Even if you don't wish to speculate in that direction, you can get wealthy simply by maintaining your money and then employing it at the bottom.
These are the theories, basically similar in nature, from the people who make their living thinking about such things. Of course, you don't have to take their word just because they're "experts." Does it make sense to you?
The common hyperinflationary wisdom seems to be that the Fed will simply be able to "print" money to avoid a deflation. This is the idea that Bernanke so ineloquently expressed, landing him the chief job at the Fed and giving him the nickname "Printing Press". Yet Prechter raises a subtle, but very important point - the Fed does not print money per se, it issues credit, and there is a big difference. Credit can simply disappear, while currency that has been printed cannot. All the analysts quoted above assume that people/entities will liquidate assets to raise cash in order to service their debts. (Prechter notes that if they won't do it their creditors will do it for them!) But others will simply walk away from their debts. This, too, is deflationary. One man's debt is his counter party (usually the bank)'s asset, so if he defaults, suddenly the bank has fewer assets and merits a lower stock price. The stock of the bank, is of course, someone else's asset, and thus begins the game of what Greenspan called "cascading cross defaults." There is little question that cascading cross defaults are deflationary -- assets plunge in price and the stock of cash rises quickly because people desire to be liquid.
The dollar is now lower than when Russell made his "synthetic short position" argument above, but higher than when Hoye predicted the rally, though just barely. The decline has been a long one, and the rally, if its coming, is off to a shaky start...
One thing that is clear, the cost of money - i.e the cost of borrowing, or the cost of credit - is going up, in the form of interest rates. John Mauldin makes an excellent case for the Fed not being done with raising rates, even though everyone seems to think they are. As the cost of money goes up, demand decreases. Decreases in demand lead to a slowing economy. A slowing economy leads to people out of work, who can't service their debts, leading to defaults. Then we get to the point that the three analysts above are talking about above ...
Out of Time Again
Once again, I've taken to much of your time without fully getting to what I wanted to say. How did I get so verbose? I have a laundry list of contributing fundamental reasons that point to a rally in the dollar - if not imminently, then eventually. Should I put together a Part III tomorrow? I think I will. To be notified, sign up here, or just dial into www.bullnotbull.com tomorrow evening to read it. In the meantime, check out this excellent, somewhat related article by Chris Laird of the Prudent Squirrel: Gold and Stock Cream Out.
As always, comments are welcome, including and especially dissenters who believe that hyperinflation is inevitable. Its just no fun to have a one sided argument!
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