I’ve been writing a lot recently about the dollar vs gold trade, with the emphasis of the discussion being on gold analysis.  The problem is that there are a lot more individuals who care more about dollar FX markets than they do about gold.  This has been the case regarding the network of people I work and converse with on a daily basis, and this has definitely been the case with main stream media.

The latter subject is the actual reason I decided to sit down and write up a piece regarding the U.S. dollar.  More specifically, on CNBC this past Friday and Monday, I’ve heard several times dollar bulls claiming dollar doomsayers have once and for all been proven wrong.  They claim the dollar correction to be done and behind us, meanwhile the greenback is repositioning itself as the reserve currency in the world.  Well, I’ve just about had enough of that talk and I am here today to debunk that farce while explaining just how the dollar rally has taken place

Wall Street’s Demise Driving the Dollar?

Let’s start this discussion in a fitting place: credit markets.  The turmoil in credit markets has been widely covered with most of the emphasis on that coverage being in the wrong places.

The first part to understanding how the short term credit tightness resulted in a dollar rally is nderstanding that almost ALL credit derivatives are valued in U.S. dollars.

Let’s look at the Lehman Brothers CDS trigger for an example.  Lehman had corporate bond volume of $160 billion.  Tied to that $160 billion was $400 billion in credit default swaps that were triggered.  Of that $400 billion, it appears that around $300 billion of those CDS have been settled through payment.  That means $300 billion U.S. dollars needed to be secured through the FX markets and transferred to the counter party.  This is obviously dollar bullish in the immediate short term.

Although the numbers differ, this scenario is essentially identical for AIG and the rest of the CDS that have triggered.  It’s also important to note the conflict of interest here.  Understanding that there are several shoes to drop and corporate bankruptcies to ensue, there are still several large CDS triggers to come.  The holders of these swaps must secure dollars to settle these contracts.  The stronger the dollar is, the more stress it puts on the parties to meet their obligations.  I promise you that the U.S. government and the Federal Reserve understand this and will act accordingly in order to limit some of the stress this will put on credit markets.  That is very dollar bearish in the long term and should be noted.

Credit Spreads Unwinding

In continuing this discussion, we are going to stay within the realm of credit markets, but look at it from a different perspective.  If you watch or read any financial media you’re most likely familiar with the notion of credit spreads.  Analysts use credit spreads in all markets to analyze a number of different items ranging from inflation to credit default risks.

That’s all great, but what you hear about less is the trillions of dollars that trade these spreads.  The aggregate positions between career traders, hedge funds, and other investment funds that trade inter-market credit spreads are truly massive.

The problem, similar to many of the historical trends that were considered to be set in stone, is that the trend changed.  We’ve seen this with the crack spread, and the unwinding of the carry trade as they deviate from their historic norms.  What had been the norm, no longer is.  Understanding that there was a global liquidity glut in these things and the lack of a counter party, meaning the trade was essentially one sided, when the worm turned, it was very difficult for these positions to be liquidated.

One of those spreads that was over utilized was the spread between short government debt and long private sector debt.  Obviously this spread has been destroyed and had you traded the exact opposite position, you would most likely be retired and extremely wealthy by now.

So what does this have to do with the U.S. dollar?  The trillions of dollars that was short government debt and long private debt was forced into margin call and massive puking of positions ensued.  Similar to the situation with the Lehman CDS, to cover the government debts shorts, the funds must secure U.S. dollars.  This short covering resulted in massive unintended dollar buying and was a main driver behind the dollar strength.

The two issues discussed in this article aren’t the ONLY drivers of the recent dollar strength, but they are the MAIN drivers.  The most common reason for the dollar strength that you hear of is the cash is king theory.  This is true, but is NOT the main reason for the dollar strength.  Understanding these notions on a very basic level is TRULY ESSENTIAL in understanding the current relationships driving capital flows, and therefore driving ALL FINANCIAL MARKETS.  Most importantly, we must realize that the same factors that are driving the dollar up in the short term are actually BEARISH in the long term.  THE DOLLAR IS TERMANILLY ILL.

Nicholas Jones
Analyst, Oxbury Research