Wednesday, February 16, 2011

Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

I am bearish on the US Dollar Long Term. This is no secret and I have been an outspoken critic of US monetary policy for a long time. Will we get a continued rally in the Dollar for the short term (next few months)? Yes, I think that is likely. But even a few months is short term in the bigger environment.

Here is an in-depth macro analysis of the Dollar that I wrote months ago:
Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog. Aside from the fundamentals, I think the technicals also paint a bleak long term picture for the Dollar:

But just because the Dollar will be weaker in the future, it DOES NOT mean that equities as a general asset class will go up. This "all one market" theory of everything trading inversely to the dollar does not make any sense at the macroeconomic level, and because everybody is using this phrase now, I am more confident that we are in the process of ending the inverse correlation between the US Dollar and Assets.

Historically, there is far more positive correlation between the US Dollar and Equities than there is inverse correlation.

I made this forecast a while ago, and the macroeconomics are finally starting to play out. The main culprit? Debt Saturation -

Since we are nearing an important macroeconomic juncture, I thought it might be useful to review a few things to put what has happened into perspective

First, we have the credit bubble bursting. In 2007, We are coming off a flat, and sometimes even inverted, yield curve in 2005-2006 and the curve begins to steepen. This is a sign of things to come. Financials are in horrible shape. Leveraged to the hilt and untrusting (LIBOR is at >5%), it takes only the exhaustion of bullish euphoria to start the avalanche. Financials lead the slide down, the yield curve continues to steepen, confidence and over-bullishness is replaced by fear.

Next we have the Great Deleveraging Event of 2008. It is clear the game is up and everybody has to liquidate their over-leveraged positions. We see some interesting behavior take place. The Dollar rallies, as people fly into Treasuries as a safe haven move (not unexpected). The Dollar doesn't rally because it is "strong", it rallies because it is "in the way" (by definition, you have to move assets into US Dollars to buy US Treasuries).

But we also have a very steep drop in LIBOR during the deleveraging crisis. Why is that? If everybody, most especially financials are scared, because there is a deleveraging and liquidity crisis, why would LIBOR go down?

Because the Fed was pumping the system with Dollar Swaps!!

**If you want the real reason for the "bottom" in March 2009, there it is.**

All arguments for compelling valuations are BS, or "once in a lifetime buying opportunities" are BS. We stopped the freefall NOT because the market said "no mas", but because the Fed stuck an inflatable pool halfway underneath the cliff divers trajectory. It forced liquidity into the system as it was seizing up. If you really want to understand this issue, read Kristjan Velbri's excellent post Dollar Liquidity Swaps & The Financial Crisis.

The "all one market" / "everything moves inverse to the Dollar" theory is a fallacy. The Fed does not make the market, it is part of it. So this was *always* going to be a transient event. In fact I stated this months ago:

Short term is all noise. And the current dollar weakness is fueling the equity rally. Long term, equities will go down (due to poor fundamentals) and the dollar will go down (due to confidence crisis) together (such as 2007-2008 and numerous other occasions)

By and large, there is **far more** positive correlation between the Dollar and Equities than there is inverse correlation. They both go up and down together as evidenced in the chart above.

However, many others including myself, have observed that the "weak dollar" is currently fueling the the equity rally right now. So why the discrepancy?

Because you need to realize that we are still in the aftermath of the Greatest Deleveraging Event in History (2008)!

During the meltdown of 2008, everything was sold / redeemed for the relative "safety" (used exceptionally loosely) of Treasuries: shares in hedge funds, commodities, stocks, etc. As such there was a massive dollar repatriation. The dollar didn't gain value because it was strong! It did because it was "in the way" (you have to buy dollars in order to buy treasuries, it is sort of a necessity that way).

In the ensuing months we have seen the Fed ream bondholders through ever more massive QE salvos, intentionally destroying the "value" of US Treasury debt and the US Dollar. Since that time, money has been moving back out of Treasuries (putting downward pressure on the dollar) and into more speculative endeavors (the stock market). You can see here that there is not a "if the Dollar goes down then Equities must go up" relationship here. Money was leaving treasuries and equities were oversold so they were bought. That's it. Another force at work is the fact that the weak dollar and the oversold nature of equities a few months ago made stocks attractive to relatively stronger foreign currency holders, who could "get more bang for their Euro" so to speak.

You can see that the current inverse relationship between the Dollar and Equities is a product of a very particular setup and is not a given. In fact, the relative valuation of all of these asset classes (Treasuries, Dollar, Foreign Currencies, and US Equities) has shifted a lot the last few months. Anybody expecting this "status-quo" relationship to persist much farther into the future is going to be rudely surprised.

Where are we now?

We have macroeconomic tremors occurring. Sovereign debt concerns are palpable. The concern about Financial leveraged positions in 2007 are the exact same concerns that investors have about Sovereign balance sheets in 2010. However, instead of "liquidating", Governments are financing growing deficits in the face of declining tax revenues with deficit spending and quantitative easing (good old-fashioned money printing / currency devaluation).

This is bearish for the outlook for the economy (Debt Saturation - and bearish for the stock market as well (What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations -

And the current LIBOR picture? I think it is starting to doubt the efficacy of Ben's "perpetual ZIRP policy"

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