Monday, September 8, 2008

The Great Dollar Pump of 2008: A Doomed Central Bank Intervention

If you are a holder of Powershares dollar bearish fund (UDN), gold (GLD) or silver (SLV), you’ve been taking a beating since late July/early August, as the dollar has powered forward, against all odds, in a bewildering climb against virtually all other currencies. In the past few weeks, after having been on a downward trajectory for years, the dollar suddenly appreciated against the euro, pound sterling, yen, ruble, rupee and almost every other world currency. On September 4, 2008, the U.S. dollar index rose an incredible 48 cents, while the DOW fell by 344 points!

How can the dollar be rising, in the face of overwhelmingly negative fundamentals? Big bank “analysts” are telling us the dollar is going up because Europe is following the U.S.A. into recession. But, this proposition is ridiculous. No other nation has been as adversely affected by the credit crisis than America, where the mess began. Ok, maybe the U.K. also. It shares our language, and most of the big Wall Street players are deeply enmeshed with players on High Street. The Bank of England does somersaults for High Street just as the Federal Reserve does for Wall Street. Both nations have essentially followed an identical path to economic implosion. This is not true of continental Europe, however.

Europe’s economy is weaker, yes. The rise in the euro’s value has hurt exports. However, the vast majority of economists agree that the ECB will not reduce interest rates until the second half of 2009. That’s a long time from now. A lot can happen between then and now. The US economy, in contrast, continues to worsen, day after day, even after the Fed dramatically lowered rates. The cuts have not worked. The U.S. overnight loan rate is less than half that of the ECB – fully 225 basis points lower. The USA has a $750 billion per year current account deficit, and it continues to rise. It has huge federal and state budget deficits. Americans save less and spend more than any other people on earth. The US economy has been hollowed out, after years of transferring vital industries to Asia. Europe, by contrast, has just begun the process of outsourcing its industry. The rising dollar has renewed the habit of importing excessive quantities of goods, because it makes foreign products cheaper for Americans. It is now very likely that the one bright spot in the U.S. economy, manufacturing for export, has been torpedoed.

The American banking system is under more stress than any other. U.S. banks are tottering, and several could fail at any moment. The Federal Reserve is favoring certain financial institutions and individuals over others, and committing taxpayer money to bailing out incompetent managements. The Fed has already polluted its balance sheets with $450 billion dollars worth of highly default prone mortgage backed trash given to it by favored institutions. This trash now amounts to almost half of the Fed’s balance sheet. The Fed’s balance sheet is the one that is supposed to back the U.S. dollar.

Remember, the real name of the dollar is “U.S. Federal Reserve Note.” That is printed across the top of every one of them. Legislation has been passed in Congress that will make things much worse. The American taxpayer is now on the hook to absorb hundreds of billions of dollars worth of likely defaults in Fannie Mae and Freddie Mac mortgages. Meanwhile, extremely overpaid executives have either already absorbed or frittered away prior profits. In short, America is riddled with a system of crony capitalism.

In the face of these fundamentals, the U.S. dollar has paradoxically appreciated against the euro, ruble, rupee, yen, real, Singapore dollar and almost all other currencies. How can this happen? Look past the double-speak, and the answer will be staring you in the face. First, we should note that the U.S. government has given its blessing to China when it enacted new currency controls, “forcing its commercial banks to build up large dollar reserves, using them as arms-length proxies in a renewed campaign of exchange rate intervention” [see here].

Previously, the Bush Administration screamed about such things, but, not now. We haven’t heard one sound, coming from the Bushies, about China’s renewed currency interventions. There’s an election happening, and the Republican candidate needs a highly valued dollars. They are financial morphine, allowing the import of cheaper goods, including clothing, toys and gasoline. While China has been forcing its commercial banks to hold more dollars, there has also been huge buying, by foreign central banks, of American treasury bills. In August, the increase in Treasury bill buying far exceeded that which is needed, to offset the huge U.S. trade deficit. The Treasury bill buying happened right before the value of the U.S. dollar started surging. See here [PDF file]. Aside from China’s currency interventions, and the heavy sale of new treasury bills helped. But, far more powerful forces have now come into play.

In March, a group of central banks planned a huge and coordinated currency intervention to buy dollars, in the world currency markets, to support the U.S. dollar [see here]. They have now started to act on their plans. To kick off the dollar intervention, the U.S. Exchange rate stabilization fund [ESF] sold about 6 billion euros in late June (see here). Where did the euros go? In my opinion, they were placed with three primary dealer banks, for the purpose of buying dollar derivatives.

Ah, you protest? 6 billion euros? A “drop in the bucket”? Worldwide currency markets involve the trading of trillions of dollars, not billions? The Europeans could print enough euros to absorb trillions of U.S. dollars, but not the U.S.A.? You are right on all counts. However, you are still wrong. It is true that the U.S. Treasury doesn’t control the euro printing press. It is also true that, if the ECB printed enough euros to soak up trillions of dollars, worldwide inflation would run wild. It is also true that 6 billion euros, when viewed alone, are nothing but a drop in the bucket. However, you’ve missed one thing.

One of the primary reasons so many “trillions” of dollars are floating about, in the so-called “currency markets” is because a lot of those dollars are “nominal” dollars. They are electronic, not real, and they are created by banks, not directly by the Federal Reserve. Trillions of “nominal” dollars are created, every day, in the form of agreements between banks. This is the nature of fractional banking, and, particular, it is the nature of derivative writing.

By using derivatives, a few billion euros, can be multiplied to exercise temporary control over trillions of dollars. If you remove a trillion dollars or so, from trader control, and take them out of the mix, the value of the U.S. dollar can be pumped up very easily. The most important first step is to take out the dollar short sellers by attacking their stop loss positions.

Prior to the intervention, most major American, European and Asian institutions held short positions in the dollar. In order to kick off the dollar intervention, they needed a substantial initial pump. Later, it becomes easier. The first pump will be used to massively drain dollars from the world system, in order to forcibly raise its cross-currency value, above the first big stop loss point. These stop loss points are well known to the Fed’s primary dealers, because they are fully enmeshed in the fabric of the worldwide trading system. Once the value was forced to the first major stop loss point, a massive covering of shorts positions began. Short after short scrambled for cover in the biggest short squeeze in history. The short position in the dollar was so enormous, up until mid-July, that, after that first stop loss point was taken down, only minimal additional effort was needed to attack the next ones. With a little added pressure, stop loss after stop loss can be demolished, and short sellers will run scared, desperately buying dollars, wherever they can, trying their best to cover what appear to be impending catastrophic losses.

At some point, the dollar gained a momentum of its own. People who were previously short, and “stopped out”, decided that the wind was blowing in favor of the dollar. These opportunistic fellows converted their funds to go long on the dollar and short on euros, yen, and whatever. We are in the midst of this reversal right now, after the major part of the intervention has run its course. The powers-that-be are still intervening, to some extent, but they don’t need to use as much force, and have probably unloaded a lot of the long contracts already, at either a profit, or, at worst, a very small loss. The rest of the money will be returned to the ESF, and, probably, to the ECB, which probably participated.

In my article, published September 4, 2008 titled Precious Metals Manipulation: Lawyers Prepare for Battle, I noted that 3 banks seem responsible for torpedoing the precious metals market, by writing a huge short position in gold and silver, immediately prior to the surge in the U.S. dollar. Some or, probably, all of those banks may have worked with the U.S. government in issuing dollar devouring derivatives.

The CME and NYMEX are huge derivatives markets, but they do not compare in size to the unregulated “dark pools” which are inter-institutional OTC forwards markets. Derivatives purchased by the ESF were probably obtained on the OTC derivatives market, rather than any regulated exchange. This insured that the entire process was secret, and few or no public records were kept, except the fact that the ESF sold 6 billion euros.

Using derivatives to temporarily remove large amounts of currency from circulation, temporarily, will manifest itself as a false reading on the M3 money supply, and that is exactly what we’ve seen, in some surveys this August. The reading is misleading. The money is only temporarily out of the system. It will shortly return, if it hasn’t already, to generate inflation. Innocent third parties will suffer a few billion worth of losses on the instruments, as the dollar falls back down in value. The third parties, of course, are unaware of the shenanigans, and they have bought control over the derivatives as part of either a hedge against other bets, or in the expectation that the dollar will be stable or will continue going up. When the dollar starts going down, again, they will be forced to sell them back to the writers, at a loss, and the episode will be closed. The consortium of writing banks will be richer, the U.S. ESF will get most of its investment back, and, the third party financial institutions will take losses, but they won’t know why, so, who cares about them, right?

The end game is a hope, on the part of the central banks that, in a matter of a few months, market psychology can be materially altered. Losses to the innocent third parties is considered inevitable “fallout” of war – something like friendly fire and collateral damage in real war. This mentality is fundamentally flawed. The lessons taught by Adam Smith, in his Wealth of Nations, are ignored, in favor of a type of financial “fascism”. Central bankers are essentially copying the type of bankrupt micro-management that caused the downfall of the former Soviet Union. The IMF, and these same central bankers have often condemned emerging market countries, like Venezuela, Argentina and India, for practicing the same type of financial fascism, and rightfully so. Yet, now, they are involved in it too.

Back in 2000, central bankers engaged in an intervention to save the euro, but they had more assets at that time to work with. The newly born euro was collapsing because of the irrational fears of a population that was about to lose money they were familiar with – well known national currencies, like the franc, lira, peseta and mark. Central bankers from the G7 intervened and heavily propped up the euro. That intervention changed the psychology, and was so successful that, subsequently, the euro embarked on an upward trajectory that lasted for years. In fact, the upward euro movement didn’t stop until the recent massive dollar intervention. Clearly, they are hoping for the same result, now. This intervention, however, in the long run, is doomed. Unlike the euro, the U.S. dollar is not the subject of irrational fear. All fears about the dollar are entirely rational and correct. In fact, not being fearful about the dollar’s future is irrational. Indeed, it is very probable that there was an earlier stealth dollar intervention back in 2005. The effect lasted a long time, but not forever. But, in 2005, we did not have the currency crisis on our hands. Nor did we face the prospect of massive bank failures.

To illustrate the availability of derivatives that could be purchased with 6 billion euros or less, here is the most recent statistical table, published by the Bank of International Settlements, in Switzerland, which shows that, at the end of 2007, over $14 trillion nominal dollars worth of currency swaps were available to carry out the intervention. As you can see, it would be easy to take a trillion or so dollars temporarily out of circulation by using locking up just a small portion of these derivatives with the 6 trillion euros sold by the U.S. ESF.

click to enlarge

So, now you have a burning question. If big shot central bankers are supporting the dollar, why shouldn’t you get in on the fun? You are probably a bit too late for the party. If you get in, now, you’ll stand a very good chance of losing money, unless it is a day or hour by hour play. Buying dollars might have been a good short term play in mid-July. But, it isn’t anymore. The hope of the central bankers, that anti-dollar sentiment can be changed in the long term, through concerted currency intervention, is a foolish one. We would all love it if the dollar were a sound, well managed, currency that we could rely on.

But, no amount of playing with derivatives will change that simple fact of life. The dollar’s fundamentals are terrible. The fall of the dollar is a rational reaction to a massively mismanaged paper currency that has no inherent value, and is no longer linked to anything that does have value. When currency intervention ends, people will want out of the dollar, again, for the same reasons as before. The dollar surge will come to an abrupt halt when all the derivatives are sold back to the writers. At this point, most of them probably are, already, or soon will be. Left on its own, the dollar will tank.

While private manipulation of the gold market is a felony, government intervention in worldwide currency markets, unfortunately, is perfectly legal. Though it contradicts basic principles of capitalism, it is considered a “sovereign right”. Nevertheless, the impending nationalization of Freddie Mac and Fannie Mae will add about $6 trillion to the Federal deficit. If we are lucky, the loss rate from defaults on GSE related bonds will not exceed 4-8% overall. The U.S. government, therefore, will be forced to print from $250 - $500 billion new dollars to offset losses in the next 2-3 years.

As you know, from a glance at the table of derivatives supplied by the BIS, this means tens of trillions of new nominal dollars will be floating about. In addition, it is very likely that a few hundred billion more dollars will need to be printed to bail out the FDIC insurance fund, as noted in my previous writings, with similar end results, due to fractional banking principles. In short, the nominal U.S. dollar money supply is about to increase by exponential amounts, which will inevitably lead to incredible levels of inflation. According to the calculations of economist, Nouriel Roubini, from $1 to about $2 trillion worth of “value” (prior production of goods and services) will be have been removed from the system, by the people who eventually default.

In other words, the subprime borrowers, ARM mortgagees, and the others who don’t pay their bills as promised, will not be doing the nominal “work”, within the economy, that they “promised” to do, in order to compensate for the huge benefit they took, prior to filing bankruptcy or otherwise defaulting on debt. This must result in a severe recession even though the price of everything will be rising, at the same time, from the shortages that result. It is a mathematical relationship that we can try to hide through Orwellian double-speak, as our government is keen on doing, but, in truth, there is just no way out.

Prior to the credit crisis, the Federal Reserve balance sheet amounted to about $940 billion worth of treasury bills. This was the fundamental support for the “Federal Reserve Note” that we affectionately talk about as the U.S. dollar. That is also now polluted with about $450 billion worth of default prone mortgage backed securities, thanks to efforts to bail out big banks from their business mistakes. This leaves the U.S. dollar with less than $500 billion in solid support. Of course, with each additional new Treasury bill that Congress is forced to issue, to support printing more money, the remaining “solid support” becomes more shaky.

In other words, let us not delude ourselves. The U.S. dollar is a medium and long term sell, with capital letters, not a buy.

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