In our latest Toward a New World Order, Part III we ended by promising to look closer at investment implications from the political and economic shift we currently find ourselves in; and that story must begin with the dollar. While known to the investing public for years, the Bank of International Settlements (BIS) recently acknowledge that the real risk-off / risk-on metric in global markets is the dollar and nothing else.
In the chart below, which we recreated from an absolute brilliant presentation by Macro Intelligence 2 Partners via RealVision-TV, we see the potential scale of the coming “dollar-problem”. The dollar moves in cycles as most things. The lower extreme around 84, only broken when Bernanke pushed through QE2, means financial conditions for emerging markets and other commodity producing economies have gotten so out of hand that conventional risk-metrics finally lead investors to pull back. The trigger, as can be seen in the chart, is often policy driven, but the underlying structural imbalance has been building for years, if not decades, prior.
Before we move on it is of utmost importance to understand that many of the dollar liabilities accumulated outside the United States are not backed by actual dollars, but are rather claims to dollar proper. This is the infamous Eurodollar market whereby banks, mostly international European ones, fund various economic activities by issuing claims to dollars, but for which no such dollars exists. Think of it as another layer of fractional reserve lending on top of fractionally created money in the first place.
When risk metrics stray too far from what is considered prudent, investors start to pull money out from emerging markets, and obviously demand that their investments are paid out in dollars. To comply, international banks scramble to get hold of as many dollars as they can in the shortest time possible in order to fulfil their part of the bargain. The value of the dollar jumps as demand suddenly outstrips supply. Financial conditions in emerging markets tighten significantly and it becomes impossible to fund further expansion. Emerging market banks, with dollar liabilities and LCU assets are particularly vulnerable. The boom turns to bust as the Eurodollar market breaks. If the cycle gets out of hand, as it did from 2008 onwards, banking solvency is not only limited to local emerging market banks, but to the international banking community at large.Taking a closer look at the previous dollar cycles, as represented by the real broad based dollar index we find that the initial shock pushes the dollar 20 – 25% higher from its low. It then pauses, drops 5% before starting a second leg higher (we outlined this process back in October). This is exactly where we are at now and if history repeats itself, which we believe it will, a new financial crisis is brewing just under the surface as the dollar moves into its second leg.
HT: ZeroHedge (don't buy gold)There are also other compelling arguments for the strong dollar case. If President-Elect Trump moves forward with his policy promises, such as changing the tax-system in accordance with the principle of destination based taxation; exports will be tax exempt, while imports will fully taxed at the corporate rate. The dollar may strengthen as much as 10 – 15% on this tax alone. Furthermore, if American companies repatriate some of their trillions held abroad it will put additional pressure on the price of dollars. Some may argue that dollars held in Wall Street are just as fungible as those held in Tokyo, Hong Kong or London, but given new money market regulations that may no longer be the case. Prime funds are starved of cash, while those investing in government bills are flush. It is therefore highly likely that repatriated cash will be stuck in New York money markets and create additional pressure on Eurodollar markets....MORE