Fallacy Of The Falling Dollar
The media has been heavily reporting that the falling dollar is responsible for the run-up in commodity prices. This is only partly true and only true since the bottom of the financial crisis in March of 2009. The real push in stocks, oil, commodities and gold has come more from financial intervention that the weakening of the dollar.
The media is replete with articles stating "Americans' cheap money spigot remains open and the flow is as fast as ever, meaning the world had better brace for even higher oil, metals and food prices and a weaker dollar." While the clear message from Federal Reserve Chairman Ben Bernanke on Wednesday was that the U.S. central bank intends to keep interest rates exceptionally low and monetary policy very easy as it continues to try to inflate the U.S. economy back to health - traders took this idea to push all asset prices higher particularly in the assets with the most leverage - commodities.
However, as shown in the chart, the rise and fall of the dollar has not always been a direct translation between rising commodity and stock prices as the dollar falls in value. In the early part of the last decade the dollar was around 140 on the US Dollar index and began to fall in 2002 - but prior to that stocks and commodities was rising with a strengthening dollar. Again, immediately after the financial crisis, the dollar was strengthening along with all other asset classes as Quantitative Easing was induced upon the market.
Bernanke, is more of the culprit for rising asset prices, rather than a falling dollar, as he continues to encourage speculators, hedge funds and proprietary trading desks to keep borrowing in dollars, paying virtually nothing and then swapping those dollars into higher-yielding currencies or using them to buy oil, metals and food futures and options.
This so-called "carry trade" has become, once again as it was prior to the last crisis, the "trade" to be in. It is highly profitable and fairly riskless when you are sure that the Federal Reserve is their to backstop any decline in the market.
Of course, the biggest risk that we have to be concerned with is that loose monetary policy once again creates the unintended consequence of boom-goes-bust, where easy-money-driven asset bubbles implode and confidence is consequently sucked out of the economy.
The record low U.S. rates of zero to 0.25 percent, which is actually -2.0% once the impact of the massive fiscal stimulus is accounted for, combined with the enormous supply of liquidity in the system due to the Fed's purchases of more than $2 trillion of Treasury and mortgage bonds, is pushing investors to seek higher returns through leveraged transactions.
A rough estimate from investment advisory firm Pi Economics in Stamford, Connecticut, showed that the Fed's easing may have fueled dollar carry trades in excess of $1 trillion, based on U.S. financial institutions' net foreign assets positions.
There is, of course, the same risk that was prevalent during the run up to the peak in 2008. No one saw the risks, save us and a few others, as valuations were in line, earnings were growing, and all was right with the world. There is entirely to much of the same rhetoric today. If everything is so good with earnings, production, etc., then why did the economy just turn in a very sub-par 1.8% growth rate and consumer and business confidence are still near recessionary lows.
The current carry-trade is very crowded and, as with in any over-crowded trade, there is always the risk of a squeeze once things get sour. This would lead to a massive unwinding of carry trades and the potential for huge losses for those slow to get out. When global stocks drop, or when the risk barometer shoots up, investors tend to repatriate funds, close out losing carry trades and buy back currencies they had shorted. This is what happened in 2008 during the global financial crisis and could well happen again.
The bottom line is no matter how you slice it the current push in commodities, gold, oil and stocks is more of a function of a Federal Reserve induced carry-trade rather than just a fall in the dollar. Instead of investors shorting the Yen leading up to 2008 to induce the carry trade - today the world is shorting the US Dollar. This probably won't end well.