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Gold, Interest Rates, and the Great USD Short Unwind


In the backdrop of a US consumption bubble collapse, the dollar is rallying, gold is falling, and real interest rates are rising while nominal rates are falling.

Make no mistake, the collapse in gold prices is 100% consistent with a reduction in consumption and falling bond yields. This is a natural progression in a reduction in excess liquidity and should not be underestimated for what it portends for the global economic and market cycle.

Over the past couple of months two emerging market experts have been sounding the alarm about the recent currency market volatility and consequences of a strengthening US dollar. Andy Xie and George Magnus are two of the most well-respected authorities on emerging markets, and the recent US dollar rally has no doubt triggered some concerns due to previous cycles of dollar strength.

On February 4 in Caixin Online Singapore based economist Andy Xie, formerly of Morgan Stanley, wrote The Consequences of a Strong Dollar citing a potential crises in emerging markets:

The first dollar bull market in the 1980s triggered the Latin American debt crisis, the second the Asian Financial Crisis. Neither was a coincidence. In a dollar bear market, the liquidity goes into emerging economies, causing their currencies and asset prices to appreciate. The double gains attract more inflow, eventually causing inflation.

These economies lose competitiveness along the way. It is not noticed when asset appreciation supports domestic demand. When the dollar changes direction, so does liquidity. The virtuous cycle on the way up becomes a vicious one on the way down. The emerging economies already suffer inflation. The liquidity outflow leads to currency depreciation, which worsens inflation.

During a prolonged dollar bear market, dollar debt tends to rise in emerging economies. The weak dollar decreases the debt service burden, which emboldens the debtors to borrow more. Extrapolation is a recurring phenomenon in financial markets. Hence, over borrowing by emerging economies is inevitable in a dollar bear market.

When the dollar turns strong, the debt burden becomes unsustainable. Hence, no lenders want to roll over the loans anymore. A liquidity crisis ensues. This is what occurred in Latin America in the 1980s and Southeast Asia in the 1990s.

On February 25 in FT's Alphaville Blog David Keohane posted some comments from a report by economist George Magnus advisor to UBS.

Perhaps the most confident conclusion is that the upshot of these developments [slowing growth, credit expansion and Chinese growth and a stronger US dollar] should see a puncturing of the commodity cycle, at least as far as industrials and metals are concerned. This might prove to be a blessing for most emerging markets, since the majority are net oil and commodity importers. But as and when this happens, the source of weakness will have to be identified carefully. Lower commodity prices resulting from a rise in the US dollar alone might be welcome. But a strong US dollar, based on higher US real interests, and perhaps also reflecting concern about the shift in China's economic model and performance, would be a different matter.

On March 18 Mangus himself wrote an article in the FT titled Rising Dollar Marks Big Investment Shift:

The contrasting economic and financial conditions of the US vis-a-vis Japan and Europe could not be starker. The US dollar should be expected to trend higher against most leading currencies, and put industrial commodities and emerging market currencies and local debt under pressure.

Clearly the yen's rapid depreciation in response to the Bank of Japan's turbo-charged easing policy has been behind dollar strength and overall currency volatility, but this is just one side of the story, and simply looking at the dollar strength as a function of yen weakness ignores the much bigger implications for market prices.

In 2007 hedge fund Corriente Advisors headed by Mark Hart was preparing for their new strategy, the European Divergence Fund which was the first fund that had identified what we now know as the European debt crisis. The fund was positioned to profit from spread widening (divergence) of southern Europe sovereign interest rates to Germany. One piece of the thesis was predicated on excess US dollar reserves exported to Asia that ultimately found their way into investments in European sovereigns. They had noted that historically USD FX reserves tended to get deposited back at the Fed by foreign central banks but that in early 2007 as reserves continued to grow Fed custody holdings began to decline:

One possible explanation is that market participants are borrowing US$ heavily and buying assets in other countries around the world on the premise that the US$ can only fall. One such asset has been, we believe, EMU government bonds.

JPYUSD Vs. Gold Over Percent of USD FX Reserves Deposited at the Fed

During the last dollar bull market in 1996 there were $760 billion in USD foreign exchange reserves representing 9.5% of nominal GDP of which 80% were held in custodial accounts at the Federal Reserve. As the economy grew in the late '90s USD FX reserves remained fairly constant at 9.5-10.0% of NGDP and the dollar strengthened. Only 65% of reserves were parked at the Fed where they remained through 2001.

Beginning in 2002 there was a notable rise in USD reserves relative to NGDP and these excess reserves found their way back into Fed coffers. You will recall in 2002 the Fed was still in the midst of a historic easing campaign and Alan Greenspan had decided to keep the funds rate below the rate of inflation, producing an extended period of negative interest rates through 2005. By the end of 2006 USD reserves were $2.17 trillion rising by a whopping 58% over the 2002 level and now represented 16% of NGDP with 80% of those reserves being deposited at the Fed.
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