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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.

In 2008 the Fed increased the size of their balance sheet by 150% from $900 billion to $2.3 trillion, and by the end of 2009 USD reserves rose to $2.8 trillion now representing 20% of NGDP with 98% of these reserves parked at the Fed. This massive increase in dollars, both outright and as a percentage of the economy, saw the value of the US dollar depreciate by 37% against the Japanese yen from 2002 to 2009 while the price of gold rallied 260%.

Since 2009 the Fed has obviously kept its foot on the accelerator with QE II, Operation Twist (balance sheet neutral), and now QE III increasing the size of their balance sheet by another 45% to $3.3 trillion at last count. USD FX reserves have also continued to climb reaching $3.7 trillion now representing 24% of NGDP from just 10% a decade ago. However you will notice that since the 2009 peak the share reserves getting deposited back at the Fed has been in decline with a steep drop beginning in August 2011. This is a major change in trend from has been in place over the past decade that indicative of a capital flow reallocation.

Just as Corriente suspected the 2007 dip reserves held at the Fed was a carry trade into European sovereigns I believe this larger reduction custody holdings is indicative of a similar short USD carry trade into emerging markets.

Consider that at the August 9 2011 FOMC meeting the Fed replaced exceptionally low levels for the federal funds rate for an extended period through mid-2013. A few months later at the January 25 meeting they extended the rate guidance to at least through late 2014 only to extend it once again in September to at least through mid-2015. This type of calendar guidance for the length of a zero percent interest rate is a dream for a leveraged carry trade. You know your exact cost of funding for a specified time period, and due to this policy, the price of the funding currency will remain depressed. What can go wrong?

The Bank of Japan QE assault on the value of the yen has been well documented, and I don't want to dismiss this as a major influence on the strength in the USDJPY, but I think some attention should be paid to the actions of the Federal Reserve. In December only a few months after the Fed extended the guidance to mid-2015 they removed the date and replaced it with a specific 6.5% level in the unemployment rate. This is a very important distinction from the carry trade perspective because now you no longer have a predictable expiration on your position but instead are at the mercy of the unpredictable economic data. At the same time you have Fed rhetoric discussing tapering purchases in order to reduce the growth of the balance which is also net dollar positive. What was once a no-brainer dream trade has now become a very complex and volatile nightmare.

I suspected this was a major risk, and on January 7 in Is US Growth Blowing Out or the QE Carry Trade Blowing Up? I faded the consensus interpretation of rising bond yields and stock prices:

The correlation between the USDJPY and US interest rates can be seen as a proxy for the larger QE short US dollar asset correlation trade. It's quite possible that bond yields and the dollar aren't rising due to an acceleration of growth but rather because the Bank of Japan is blowing up the Fed's QE carry trade. As happened in 2007, when the S&P 500 made a new high as the mother of all credit bubble carry trades was imploding underneath, it may be the case today that investors are again misinterpreting the price action of a blow-off in the mother of all short squeezes in stocks while the QE carry trade blows up underneath.

So here we are at a critical juncture. Both bond yields and stocks appear to breaking out, but it is not clear what is driving the price action. Is this a product of US growth accelerating or a QE short USD carry trade that is unwinding? It's still not clear, and neither side has an edge. It will be very difficult to position for the move, likely breeding an environment of increased volatility. The market is not going to make this easy on anyone, but if you are patient, stick to your discipline, and, as I said last week, leave your bias at the door, the market should begin to provide more answers as we progress through the ensuing months.

This is what is happening. 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.

Due to Fed policy over the past decade, market prices have been the function of a bunch of USD short carry trades that on the surface look very complex. These trades come in many forms including emerging market bonds, multinational stocks, gold, TIPS, and farm land. Whether short the dollar explicitly through leverage or implicitly through exposure, the risk is the same and very simple to analyze.

The initial reaction to the yen collapse has been an explosive rally in risk assets. As the smoke clears we are starting to witness the true macro effects of dollar strength with falling nominal yields, rising real yields, and collapsing commodity prices. This is exactly type of price action you would expect if the great short USD carry trade was unwinding, and I don't think investors currently appreciate the significance of what that means or how ugly it could get.

Twitter: @exantefactor
No positions in stocks mentioned.
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