Posts Tagged ‘dollar’
Fed’s Currency Swap Lines: A BIG deal for the Dollar
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The Fed met this week on monetary policy. It was a bit of a snoozer. What wasn’t a snoozer, however, was what they’ve included in their recent monetary policy statements regarding currencies.
Most market participants have been entranced by the Fed’s language about their target interest rates …
Will they say they’ll keep rates low for an “extended period” or not?
But the real story was buried in the last paragraph of the December Fed statement and reiterated in their latest statement.
Here’s what it said …
“The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1.”
Following the Fed’s statement this week, there was a coordinated release of comments from the European Central Bank, the Bank of England and the Swiss National Bank confirming that the swap lines were no longer needed.
For the currency markets, this is a big deal. Yet, few have thought the juicy details of the Fed’s plans on currency swaps are of interest.
But I do. I suspected it was a game changer for the dollar when I was studying the statement last December. And so far, the price action in the currency markets is confirming that.
Here’s a bit of background …
In September and October of 2008, the Fed announced that it would be opening temporary currency swap lines with central banks around the world in fixed amounts through April of 2009. As that expiry date neared, the Fed extended the period to October, and then extended it again until February of this year.
Here’s what that means: The Fed agreed to give foreign central banks U.S. dollars at a determined exchange rate for the currency of the respective foreign counterpart. And when the swap ends, the two central banks simply repay the same quantity of currency back. There’s no exchange rate risk and no impact on the demand for currency in the open market.
Why Did the Fed Offer Dollars to the Rest of the World?
When the credit crisis was at its peak, banks around the world were hesitant to do any short-term lending with other banks. As a result foreign bank-to-bank lending rates for dollars, the world’s primary business currency, shot up. That restricted access to dollar borrowing and pushed a lot of consumer interest rates higher in the U.S. and abroad.
By providing these currency swaps with other central banks, the Fed helped to inject dollar liquidity into banks around the world. And it was well needed.
In short, it was good for the global financial system because it helped reduce the fear premium that was causing market interest rates to soar.
You can see this clearly in the chart below. In panel A, while the Fed and other central banks were cutting benchmark interest rates to the bone (the white line), the Libor rate (the orange line), or the rates at which banks make short term loans between themselves, was going in the opposite direction.
Subsequently, when the dollar swap lines were rolled out, you can see in panel B how this divergence was reversed.
The Implication for Currencies
Most importantly for currencies, what these currency swaps did was increase the supply of U.S. dollars in the global markets — a negative drag on the value of the dollar.
So with the Fed announcing that it will close its currency swap lines with foreign central banks by February 1, the unlimited access to dollars by foreign central banks has come to an end.
This development is easily a positive for the dollar.
Let’s take a look at the timeline of these developments and the respective performance of the dollar …
As you can see from the chart, following the Fed announcement that the swap lines would be extended through October, the dollar has gone through a period of decline. Since December, when the Fed announced these facilities would be ending in a little more than a month’s time, the dollar has been on the rise.
When they opened these massive swap lines in late 2008, the goal was to alleviate the dollar liquidity crunch at banks around the world. However, in the process they increased the supply of dollars around the globe — a negative consequence for the value of the dollar. But now that these lines will be closed, it’s clearly a dollar-positive development.
And with the weight of evidence leaning in favor of the dollar at this stage, as I laid out here in my article last week, this latest announcement by the Fed provides more reason to believe in this dollar rally.
Regards,
What Could Lift the Dollar?
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The most recent employment data in the U.S. came in significantly better than what was expected. And the financial markets reacted in a different way this time. Interest rates went screaming higher, the stock market surged, gold fell and the dollar shot up.
In a normal environment a stronger dollar following better U.S. economic data sounds perfectly reasonable, but in the current “risk-centric” environment good news has been bad news for the dollar. That’s because it has emboldened risk appetite, which has translated into investors selling dollars in exchange for higher yielding/higher risk currencies.
This time the improving data gave investors the idea that the Fed could begin reversing its zero interest rate policy sooner. That got the dollar moving higher. And that got the wheels turning for a bounce in the weak dollar trend.
The dollar has continued to show strength following that turn in sentiment, but the prospects of a sooner move on rates has now been dismissed. The knee-jerk reaction in the markets that priced in an earlier hike in rates was subsequently fully reversed.
What is now underpinning dollar strength is a shift in market focus toward some of the headwinds facing the global economic environment. That’s swinging the risk appetite pendulum back toward safety, which is positive for the dollar.
So what can keep this momentum going in the dollar?
Answer: Growing risks to the global economy.
Let’s take a look at some of the specific catalysts that could fuel more demand for dollars …
Catalyst #1: Rising Prospects of a Sovereign Debt Crisis
First it was Dubai that stoked fear in the financial markets over the Thanksgiving Day holiday. Now, Greece has been called on the carpet over concerns that the nation will struggle to meet debt commitments. Fitch downgraded Greece to just three notches above the lowest investment grade status.
Debt problems in a global crisis have the ability to be contagious. And that can destroy investor confidence in the capital markets of such countries, and in the global economy. And when confidence wanes, capital flees. That’s a recipe for falling dominoes.
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| First it was Dubai that rattled the markets. Now Greece’s debt has investors worried. |
Catalyst #2: Problems for the Euro
The recent downgrade in Greece turns the market focus back to the problems that exist in the Eurozone, and that’s putting downward pressure on the euro … which means upward pressure on the dollar.
The European Union’s growth and stability pact limits all member countries to a budget deficit of 3 percent of GDP. But Greece is running a budget deficit of 12.7 percent of GDP, over four times the limit.
In fact, on average, the 16 member states of the single currency are running a budget deficit more than twice the 3 percent limit!
So the uneven performance in Europe will likely call into question the viability of the euro currency again. Another bout of speculation of a break-up of the euro is hugely dollar positive.
Catalyst #3: Growing Uncertainty Surrounding Economic Recovery
Now that sovereign debt problems are surfacing, investors are getting concerned about the sustainability of this recovery. After all, the unprecedented global fiscal and monetary response was an experiment. The outcome is unknown. And the underlying problems related to the crisis still exist: Bad debt, reduced wealth and tight credit to name a few.
Moreover, when you answer a liquidity crisis with more liquidity, you’re bound to create more bubbles. While ground zero for the credit crisis was the U.S. housing market, new bubbles in real estate are developing in the areas that were relative outperformers in the downturn (such as China, India and Canada).
In Shanghai, housing prices were up 40 percent in October from the same period a year earlier. And in a story about the Canadian housing market this week, Bloomberg quoted a real estate agent as saying, “Where else in the world do you have agents lining up overnight to buy a condominium?”
To someone here in the U.S., that sounds familiar.
Catalyst #4: Protectionism
We’ve already seen evidence of restrictions on global trade and capital flows. Considering protectionism was a key accomplice in fueling the Great Depression, this activity represents a major threat to global economic recovery.
After the lessons from the Great Depression, the leaders from the top 20 countries of the world vowed to avoid protectionist activity. But actions from the G-20 countries are speaking louder than words. New trade restrictions have been erected by most of them since the pledge was made.
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| Trade restrictions could derail global economic recovery. |
Perhaps the biggest factor in the protectionism threat is China’s currency policy. Even after recent tour stops in China by U.S. President Obama and European Central Bank President Jean-Claude Trichet to lobby for a stronger yuan, the Chinese have remained steadfast on keeping their currency weak. As this issue with China’s currency gains in intensity, expect protectionist acts to rise in retaliation. And expect collateral economic and political damage.
Bottom line: If sovereign debt problems and the prospects of a double dip grow, you can expect investors to pull in the reins on risk. And this time, they might not be as eager to turn the risk appetite switch back on. That could give the buck a strong lift … a lift that might last longer and rise further than many expect.
Regards,
Gold & US Dollar Relationship
When it comes to Gold, there is actually too much focus or incorrect focus on the US Dollar. The fact is that throughout this bull market, Gold has been leading the US Dollar. In other words, the breakouts in Gold occur well in advance of the breakdowns in the dollar. Also, bottoms in Gold occur in advance of tops in the dollar. See the chart below.
Just take a look at this year! The peaks in Gold and the dollar occurred within days of each other! The bottom in Gold occurred four months prior to the top in the dollar.
A falling dollar is not necessarily a good thing for the leverage in gold shares. In this chart, I compare the HUI/Gold ratio to the US Dollar (inverted). We can see that the dollar significantly lags the HUI/Gold ratio. By the time the dollar starts to fall (rise in the lower chart), gold shares have already gained materially against Gold.
There are two reasons why a falling dollar isn’t necessarily positive for gold shares. First, many gold companies operate outside of the USA. A falling dollar means stronger local currencies, which means higher costs. Second, after a while a falling dollar creates cost inflation, which ends up hurting the margins of gold companies.
Conclusion
A significant breakdown in the US Dollar will come AFTER a major breakout in Gold. Gold has been consolidating for months, even as the dollar has trended down. The recent bottom in the greenback confirms that Gold is still in a consolidation phase. In March we asserted that Gold wouldn’t break 1000 because money would pour into stocks and commodities, thereby diverting Gold’s strength.
Gold’s relative strength has been poor due to the ensuing recoveries in stocks, commodities and foreign currencies. In recent weeks we noted this to subscribers as well as the fact that dollar sentiment was too bearish. Hence, we didn’t see a major breakout in gold or a sustained breakdown in the dollar.
Where will demand come from (to push Gold to breakout) if Gold is underperforming currencies, commodities and stocks? In other words, money is favoring the other asset classes. This is why relative strength matters. And it also matters because it shows the ‘real’ price of Gold (something that Bob Hoye talks about). If Gold is rising against foreign currencies, oil and commodities it means stronger leverage for the Gold companies. We can compare and contrast all of these things with charts. Technical analysis is very effective if you know how to use it.
