Global inflation, commodity prices and stock prices are up thanks to a strategy put in place by the U.S. Federal Reserve. Though these are viewed as successes they put the "dollar carry trade" practice at significant risk if the dollar rebounds. Read more about this in the full article from Money Morning.
By maintaining a Federal Funds rate below the 0.25% level — and injecting $600 billion into the banking system through a second round of quantitative easing — the U.S. Federal Reserve has orchestrated a bubble-like surge in commodity prices, an uptick in global inflation and a historic resurgence in U.S. stock prices.
The low-interest-rate strategy has enabled the U.S. central bank to achieve another important objective – a massive depreciation in the value of the U.S. dollar.
There’s only one problem with all these "successes" the Fed has achieved: If the dollar ever rebounds, this elaborate financial structure the central bank has engineered will be exposed for what it really is – a shaky arrangement that will collapse like the house of cards that it is.
The fallout from such a collapse could be widespread and painful – especially for investors who’ve been riding the so-called "dollar carry trade" to major profits.
The Fed’s Seven Risky Roads to Recovery
Low interest rates drove us over the credit crisis cliff and into the Great Recession.
Because rates were kept artificially low for too long, investors were forced to chase yields – which often forced them to pursue some pretty questionable quarry. For instance, investors leveraged themselves up and speculated on subprime mortgage-backed securities that were themselves a product of too much cheap money being thrown at homebuyers who really shouldn’t have qualified for financing in the first place.
This couldn’t continue indefinitely – the laws of finance say as much – meaning this had to collapse. And when it did, in order to keep the global financial system from becoming a big black hole, central banks around the world flooded their banking systems and capital markets with still more cheap money.
And none of these central banks did more to "re-liquefy" their banks and financial markets than the U.S. Federal Reserve.
The Fed’s resultant cheap-money plan has several intended consequences:
1. By throwing money at too-big-to-fail banks, the central bank enabled commercial banks to trade their way out of insolvency. The banks were able to massively leverage up and buy (and hold) government securities that they financed for practically nothing.
2. By creating the ultra-low-interest-rate environment, the Fed made it possible for U.S. companies to cheaply refinance their balance-sheet debt – a trend that will lead to higher corporate profits.
3. Because low rates make it unattractive to hold cash, corporations that are sitting on giant pools of cash are announcing massive stock buybacks – which will boost earnings and lift share prices.
4. Because the U.S. dollar has fallen so much against other world currencies, U.S. firms that derive a big share of their sales from overseas can buy more dollars when they convert their foreign revenue into U.S. currency. That increases dollar earnings – and stock prices.
5. Conversely, since oil and most commodities are priced in dollars, the depreciating dollar means it takes more dollars to pay for oil and commodities. That equates to a price increase for all of those goods – which has saved the world from dreaded deflation.
6. Since a cheap dollar makes U.S. goods and services more competitive on world markets, the Fed policy is fostering a U.S. export boom – yet another bonus for American companies.
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7. At a time of growing worries about U.S. federal budget deficits and out-of-control national debt, the Fed strategy contains a perceived solution: It means the central bank can monetize federal deficits by flooding the system with money, so future inflation makes repayment of debts with cheaper paper money more affordable.
The Death of the "Dollar Carry Trade"
The U.S. Federal Reserve strategy has been working. Stock prices are higher. Commodities prices are higher. Asset prices – except for the troubled real estate sector – have been rising across the board. Corporations are healthier. Banks look like they are past insolvency worries. Even unemployment is ticking down.
Everything seems to working according to plan.
But there’s plenty that could go wrong.
While it’s true that deflation has been dismissed as a problem, now with higher commodity prices working their way through economies around the world, inflation has become a major worry.
In fact, Australia, Britain, China, Canada and Brazil are already feeling the pressure of rising prices, and are raising domestic interest rates or bank reserve requirements as a result.
This is going to have a very predictable outcome. These rate increases will widen the interest-rate differential between those countries and the United States. That, in turn, will lead to still more depreciation of the U.S. currency: Global investors – very naturally wanting to park their money in the market that gives them the highest return – will sell dollars to buy these other currencies.
What has happened is that the United States has become the world’s financing machine, but in a dangerous way. What used to be known as the "yen carry trade" has now become the "dollar carry trade."
It works like this. Because rates are so low here in the U.S. market, investors and leveraged speculators borrow cheaply from U.S. banks and lenders. They take the borrowed dollars into the world currency markets, where they sell them and buy other currencies (these other currencies, of course, are from markets with higher interest rates).
Collecting the higher return from the interest-rate differential, or when investors bid up other asset prices with the cheap money they’ve borrowed, is known as a "carry trade," because the transaction is financed, or "carried," by borrowing cheaply.
And it’s now technically the "dollar carry trade," since U.S. dollars are the currency being used to finance these often leveraged and sometimes speculative trades.
For years, because Japan’s economy suffered from a stock market and real estate implosion, to keep the economy liquid the Bank of Japan (BOJ) kept interest rates lower than anywhere else in the world. That’s how the Japanese yen carry trade came about in the first place.
Now the dollar-carry trade has replaced it.
One big problem with these trades is that they are leveraged trades. So if the U.S. dollar starts to appreciate – no matter what the reason – then the dollar carry trade can quickly become a loser if the amount of interest earned is eaten up by having to buy back "shorted" dollars that are rising in relative terms. The act of buying dollars back raises the price for other traders still in their trades. And if those traders have also "leveraged up" on positions in other asset classes, there could be a mad rush for the exit doors and a wholesale dumping of assets – a classic, and potentially ruinous, "short squeeze " – as the dollar rises.
What could cause the dollar to rise?
Though it might be surprising to some, there are plenty of credible candidates. There are also a gaggle of questions to be answered. For instance:
* How about, for starters, what happens when "quantitative easing" is over? What happens when the central bank has to signal to the world that it is willing and able to do something about inflationary expectations?
* What will happen if our rates start to rise because fewer and fewer investors will want to buy our government’s debts, and won’t accept the piddling returns they get on their U.S. Treasury holdings?
* What will happen if strong growth returns to our shores? Will there be enough money to lend to meet demand? We’ll find out then if our banks are really as flush with cash as they claim to be.
A rising dollar would make commodities cheaper, which is a good thing. Unless you are one of the millions of speculators who bid them up, or any of the emerging markets countries like China that’s been stockpiling them.
A rising dollar would make oil cheaper, which is a good thing. Unless you are one of the many countries that sells it and needs increasing oil revenue to meet budget demands.
The whole problem with the Fed’s policy of engineering artificially low interest rates is that it distorts the free markets. Naturally rising rates would have snuffed out the subprime spree, as well as the excessive speculation in leveraged assets that could be financed so cheaply back then (a capability that still exists today).
Moves to Make Now
To those who are issuing congratulations for having avoided the deflation that was a much-feared possibility last year, it’s time to face the future: A look through the windshield shows us that inflation is headed right at us.
If you really want to understand the situation at hand – as well as what’s to come – keep a keen eye on the dollar: If you understand where it’s headed, and how fast it will get to that projected point, you’ll have a leg up on everyone else. You’ll be able to gauge the likelihood of any future rounds of blow-off selling by leveraged speculators, and possibly even benefit, too.
It used to be that a strong dollar meant a strong America. I’d like to see us get back there and let the free market determine where interest rates have to be – a natural process and one that’s most preferable to the artificially created disasters we’ve experienced, and which we’re still trying to escape from today.
Actions to Take: To watch for a dollar rally, and to profit from the dollar’s appreciation against a basket of currencies, watch the PowerShares DB US Dollar Index Bullish Exchange-Traded Fund (NYSE: UUP). This ETF is making new lows around $21.50; if it turns north and strengthens, it would be a good indicator that dollar strength may be forming. Buying the UUP ETF here, with a 15% to 20% stop isn’t a bad way to take a position on a resurgent dollar – and America.
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This article was republished with permission from Money Morning.