June 06, 2012 at 06:00 AM EDT
Three Reasons Why the U.S. Dollar is Really Rising
By all accounts, the U.S. dollar should be the functional equivalent of a Zimbabwean bill. The Fed has pumped trillions into the worldwide financial system as part of misguided stimulus efforts that should be incredibly inflationary. Yet, instead of a disastrous repeat of the Weimar Republic, the U.S. dollar has strengthened considerably. This despite rising unemployment, slowing economic growth and a debt debate that's about to begin anew. Since last July, the U.S. dollar has risen against all 16 major currencies while the Intercontinental Exchange Dollar Index is up 12%, according to Bloomberg . In fact, the greenback is now higher than it was when the Fed engaged in Operation Twist in late 2011 as part of a plan to keep the dollar low by buying bonds. So much for Club Fed's plans... As usual, they don't really have a clue about how real money works -- let alone why it flows and where it's going. Taking the Mystery Out of the U.S. Dollar Here are the three reasons why the U.S. dollar is really rising: Institutions are unloading gold to raise cash against anticipated margin calls, redemption requests, or both . They are parking that money in treasuries and in dollars, creating additional demand. There are simply more buyers than sellers at the moment, so prices for dollars and treasuries are rising. And not just by small amounts, either. Institutional portfolio managers and traders are required to maintain specific classes of assets under very specific guidelines. These guidelines dictate everything from the amounts being held to the quality of specific investments. Many, for example, are required to hold only AAA-rated bonds, or invest in stocks meeting certain income, asset size and volatility criteria. Imagine you're Jamie Dimon and you have to hold reserves against trading losses or you're Mark Zuckerberg and you've got to build up a large legal settlement fund for the Facebook IPO. Or, perhaps you're Tim Cook of Apple and you're sitting on $110 billion in cash for future investments. Chances are you're going to want to buy things that are as close to risk-free as possible to ensure your assets hold their value. A year ago, you could choose from eight currencies in the G10 that met internationally accepted "risk-free" ratings criteria as measured by the cost of credit default swaps priced under 100 basis points. Now, there are only five to choose from. A year from now, there might only be two or three. To continue reading, please click here...
By all accounts, the U.S. dollar should be the functional equivalent of a Zimbabwean bill.

The Fed has pumped trillions into the worldwide financial system as part of misguided stimulus efforts that should be incredibly inflationary.

Yet, instead of a disastrous repeat of the Weimar Republic, the U.S. dollar has strengthened considerably.

This despite rising unemployment, slowing economic growth and a debt debate that's about to begin anew.

Since last July, the U.S. dollar has risen against all 16 major currencies while the Intercontinental Exchange Dollar Index is up 12%, according to Bloomberg.

In fact, the greenback is now higher than it was when the Fed engaged in Operation Twist in late 2011 as part of a plan to keep the dollar low by buying bonds.

So much for Club Fed's plans...

As usual, they don't really have a clue about how real money works -- let alone why it flows and where it's going.

Taking the Mystery Out of the U.S. Dollar

Here are the three reasons why the U.S. dollar is really rising:

  1. Institutions are unloading gold to raise cash against anticipated margin calls, redemption requests, or both. They are parking that money in treasuries and in dollars, creating additional demand. There are simply more buyers than sellers at the moment, so prices for dollars and treasuries are rising. And not just by small amounts, either.

  2. Institutional portfolio managers and traders are required to maintain specific classes of assets under very specific guidelines. These guidelines dictate everything from the amounts being held to the quality of specific investments.
Many, for example, are required to hold only AAA-rated bonds, or invest in stocks meeting certain income, asset size and volatility criteria.

Imagine you're Jamie Dimon and you have to hold reserves against trading losses or you're Mark Zuckerberg and you've got to build up a large legal settlement fund for the Facebook IPO.

Or, perhaps you're Tim Cook of Apple and you're sitting on $110 billion in cash for future investments.

Chances are you're going to want to buy things that are as close to risk-free as possible to ensure your assets hold their value.

A year ago, you could choose from eight currencies in the G10 that met internationally accepted "risk-free" ratings criteria as measured by the cost of credit default swaps priced under 100 basis points.

Now, there are only five to choose from. A year from now, there might only be two or three.

In practical terms, what this means is that your capital, along with everyone else's, is chasing a diminishing pool of high-quality, risk-free assets. So the prices for those risk-free assets -- like the dollar and U.S. treasuries -- are going to go up.

This is not unlike the last egg at the grocery store. If there are a 1,000 buyers and only one egg, the price of the egg skyrockets -- like the dollar is now.

3. Bank demand for capital reserves is increasing markedly as they scramble to meet requirements set by the Bank for International Settlements in accordance with Basel III regulations. Created by the International Monetary Fund ostensibly to ensure adequate capital buffers in the event the stuff hits the proverbial fan, the requirements are causing banks to change the composition of the assets used to backstop their operations and to buy even more dollar-denominated assets. This, too, provides upward pricing pressure.

This is the law of unintended consequences at its very best.

While the IMF had its heart in the right place, the corresponding connections between the banks subjected to the Basel III requirements will increase the cost of capital, change funding patterns, and produce a migration of risk that wasn't contemplated at the time the regulations were created.

Here's why.

Banks make their money via the spread between income earned on their assets and the cost of their liabilities. Therefore, as banks reduce their debt to meet the new capital reserve requirements, the rules requiring a reduction in leverage ratios actually encourage greater risk taking.

Let me give you an example.

If I buy $1 billion in U.S. treasuries, I have to place them on my balance sheet and accept the corresponding reduction in the return on my equity and my borrowing capacity.

On the other hand, if I buy $1 billion in stinky sweatshirt swaps and I'm levered 10-1, I only have to reflect $100 million on my balance sheet.

This improves my return on equity and allows me to use the remaining $900 million to buy more stinky swaps, further increasing my equity efficiency.

Then there's securitization.

Banks typically reduce exposure to specific loans, trades, borrowers or holdings by removing assets from the balance sheet. Doing so effectively releases regulatory capital which can then - ta da -- be used to support additional loans and/or investments.

This increases equity efficiency even further. Never mind that it also exposes shareholders to true risk levels that remain off the books, invisible and at completely preposterous levels.

The Reserve Status of the U.S. Dollar So where does that leave us?

There are a couple of things to consider.

As long as the overall deleveraging process continues, the relative scarcity of risk-free assets will increase. This suggests the dollar will rise further.

How much further is unknown, but the key event in an eventual dollar reversal will be either a complete recapitalization of the European banking system or additional stimulus in a concerted U.S./EU effort designed to stave off the day of reckoning.

It won't work, but the illusion will hold for a while longer.

Speaking of illusions, if there is ever an argument as to why the USD will eventually lose its reserve status, this is it.

The gradual decomposition of quality assets all but guarantees that the few remaining viable currencies with risk-free status will have to band together in a last-ditch effort to maintain global liquidity.

My best guess at this point is that the basket of assets will eventually consist of a blend of currencies and hard assets.

I see that including the USD, the Japanese yen, Swiss francs, a neutered euro and Chinese yuan blended with gold and some form of oil-related instrument.

But there's no question about it. Absent complete financial reform, each is badly flawed in one way or another -- including the U.S. dollar.

Then again, that's what bailouts are for...sigh.

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