A currency reflects the level of international confidence in that country's political and economic well-being. Currency values also reflect the degree to which that nation's central bank has created excessive credit and has manipulated short-term interest rates below a free-market equilibrium level. On both accounts the dollar is now extremely vulnerable. Dollar bulls claim that U.S. sole-superpower status, a corporate and business renaissance, low inflation, reduced budget deficits and favorable interest rate differentials are all conducive to further dollar strength.

I've got a different theory. First, the Clinton Administration's legal and ethical problems have advanced to the stage where even the super-liberal and influential NY Times editorial columnist Abe Rosenthal recently gave up and said "...it became impossible for me to believe it happened the way President Clinton and his wife said it had." The allegations of wrongdoing have now progressed way beyond the whisper circuit on the Internet and private newsletters - onto the NY Times editorial page. Obstruction of justice is the charge that caused Nixon to resign under threat of impeachment. If evidence proves that Clinton has lied to the Special Prosecutor who is pursuing the charges against Hubbell, Clinton faces Nixon's destiny. That reality would surely destroy international confidence in U.S. markets and the dollar (as it did during Nixon's scandal during 1973-1974).

The recent dollar rally began in August 1995 and has lasted 20 months. Its genesis was in desperation - Japan's financial system threatened to implode two years ago when the strong yen reduced the value of Japanese foreign assets and made Japan's export industries uncompetitive. G7 finance officials panicked and conspired to create a dollar rally through massive FX intervention to avert a Japanese financial Armageddon. Japan lowered interest rates almost to zero and tirelessly bought unlimited amounts of dollars. This G7 dollar support operation had absolutely no basis in U.S. economic reality. The U.S. trade deficit expanded from extreme to ridiculous as the ill-considered strong dollar policy encouraged overconsumption of cheap imported goods in the U.S. and penalized U.S. exports. Meanwhile, in Orwellian double-speak, Treasury Secretary Robert Rubin incessantly repeated the mantra that currency markets should reflect fundamentals (in his mind a strong dollar), while economic reality clearly called for exactly the opposite of his policy - a reduction in the rising trade deficit by a decline in the value of the dollar that would discourage overconsumption of cheap imports and revitalize U.S. export industries.

The G7 and Rubin's yen bashing policy, along with unlimited dollar purchases and 1/2% interest rates in Japan - in concert - sent a green light to hedge funds, investment banks and Japanese financial institutions to speculate on the enormous interest rate differential between the U.S. and Japan. The authorities seemed to guarantee a huge excess investment return to leveraged speculators. Speculators funded long U.S. Treasury Note positions by borrowing in Yen at an average interest rate 525 basis points below that of the 2-year U.S. Treasury Note. With the G7 and Bank of Japan implicitly guaranteeing no currency risk (even a gain from a depreciating yen lowering borrowing costs further) - speculators flocked to what seemed like a free lunch. The scheme also generated demand for U.S. Treasury securities at a time when little or no domestic money was going into U.S. fixed-income investments (the stock market bubble was attracting most public money flows). Additionally, it seemed to provide a way for sickly Japanese financial institutions to slowly heal their balance sheets. A true magic potion that would solve the world's financial problems and put a chicken in every speculator's pot.

If we deconstruct the yen carry trade and ponder its consequences, we can reach several conclusions. 1) Interest rates in the U.S. have been held down by artificial demand from the scheme and thus when the yen carry trade falls out of fashion we can expect U.S. interest rates to rise to a level that reflects the true diminished domestic demand for U.S. Treasury securities. 2) The enormous borrowing in yen to fund yen carry positions is essentially a huge yen short position that could lead to a short squeeze of colossal magnitude when speculators are forced to close out their leveraged positions. In that scenario the dollar/yen would quickly collapse. 3) Japanese financial institutions, which recently purchased large amounts of U.S. Treasury securities in the belief that it would salvage their balance sheets, are instead likely to suffer big currency losses when the dollar/yen collapses, which will compound their solvency problems. 4) There is a built in margin call looming for the yen carry trade when Japanese interest rates rise, the dollar weakens or the U.S. bond market declines. The closing out of the position would feed on itself. Selling U.S. Treasuries would drive prices down, leading to more forced sales. Buying back short yen sold forward would strengthen the yen and thus cause further liquidation of yen-carry positions. This G7-inspired leveraged speculation has no exit strategy.

The gold-carry trade

Another market that has been warped by leveraged speculation is gold. Think about it. If you had recently wanted to leverage up big by borrowing in a low-interest rate currency and investing in the 2-Year T-Note or something more exotic, you only had a few choices. Yen, Swiss francs or gold. Gold? Yes gold. After all, gold is a currency, one that is at someone else's liability. It is also a deep and liquid market that can be sold forward. Gold has a low implied interest rate (about 2%) and best of all from a speculator's standpoint it has had European and Brazilian central bank sales keeping a stifling lid on any rally. What better place to borrow money at 2% to buy 2-year T-notes yielding 6.3%? It has been brought to my attention that hedge funds have sold gold forward in huge amounts and invested the proceeds in Treasuries. The gold-carry trade. Like with the yen-carry trade, leveraged funding in the gold market has created a short position of staggering proportion.

So, given this backdrop - where are markets headed? The 5% decline in the dollar/yen in the week ending May 9th was the biggest weekly drop in 8 1/2 years. The authorities seem to have come to their senses and have stopped encouraging the leveraged dollar party. We are probably moving into a period of yen carry trade liquidation. my model projects that the dollar is just beginning a powerful decline that will last many months. The U.S. bond market has been artificially supported by the yen-carry gold-carry Ponzi scheme. Real rates might be attractive to airhead brokerage house economists, but any rational analysis of supply/demand in the U.S. bond market must acknowledge that dollar weakness or gold strength will turn artificial leveraged buyers into forced sellers. Inflows into U.S. bond funds are nonexistent. More sellers than buyers means U.S. bonds should head lower and U.S. interest rates should head higher. After months of sloppy trading, gold rallied 8 dollars in the week ending May 9th. Rumors are surfacing of funding problems for gold-carry leveraged speculators. Gold has held in around $340 successfully in the face of huge forward selling. A short covering rally seems to be starting as the gold carry trade unwinds.

The 12% bounce in the stock market during April early May was beyond anything my work expected. A potential explanation for the bounce lies in the Feds record expansion of credit in late April. But that is a temporary factor related to the bulge in Fed Treasury deposits from stronger than anticipated tax revenues - and those excessive Fed repos will be retired over coming weeks as the Treasury pays interest in its debt. That credit bulge can also be blamed for the dollar's swoon (dilution). If my views of the dollar and U.S. bonds are correct - the stock market will soon stall out and head lower again. The strongest trading model signal on the equity market right now concerns industry group performance. I can find very few groups with out-performance potential and the model has a huge sell just starting for an equally-weighted industry group index versus the S&P500. It's been difficult to match S&P performance this year - and the model projects that theme is about to get worse. Financials, textiles and retailers appear most vulnerable. Given the looming de-leveraging of the currency and bond markets, stocks are likely to come under pressure again. Therefore, portfolio managers should take advantage of the current elevated level of the market to sell equities and raise cash. Currency and bond weakness should soon spill over into stocks as the market completes its long, convoluted topping process.

Courtesy of Strategic Investment
http://www.strategicinvestment.com/about.htm

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