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The Synthetic Short Dollar Theory Weighed in the Balance
Understanding Currency Valuations
Dan Norcini
Of late there has appeared a theory which postulates as its main premise that in a deflationary environment resulting from credit contraction, that the U.S. dollar will experience an increase in value as cash is hoarded and attempts at reducing debt are undertaken. While there are some variations on this, some much more scholarly than others, the basic conclusion reached is the same - the U.S. Dollar will experience a significant short squeeze pushing it into a type of mini bull market with the corresponding effect of reducing the gold price and driving it significantly lower. The nomenclature of this view is the "synthetic dollar short theory".

The only reason I felt compelled to attempt to discredit this notion is out of no particular ill will towards those who espouse this premise nor to ridicule their research or analysis, but rather to assuage the fears of many in the gold community who have literally been terrified to invest in gold as a result of the dire predictions made by some of those who are the leading proponents of this view. Were it not for that, I would be content to simply allow the theory to go unchallenged as I believe that in the end, it will have been proven to been based around an incomplete understanding as to the manner in which currencies attain their valuation in a completely free-floating exchange rate mechanism un-backed by gold.

Following is a summary of the main points that I will raise dealing with the flaws in the synthetic short dollar thesis which will be followed by the actual dissertation itself in which I will deal with these points in detail.

SUMMARY

Factors that chiefly determine a currency's valuation

  1. Fundamentals
    1. The Sale of merchandise abroad; Exports
    2. The purchase of merchandise from abroad; Imports
    3. Foreign investment flows; Capital Flows
    4. Speculators and their actions
    5. Central Bank and its actions; Intervention and Monetary Policy
  2. Financial Factors
    1. Interest rate differentials
    2. Economic Growth Expectations
    3. Inflation Pressures

Synthetic short dollar thesis fails to provide for the influence of these factors on the value of the U.S. dollar. Its premise is built solely upon the notion of domestic demand for dollars due to asset liquidation and attempts to hoard cash in a deflationary environment.

It overlooks the impact of foreign demand on currency valuation which consists of Capital Flows and Trade Flows. It is based on a model of global trade which no longer exists.

It fails to account for decreased capital flows during a sustained bear market in stocks.

It fails to account for increased supply of dollars due to runaway trade deficits.

It overlooks the hazard posed to the dollar by the mammoth derivative structure.

It overlooks the effect of debt liquidation occurring in a crisis mode.

DETAILED ANALYSIS

I think that it might be helpful to first of all understand the factors that go into determining the value of any given major currency and with that in mind, then to approach the synthetic dollar short view and see perhaps where it might be overlooking something.

As a long time trader I have learned through experience to avoid complex, exotic arguments which I believe more often than not result in the "paralysis of over-analysis". Attempting to keep things as simple and as understandable as possible may not make for selling books which enrich their authors but more often than not it is of far more value when it comes to real time trading in the markets. Investors or traders can get so caught up in the minutia of such analytical postulates that they become too confused to actually pull the trigger on a trade. Overwhelmed with theorems and theses, they cannot actually settle on a basic fundamental approach to a market. Much to their own dismay, they will find themselves vacillating back and forth as price changes in regular cycles. One moment they are wildly bullish; they next they are gloomily bearish. The reason in all honesty is that the theorems being propagated are so complex that most do not really understand them. As such, it becomes IMPOSSIBLE for them to trade since they cannot grasp the arguments being set forth. The result is that they end up as unstable as water, being tossed to and fro by price action.

With that in mind, let's turn our attention to the matter at hand - the factors that go into determining the value of a currency; in other words, the basics.

The Fundamentals

It is important to keep in mind that in a sense, a currency is like any other given commodity. As such its value is determined by the laws of supply and demand. This is a CRITICAL factor to grasp and cannot be lost sight of when dealing with currency valuations. As a matter of fact, it is the simplest and most basic of things that sometimes tend to become overlooked, which are the most essential if we are to keep a proper perspective.

Like any basic commodity therefore, more demand and/or less supply for a currency tends to increase the value of that currency; less demand and/or more supply tends to decrease its value. That is axiomatic and will serve the one who constantly reminds himself of it when faced with complex and oftentimes esoteric theories.

Having stated this, let's now take a look at some of the factors that contribute to demand/supply for a currency.

  1. The Sale of merchandise abroad; Exports
  2. The purchase of merchandise from abroad; Imports
  3. Foreign investment flows; Capital Flows
  4. Speculators and their actions
  5. Central Bank and its actions; Intervention and Monetary Policy

EXPORTS and IMPORTS - These are often referred to as TRADE FLOWS. The greater a nation's exports are abroad, the more demand there is for its currency. The reason is that those nations who purchase its goods, MUST exchange their own native currency for that of the nation whose goods they have purchased.

For example, let's suppose that American Piano manufacturer, ABC Pianos, sells 50% of its pianos abroad. Since ABC Pianos must pay its employees in dollars, pay its taxes in dollars, pay its utilities, etc, in dollars, it does it no good whatsoever to sell pianos to Japan for example without a FOREIGN EXCHANGE. The Japanese importer who buys the pianos must convert its currency, the yen, into dollars to buy the pianos it wants or it may pay directly in yen to ABC Pianos. In that case, ABC Pianos must EXCHANGE the yen for dollars. IN both instances, DEMAND is created for the dollar since yen must be exchanged or SOLD while dollars are simultaneously BOUGHT. The larger the quantity of pianos sold abroad, the more demand there will be for dollars with which to buy those pianos from ABC Piano Company. Multiply this 1000 fold and it is easy to see how a nation which has a large quantity of goods or services that it sells abroad as exports, will have a large source of demand generated for its currency. This is the significance of the Balance of Trade and why a nation that runs huge trade surplus, exports exceeding its own imports, will tend to have a stronger currency, all other things being the same.

The opposite occurs when a nation imports the goods and/or services from another nation. In that case, the local currency must be EXCHANGED for the currency of that nation which is the source of the good or service. Using our above example, let's assume that ABC Pianos must obtain Brazilian rosewood for use in the piano shell. It must find a company headquartered in Brazil which sells the wood which will be priced in reals. ABC Pianos then must convert dollars into reals which can then be paid to the Brazilian exporter. Either that or the Brazilian exporter will convert the dollars into reals. In either case, the dollar will be sold adding to supply and the real will be bought, adding to its demand.

The implication is that a nation which has a trade deficit will have its imports exceed its exports. That will add more SUPPLY of its currency into the market as its currency is sold or exchanged into the currencies of the nations that are the source of the imports. There will be a corresponding increase in DEMAND therefore of the nation's currency which is exporting the good or service. Again, the corollary is that nations with a negative balance of trade tend to have a weaker currency due to increased supply of that currency in the market.

FOREIGN INVESTMENT FLOWS - Simply put this is money that flows into a nation seeking return on investment. Most refer to this as Capital Flows. Investors are always seeking the safest and highest yield for their investment capital. As such, capital will tend to flow towards that nation where high yields can be achieved especially if there are safeguards in place to prevent against risk factors such as arbitrary seizure of capital (think nationalizing here). Such safeguards include a sound and stable government; protection of private property, the rule of law, etc. A nation might offer a great return on money invested there from abroad but there will not be a whole lot of takers if it has a history of one revolution every six months or a government that has a history of arbitrarily nationalizing an entire industry and seizing its assets. By the way, that is why the Yukos thing in Russia is so important to watch right now.

Assuming that these safeguards are in place, money will tend to flow into that nation from abroad which offers real potential for profits as investors seek to buy stock in its companies, or its bonds or its real estate, etc. The greater this investment flow, the greater the demand for that currency. The greater the demand for that currency, the stronger its value will tend to become.

That is one of the reasons that when looking at the chart of the U.S. dollar during the bull market of the 1990's you can see the dollar rising alongside of the Dow Jones Industrials and the NASDAQ. Investors from all over the world were EXCHANGING their native currencies to buy American stocks. That contributed to strong demand for the dollar since those stocks must be bought and paid for in DOLLARS, not yen or euros for example. Those currencies must be sold and the dollar must be bought in order for these foreign investors to own American stock.

The exact opposite takes place during foreign investment outflows. A bearish environment for a nation's stock market results in investment flows OUT of the country reducing DEMAND for that nation's currency. This acts to depress its value. Ditto for a low interest rate environment - it results in the flight of capital out of that nation.

SPECULATORS - Speculators hope to profit from either the rise or fall in value of a particular currency. As such their actions can have a tremendous influence on the value of any given currency. Should they decide to amass their firepower on one side of the market, they can do considerable damage to a currency if they decide that it is overvalued. In that case their actions are similar to adding supply to the market. On the other hand, they can drive it sharply higher if it is considerably undervalued in their view. In this case their actions are similar to adding demand for that currency.

CENTRAL BANKS - Central Banks may set a loose monetary policy which tends to induce currency weakness as it results in increased supply of that particular currency or they make act to restrict the money supply which tends to deplete supply and works towards strengthening the local currency. They may also intervene in the marketplace either verbally and threaten to intervene and either buy or sell that particular currency or actually intervene and sell or buy large amounts of the currency. This tends to either add or reduce supply and moves the currency accordingly. Currency traders tend to pay a great deal of attention to the announcements of Central Bank officials in an attempt to gauge their particular frame of mind for clues as to their intentions with regards to their currency.

These are very basic reference points that are significant for currency valuations. Perhaps for the sake of simplicity, the above factors can be referred to as economic factors. A further breakdown of the Foreign Investment Flows factor might be better referred to as financial factors. They can be enumerated as follows:

  1. Interest rate differentials
  2. Economic Growth Expectations
  3. Inflation Pressures

All of the above must be taken into account when accounting for currency valuation. The sum of all three can be broadly classified under the heading of YIELD. Simply put, investment capital, and I have already alluded to this previously under the heading, "Foreign Investment Flows", tends to flow towards those nations that offer a higher yield potential or higher rate of return on invested capital.

As a current example, we have both New Zealand and Australia offering the highest rates on their government bonds of the industrialized nations. That has attracted significant capital flows into those nations ADDING to DEMAND for both the New Zealand Dollar (the "Kiwi") and the Australian Dollar (the "Aussie"). One of the reasons that the U.S. dollar is currently not all that attractive to foreign investors is the low rate of return on U.S. Treasury paper in comparison to other industrialized nations.

That brings us to the next factor which is Economic Growth Expectations. A nation that appears to be weakening economically will find its currency falling out of favor with investors. Such weakness tends to be reflected in that nation's stock market and as stock prices fall, investors tend to flee from its stock market. In the process, they sell their stocks in that nation in order to take what is left of their money to invest in the market of a nation that they feel has better prospects. This results in REDUCED DEMAND and INCREASED SUPPLY of the weaker economic nation's currency. The net result is CAPITAL OUTFLOWS exceeding CAPITAL INFLOWS.

The final of the above factors has to do with INFLATION EXPECTATIONS. A nation which has a high rate of inflation will tend to have a weaker currency in relation to that nation which does not. The reason is that inflation is in reality a decline in the purchasing power of that particular currency. A currency that buys less than it did six months ago is a currency that is dropping in value. As with any investment, things that lose value tend to get sold. This adds increasing supply at a time in which demand is falling off both of which factors tend to depress the value of that currency.

Having these basics for our foundation, let's next proceed to defining what a currency valuation itself is. That might seem a bit strange to some but I believe it is important to define this. When we say that the U.S. dollar is weaker, for instance, the question that should be raised is, "Weaker against what?"

At one time the answer to that question would be weaker against a fixed amount of gold. However, since 1971 (more accurately - 1973), most of the major currencies have been free to FLOAT against one another. Therefore when we say that the U.S. dollar has weakened, we need to define exactly what it has weakened against. I believe it is critical to get this distinction straight since I believe it is one of the flaws in the synthetic short dollar theory. I will come back to that in a moment.

As it now stands, when we speak of the U. S. dollar, most market analysts are referring to the U. S. Dollar Index. This index is traded on the NYBOT under the symbol USDX. I am supplying the following data taken directly from their web site (www.nyce.com) to reveal the components of this index.

The U.S. Dollar Index® is computed using a trade-weighted geometric average of six currencies. The six currencies and their trade weights are:

Notice that this particular index contains only 6 currencies and that some of the major currencies are not even included in it such as the Australian and New Zealand Dollars. To be perfectly honest to this day I do not understand the choice of the Swedish Krona in the index (no affront to my Swedish friends) but nonetheless, there it is. Also note that the Chinese yuan or renmimbi is not included in this index (that is currently fixed or pegged anyway).

With this in mind, when we now state that the U.S. dollar has risen in value, we are saying that it is floating upward in comparison NOT TO GOLD in a direct sense (indirectly it is), but in comparison to this basket of six currencies. When the dollar weakens, it is adjusting downward in comparison, NOT TO GOLD directly, but in comparison to this same basket of six currencies. That is important. Why?

The obvious answer is that when we speak of the dollar's valuation, we are referring to its valuation on what is termed the Foreign Exchange Market. That is oftentimes simply referred to as the FOREX. Now, the very words, "foreign exchange" tell us something that I believe many of the proponents of the synthetic short dollar position have completely overlooked, namely, that every time the dollar is bought or sold on the international market, there is AN EXCHANGE that takes place. It is the sum total of these exchanges which contributes to the dollar's valuation. The greater the supply of dollars being exchanged, the weaker the dollar's value will tend to become in comparison against those currencies for which it is being exchanged.

In my opinion, this is the single, weakest point in the synthetic short dollar theory. It fails to account for the impact on the dollar by the sum total of these foreign exchanges.

As I understand that view being propounded by its advocates, the idea is that during a period of intense deflation, American citizens who have managed to amass significant amounts of indebtedness will attempt to reduce their debt by selling their goods or possessions in an attempt to raise cash with which to pay off their debts. This will result in increased demand for dollars as people will tend to hoard cash as the deflationary spiral worsens. In a deflationary environment of falling prices, the purchasing power of the U.S. Dollar will actually increase since falling prices will allow holders of cash to actually obtain more goods for the same amount of money. The claim is that this increased demand for dollars will result in the dollar actually strengthening much to the consternation and surprise of many who are expecting a severe decline in the dollar.

Let me first deal with this assertion. There are two obvious flaws as I see it. The first is that while this may have been true at one time in American history, it is no longer true today. The reason is due to the profound changes that have taken place in global trade and the resultant dislocation of entire industries as well as the changed climate of global investment and the ability to move investment capital around the globe quickly and efficiently.

Earlier in the past century, the U.S. produced the vast majority of its own goods and services domestically. That is simply no longer the case. Many of our manufacturing industries have now moved overseas with the result that domestic demand for dollars is no longer a sufficient factor in itself to affect currency valuations.

The second and most obvious flaw in this reasoning piggybacks upon what was just stated. The synthetic short dollar theory's failure to deal with the influence of the fundamental factors detailed above, most notably trade flows and capital flows from abroad, is a serious omission of two of the most critical factors that go into determining the value of a currency and cannot be overlooked. Let me explain.

Let's suppose that the deflationist argument is correct and that assets begin to get sold in an attempt to raise cash. Such selling will precipitate further selling as those who have stood on the sidelines begin to sell in an attempt to avoid being left holding the bag as prices of various goods begin to decline at a more accelerated rate. Is it not logical to assume that among those assets which will fall in value are stocks? I would think so. One need only refer to the 1998 collapse of the Belarussian Ruble and the Russian ruble as posted by Jim Sinclair at www.jsmineset.com for proof. The BBC story referenced there makes it plain that share trading on the Moscow stock exchange for all practical purposes ceased as foreign capital took flight further adding to the ruble's woes.

As a matter of fact, those of us in the other camp who look for a catastrophic collapse in the value of the dollar agree with the synthetic short dollar folks on this. We both believe that the price of stocks will fall sharply at some point in the future. Unless I am missing something here, every synthetic short dollar advocate agrees that stocks are destined to take a hard fall. So the question they need to answer, and to this point, I have not seen an answer that satisfactorily deals with this, is "What will be the impact of falling stock prices in regards to foreign investors?"

Let me state here for the record that the answer to that question is obvious - falling stock prices will result in foreign holders of American stocks selling right along with the rest of the American public.

Now refer back to our discussion of capital flows above. If foreign investment capital begins to flee the U.S. stock markets, then the SUPPLY OF DOLLARS WILL INCREASE as foreigners sell dollars in exchange for their native currencies so as to repatriate their capital. Remember, more supply and reduced demand leads to a WEAKER currency. The result will be to further push the dollar downward as investment demand dries up. That is a simple, hard fact and in my opinion cannot be gotten around by any sleight of hand or sophistry.

To give you some idea of the amount of dollar demand that can be created in a year's time from foreign investment flows towards U.S. Stocks alone, please observe the following chart below derived from data at the web site of the Federal Reserve. The Fed has data for each month's net purchases of U.S. equities by foreigners. I have taken the data and summed it for each year going back to 1995 at which time the bull market in U.S. stocks began to move into an acceleration phase. Look at how sharply the dollar figure of foreign purchases escalated during the phase leading up to the blow-off peak in 2000. Keep in mind that the entire sum of $174.9 Billion that peaked in the year 2000 was DIRECT DEMAND for the U.S. Dollar. All that foreign currency had to be exchanged for dollars with which to buy those nifty tech stocks and dot.coms.

Now notice how net foreign purchases of U.S. equities began to decline immediately as the stock market peaked in that same year and has continued to decline going negative for the first half of this year (2004). It is no coincidence that shortly after the short market peaked and foreign demand for U.S. equities declined, the dollar began its precipitous decline right along with it as you can see by observing the chart of the dollar index. A significant source of dollar demand was removed. Remember - decreasing demand leads to a weaker currency.

Those who advocate a mini demand led bull market in the U.S. Dollar due to any so-called synthetic dollar short theory MUST come to grips with this harsh reality. Their omission of this influence on the dollar is quite frankly inexcusable in my opinion especially in the light of their unanimous belief that the U.S. stock market will suffer a precipitous decline as deflation takes hold in earnest.

Something that needs mentioning here is the idea advanced by some that in a deflationary environment of falling interest rates that asset backed loans such as Mortgage backed securities (MBS) will find favor with investors who are hungry for yield. There is a good deal to be said for such a premise. A security like this paying 6% or so in an environment of falling interest rates might indeed be attractive to would-be buyers. This would seem to generate additional dollar demand from abroad and thus contribute to dollar strength. The reasoning behind this idea is that people will tend to want to keep a roof over their head even in the midst of falling house prices and thus these loans will tend to be serviced FIRST among consumers with what disposable income they have. Such loans then might offer a relatively "safe" place for those hungry for yield and attract capital flows from abroad. On the surface this seems to make a lot of sense.

Here's the problem with argument as I see it however. A severe deflation of the nature the many are looking for will result in widespread unemployment. Having been through several real estate boom and bust cycles in which housing prices plummeted due to a stagnant economy, it has been my experience that many homeowners will simply "walk" on their home mortgages and allow the house to go back to the lender in the foreclosure process. Mortgage companies and banks stuck with this situation will attempt to sell the houses they have repossessed as quickly as possible to try to recapture some of their losses and to get out from managing and maintaining the properties. Mortgage companies do not make money foreclosing on houses. They make money providing mortgages. Their actions tend to depress the housing market in the area even further as they move to get these properties back on the market which in the process simply adds additional supply to the market. This can tend to result in a cascading effect as many homeowners unload their houses in an attempt to salvage their equity and to get out from beneath a loan on a piece of property that might have fallen 20-25 % in value or more. Here there are stuck with a $250,000 mortgage on a home now worth $185,000 or less! All of a sudden those MBS might not look quite so attractive to would be investors. There is too much risk of default in an environment of falling property values. They are going to want higher yields to compensate them for the additional risk they are taking on.

Furthermore, many homeowners will simply sell their homes and those loans will be retired. New loans will then be obtained that will be at a reduced rate as interest rates plummet across the board in the deflation. Such new loans will offer a much lower yield and will not be near as attractive to would be foreign investors. Remember one of the factors discussed above that determines the strength of a particular currency - Economic Growth Expectations. If a severe deflation indeed occurs in the U.S., the dollar will suffer out of the fear of foreigners who have no confidence in the overall health of that economy. Their money will tend to stay at home or move into another investment vehicle.

Something else that should be considered - those who sell their homes will either choose to rent or will look to downsize. Some will be forced to rent out of necessity. I can easily foresee the situation where smaller, less expensive homes will suddenly be in greater demand while the more upscale will drop rapidly in price. As I see it, the idea advanced by the synthetic short dollar folks that people selling their assets will create additional demand for dollars and thus contribute to dollar strength as they hoard cash runs into a serious obstacle here.

To illustrate this, let's assume something very simple and easily understood. Let's create a monetary system based on apples. Referring to our housing scenario above - Let's assume that John Q. Public lives in a house which was worth 1000 apples at the time he purchased it. Like most of the public, he borrowed a goodly portion of the apples he needed to purchase the home, let's say 950 apples after having furnished 50 apples of his own. Now let's say that he has lived in this home for 5 years and has built up equity of 200 apples. He owes a balance of 750 apples on his mortgage at this point. Suddenly John is a victim of the deflation and loses his job. Unfortunately John bought way too much house for his salary and spent lavishly and has no cushion upon which to fall back on. John has no choice but to sell his house and look for something that he can afford. The problem is John's house has fallen in value and is no longer worth the 1000 apples it was worth when he bought it but has declined in value to only 800 apples (20% fall in value). John has no choice so he puts his home up on the market and sells it for 800 apples. He owes 750 apples as his equity was 200 apples so he pays off the original loan and is left with 50 apples for his 5 years of ownership.

What does John do now? He looks for a home that he can afford and finds that one is available for 600 apples. The problem is that he only has 50 apples for the down payment so he is forced to borrow the rest. This time around John borrows 550 apples and moves into his home. Would someone please explain to me exactly how this is supposed to result in increased demand for apples and contribute to its strength? As much as I have tried to grasp the argument I cannot see it. The simple fact is that John must have a place to stay and in order to do so he is going to need to spend apples. He can only hoard so many apples for so long. Any apples he might happen to raise from the sale of this first home are going to go back into the next home. The net result will be a wash.

Moving along in attempting to dispel the line of reasoning held by the synthetic short dollar folks - I have already mentioned the fact they disregard or completely overlook in some instances the impact of foreign investment flows and the HUGE impact those have on the value of the currency, in our case, the Dollar. Additionally, they also overlook the situation as regards TRADE FLOWS. As a matter of fact, this most important of factors seems to be passed by in complete silence by many.

Recall what I mentioned earlier - a nation that has a huge trade deficit will tend to see its currency weaken since SUPPLY of that currency will exceed DEMAND. It is a given that the U.S. has reached a point where in the opinion of many, including myself, its trade deficits are no longer sustainable. The U.S. yearly trade deficit is rapidly approaching levels closer to $600 billion. In other words, Imports of goods and services from abroad are exceeding exports by 600 billion dollars per year. In a normal market, those dollars would be exchanged for the native currencies of the countries which are the source of those goods and/or services. That would add an incredible SUPPLY of dollars onto the market which should depress the price of the dollar. (The sad reality of this is that this huge supply of dollars is actually working to create a world wide source of credit creation).

Again, the advocates of the synthetic short dollar theory seem to completely overlook the impact that these TRADE FLOWS will have on the dollar. I get the impression from reading some of their statements that the trade deficit is almost inconsequential; all that matters is the demand created by American consumers who attempt to pay off debt and collect the dollars needed to do so. This seems to me to be incredibly short-sighted or narrow minded to say the least since we are talking about enormous sums of money here which can easily make a significant impact on the dollar.

To me what is remarkable is not that the dollar has yet to experience some sort of supposed mini bull market rally, but rather that it has not yet weakened to the degree many of us are looking for. The question is "Why"? I believe the answer is to be found in something that my friend "Jesse" has brought to the attention of the gold community and that has to do with what are termed "Custodial Accounts". The New York branch of the Federal Reserve has on its web site (www.newyorkfed.org) the following information which I ask the reader to please review carefully:

On behalf of the Federal Reserve System, the Federal Reserve Bank of New York offers banking and financial services to over 200 foreign central banks, foreign governments, and international official institutions. The services provided by the New York Fed are available only to public institutions.

The Bank's services for foreign official account holders are in four main areas: demand deposit transactions, investments, custodial and safekeeping responsibilities, and foreign exchange operations. The Bank offers other services on an occasional basis, such as providing technical assistance and training to foreign central bankers. The wide-ranging services available to foreign account holders have, in large part, given the New York Fed its significant role in the international financial system….

Foreign official account holders also can send U.S. currency to the Bank for deposit in the accounts. Should other central banks need U.S. currency, the New York Fed will arrange the shipment of banknotes or make the currency available for pickup at the Bank. The customer's account is charged for the amount of currency provided.

Notice the section in the paragraph above which I have underlined for emphasis. It can be seen that a foreign central bank, such as the Bank of Japan, can be provided with one of these custodial accounts at the New York Fed. This account can then serve as a depository for U. S. dollars that that bank wishes to deposit into that account which are used to purchase U. S. Government issued debt or Government agency issued debt. That is significant and I will come back to it in a moment. Let me add some further information from this same web site which I believe also bears on this matter of trade flows.

Custodial and Safekeeping Responsibilities
Most of the assets held by foreign official accounts at the Bank are held in the form of marketable U.S. Government and agency securities, most of which are deposited in electronic (book-entry) form at the New York Fed. At year-end 2002, foreign official and international accounts held about $850 billion in U.S. dollar-denominated assets.

Safekeeping services include presenting the securities to the paying agency for coupon-interest payments and for redemption at maturity. In 2002, the volume of these services totaled $9.6 trillion. The Bank also provides facilities for the clearing and settlement of a customer's own investment trades.

Foreign Exchange
The New York Fed will, at the request of a customer, execute transactions in the U.S. foreign exchange market for the purchase and sale of certain non-dollar currencies. In such transactions the Bank acts as agent for the customers, and these transactions are not considered intervention operations by the U.S. monetary authorities.

Please note carefully the section that I have underlined for emphasis. This little blurb is most insightful and I believe it helps a great deal in understanding exactly what sort of game has been taking place of late in the realm of the foreign exchange markets. Before doing so, please examine the following chart.

The implications of this chart are enormous. You will observe that since the beginning of 2001, holdings in these accounts have jumped from roughly $700 Billion to nearly $1.3 TRILLION. These holdings consist mainly of U.S. Government issued debt (bills, notes, bonds) and government agency debt. In the span of 3 ˝ years, the total amount of Dollar denominated debt being held for foreign central banks has nearly doubled and the sums involved are simply staggering. I believe right here is the key to understanding why the U.S. Dollar has not simply collapsed and continues to hold up even as its fundamentals continue to deteriorate with each passing day.

Simply stated, the Bank of Japan, and I am referring to them primarily as I believe they are the source of the majority of the holdings in these accounts, has been almost single-handedly preventing the dollar's demise by recycling Japan's trade surplus with the U.S. into these accounts which are then used to purchase U.S. Treasuries.

This has had a three fold effect. First, it has served to keep an artificially low long-term interest rate environment in the U. S. Second, as a consequence, it has acted as a source of credit creation in the U.S. Third; it has served to keep the dollar from weakening further than the current fundamentals would seem to call for.

In a normal environment in which a nation has a trade surplus the size of that which Japan has with the U. S., that trade surplus would serve as a SOURCE OF SUPPLY for all those dollars which must be exchanged for the native currency, the yen. Doing that however would strengthen the yen substantially and work to slow down Japanese exported goods by effectively raising their price on the world market, especially for American consumers. The Japanese have gotten around this by reinvesting those dollars in U.S. debt instruments effectively negating much of the normal effect on the foreign exchange market.

My friend Warren Pollock (Pollock.warren@verizon.net) has a brilliant thesis on this in his regular newsletter which I would refer the reader to. Warren suggests that the Japanese are playing a form of interest rate arbitrage by selling their own government bonds which are paying a very low yield and then taking those proceeds and buying U.S. government bonds which, though paying a relatively low yield themselves, are still a couple of percentage points above what they are paying buyers of Japanese bonds. They are profiting on the difference between the spreads. This is downright ingenious even if it borders on the morally bankrupt since the reality is that the Japanese financial authorities are using the savings of their own citizens to keep interest rates artificially low in the U.S. and thus contribute to the U.S.'s profligate ways. The net effect however has been to provide a source of DEMAND for U.S. dollar denominated debt which is adding DEMAND for the U.S. Dollar and that, in my humble opinion, is the ONLY REASON that the dollar has not dropped off a cliff already. Try throwing a Trillion dollars at the U.S. Bond market and tell me if that doesn't provide some dollar demand!

The reason that the Japanese in particular (the Chinese are doing so to maintain their peg of the yuan) would do this is that this kind of DEMAND generated for the dollar is working to keep it from weakening and thus simultaneously exerts downward pressure on the value of the yen. The weak yen works to facilitate the Japanese export market which has been the main source of economic strength for them these past few years. It is all quite self serving for the parties involved. For the Japanese it is, to quote my friend Jesse, "a form of Asian mercantilism" which allows them to hurt their competition while simultaneously benefiting the U.S. financial industry in the process. The same New York based banking outfits whose names keep showing up wherever there seems to be some sort of financial scandal such as Enron, WorldCom, etc., no doubt get to handle the inflows and keep whatever portion of the skim is involved for providing the service. The Fed gets to keep long term rates cheaper than market conditions should allow for thus keeping the credit gambit afloat.

There is no doubt in my mind that this process is exactly what Fed governor Bernanke was referring to when he made the statement some time ago that the Fed possessed some "unconventional means" that would allow it to handle the zero bound problem should it arise - the idea no doubt being that the Fed could ramp up the money supply all it wanted to if conditions called for it and not fear the normal effect on long term interest rates. How convenient!

Let me refer back to a section from the New York Fed's web site detailing these custodial accounts which I referenced earlier and include that once again:

Foreign official account holders also can send U.S. currency to the Bank for deposit in the accounts. Should other central banks need U.S. currency, the New York Fed will arrange the shipment of banknotes or make the currency available for pickup at the Bank. The customer's account is charged for the amount of currency provided.

Foreign Exchange
The New York Fed will, at the request of a customer, execute transactions in the U.S. foreign exchange market for the purchase and sale of certain non-dollar currencies. In such transactions the Bank acts as agent for the customers, and these transactions are not considered intervention operations by the U.S. monetary authorities.

When I first read these words, my gut reaction was one of singular amazement that I had never seen this before. If I am reading this correctly, it seems to me that any foreign Central Bank could move blocks of currency into its custodial account at the Fed and give instruction to the Fed to either buy or sell its currency of choice. For instance, the BOJ could conceivably move U.S. trade surplus dollars into its custodial account and tell the Fed to sell these dollars on the open market and exchange them for yen. What is the big deal some might ask- Central Banks can intervene in the foreign exchange markets all the time? According to this statement underlined above, they could do exactly this but are under no obligation to report their activity to the public since it is not considered an intervention operation by the U.S. monetary authorities and therefore would not have to be included in its quarterly report to Congress. Conceivably, they could run this little gig until the "cows come home" as we say down here in Texas, and the public would never be the wiser since no one would know except the foreign Central Bank who gave the instructions to do so or who might have been asked by the Fed to do this exact same thing! It seems Central Bank collusion is alive and well as they work hand in hand to prop up a rotting system of fiat excess.

It is highly doubtful however that this sort of gambit can continue on indefinitely. When the gold standard ruled the day, nations that ran huge trade deficits were punished by seeing their gold flow to those countries which were running the surpluses. This worked to correct the imbalance by reducing the money supply of the deficit nation and slowing its economy. Today, this same imbalance is settled with the issuance of DEBT (financial instruments). As such there is little to punish the nation that runs the deficits and certainly not much incentive to correct the imbalance as long as the surplus nation continues to accept paper IOU's. Eventually however, a point will be reached where one nation cannot continue to heap up nothing but promises to pay in return for its manufactured goods even if it is advantageous to that nation in the short term to do so. When this point is reached, and I do not claim to know when that might be, the gig will be up and it will be time to pay the piper. When that occurs, I believe we will see the dollar literally MAULED on the foreign exchange market as the last source of dollar demand disappears and with it, the only support of consequence for the dollar. God help us when it does is all that I can say for I believe that we will witness the end of the Dollar as the world's reserve currency and perhaps the final end of the remaining vestiges of Bretton Woods and I honestly have no idea what will arise to take its place.

Above and beyond all this, stands the spectre of the over-the-counter derivative crisis that is brewing behind the scenes. Suffice it to say that this situation is a time-bomb slowly ticking away and that its detonation will have profound repercussions as related to the valuation of the dollar. A cascading failure in any one link of the chain of risk dispersal created by these completely unregulated and non-transparent instruments will result in a wave of systemic ripples that in my opinion will only add further downward pressure on the dollar.

Finally, before taking my leave, I think it also important to mention that in a deflationary environment as envisioned by the synthetic short dollar proponents, there will be wave after wave of default as consumers seek to liquidate debt.

The problem will be that everyone will be liquidating at the same time! Imagine what a fire-sale that is going to be. The synthetic short dollar folks seem to somehow believe that the average homeowner/consumer is going to be faithfully checking the level of the U.S. dollar on a weekly, if not daily basis, and will observe its precarious situation and prudently take steps to protect him or her self from the coming storm. As the stock market drops violently, these same people will of course take steps to sell their stocks in an orderly manner and between the two sets of actions, carefully and systematically accumulate hoards of cash with which to protect their families. Nothing could be further from the truth as the event is likely to unfold.

Most will not have the foggiest idea that a crisis is upon them until it is too late. They will have sat idly by listening to the prognostications of the political and financial leaders calmly reassuring them that all is well and that panic is to be avoided as "in the long run stocks will be just fine and they need only to sit tight and ride out the storm". "Hasn't the stock market always come back" will be the retort. "Just think how much money you would have avoided losing if you had only held onto your stocks after 9/11 instead of blindly selling", they will be reminded by the "experts" that CNBC and Bloomberg among others will no doubt trot out to assure the public that all is well.

By the time the poor public actually realizes that something is seriously wrong this time around, they will all begin to panic simultaneously and a wave of liquidation selling will unfold which will act to swamp stock prices and the prices of other assets in liquidation mode. Consumers will be lucky to come away with two nickels to rub together as prices collapse due to the lack of buyers. Perhaps .50 on the $1.00 might be considered a fine price if one can fetch it. For all we know it might be closer to .10 or .20 on the $1.00. Either way, I fail to see how this is going to create some sort of overwhelming demand for dollars given the fact that prices will supposedly be collapsing across the board.

In conclusion, my purpose in presenting this essay is that the reader will come away with enough ammunition to quiet those who are so vociferously upsetting so many in the gold community with their claims of a soaring dollar and a corresponding collapse in the gold price. If nothing else, it might at the very least give those who are advocating such a theory room to pause and consider the foundation of their thesis. If that takes place, then this effort will have served its purpose.

I invite those who differ and those who agree to voice their comments. I cannot promise that I will be able to respond in depth to all such emails as time constraints will not allow for that. For that, I ask your understanding in advance.


Dan Norcini
September 11, 2004

Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments.

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