Is the dollar now a credit market play, not an equity play?
David Bloom (director of currency strategy at HSBC), paraphrased by Peter Garnham in Friday’s FT:
“Today the euro represents growth and has become a big equity bet, while the dollar is firmly entrenched as a fixed income currency.
“In order to get yield enhancement the market [BWS note: really just the part of the market that isn’t central banks] moved away from government bonds in the US and since 1999, has taken a $2,100bn bet of US credit” says Mr. Bloom. “Given that the big play on the US has been the credit markets it makes total sense that a credit market problem is a dollar problem”
One of the reasons why the dollar rallied over the past few days – at least in the eyes of some – is that Americans who had heavily invested in foreign, including European, equities over the past year or so decided to take some money off the table. So, strangely enough, bad news for the US stock market became bad news for the global stock market and good news for the dollar (see BNP), overwhelming, at least temporarily, the dollar’s subprime problem.
At least that is one story.
Incidentally, one question I have long had is whether or not Europeans holding exposure to US credits typically hedge their exchange rate risk. AXA's cash plus fund must have, though that didn't prevent the fund from getting into trouble taking a bit of ill-advised credit risk …
UPDATE: More from the Financial Times, drawing on the thinking of UBS's Mohi-uddin:
Mansoor Mohi-uddin, chief foreign exchange strategist at UBS, said while the sudden sell-offs in asset markets, carry trades and emerging market currencies were helping the yen and the Swiss franc to regain lost ground, investors should be aware that the dollar would benefit from safe haven seeking flows as well.
He said since global equity markets started rallying in 2003, the dollar had weakened as US investors bought foreign equities, emerging market currencies and commodities. “Increased risk aversion now will halt such flows while encouraging US investors to repatriate funds to cover losses in domestic markets"
One small point: I wouldn't call the reversal of risk-seeking trades by American investors safe haven flows, at least in the classic sense. At least in my view, there is a difference between the dollar serving as a "safe haven" for US investors in times of stress and the dollar serving as a "safe haven" for foreign investors in times of stress. The reporting that I have seen is telling "a US money coming home" story (or an unwinding of dollar-funded trades story) more than "a foreign money coming to the US" story.
Barclays Deal Spurs Drive to Limit Government-Fund Investments
The U.S., France and Germany are racing to draw up rules to govern developing nations’ secretive state-controlled investment funds, spurred in part by Barclays Plc’s use of Chinese and Singaporean money in its takeover bid for ABN Amro Holding NV.
With no international body such as the World Trade Organization to oversee such investment, officials in the U.S. are pushing the International Monetary Fund and World Bank to set guidelines. Germany and France, meanwhile, are urging a joint European response.
The idea that the dollar would be *strengthened* by a rise in recession risk and financial dislocation is very puzzling.
Sure, those who need to raise cash due to an emergency will withdraw funds, but presumably they will (a) withdraw first from cash and only if necessary from equities, bonds, or other less liquid assets, and (b) among cash accounts, withdraw from the account that is delivering the lowest rate of real interest.
And then, after they pay out the money, where will the money go? Either into cash reserves or into whatever investment is expected to produce the highest return.
What we saw last week was a 1.4% drop in the Euro (cf. Bloomberg), but substantially larger drops in the Dow, the DAX, the FTSE, etc. Bond yields also dropped, implying a surfeit of cash. In other words, all equities fell, and cash increased. Among the different currencies, the dollar was temporarily stronger. But is that a safe haven effect, or simply the demand effect created by having to pay off all that debt?
And once it is paid off, where does the money go?
On economic grounds, one expects to see dollar weakness for the indefinite future. A 1.4% move is within the noise one expects.
However, I wouldn’t be surprised to see Europe try to force the dollar higher. Their manufacturing sector is being squeezed. They might easily be trying to make carry traders nervous. But if they succeed, they’ll end up paying higher interest rates.
Tougher lending terms for hedge funds
Investment banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.
Bonds hit by credit market dip
The contraction in the credit markets is spreading to global investment-grade debt, with issuance of highly-rated bonds falling to the lowest levels in years.
anonymous ibid — i would tend to think the relatively stronger shift into $ cash than euros cash is associated with the deleveraging of some dollar-based investors (i.e. some folks had borrowed $ to buy european equities). in 06, trouble in emerging economies also led to a temporary boost to the dollar, as the dollar happened to have been a popular funding currency at the time (b/c of expectations of $ depreciation). that also might be the case now — not everything if financed using yen. dollar rats are higher, but if there is an expected $ depreciation, it is still can work as a funding currency.
I take your point, Brad, but as I said, once those loans are paid back, the money has to go somewhere. If it goes into M2, there’s no mortgage market to soak it up. Interest rates would fall, with the dollar in their wake.
Alternatively, assuming the loans originated in international banks/brokerages, the loan repayments could be loaned out abroad. That would mean buying yen or Euros.
Figuring out economic effects to first order is not, IMO, a quadruple bankshot. What appears to be bad to the dollar will be, to first order, bad to the dollar. Selling off European equities and/or currency and/or bonds and/ot whatever to pay off failed investments in the US should be bad for the dollar and, I predict, will be.
” once those loans are paid back, the money has to go somewhere. If it goes into M2, there’s no mortgage market to soak it up ”
Not so. Repayment of bank credit results in a drop in global dollar M measures. (Assets equally liabilities globally.) The result is marginally deflationary in terms of effect on credit supply, money supply, and in this case dollar appreciation.
The US Dollar Rising from the giant hedge funds, major money center banks, and Wall Street Investment banks selling marketable foreign assets to cover massive losses on US assets.
http://www.prudentbear.com/articles/show/2073
So, why are the Big Boys still reporting record profits? It’s actually easy, with a combination of the following: 1) Taking on unprecedented risk by exploding up the size of the balance sheet; 2) Adding massive amounts of leverage, including hidden leverage through derivatives; 3) Robbing loan loss reserves; and 4) Playing accounting games that allow earnings to be booked today at the expense of losses tomorrow.
Included in the unprecedented risk category is when these same financial firms switch to the foreign carry trade. Big carry trade profits can be achieved by borrowing in a low interest rate foreign currency (such as the Yen). As long as the Yen declines in value, a fortune can be made borrowing below one percent interest, and investing in U.S. financial assets yielding much more. However, this trade is placed and highly leveraged and if the Yen ever goes up against the dollar, the carry trade losses will make the subprime fiasco appear like a minor footnote in history.
The Big Boys have exploded the size of their balance sheets and are funding massive positions in securities with short term “repurchase agreements” in the money market. (Many of the securities funded are just like those in the subprime mortgage hedge funds where the security can’t find a
buyer who will make a bid in the market.) These securities have value recorded on the balance sheet because a trader or portfolio manager, with a fancy financial model, says they have value, not because the market says they do. These balance sheets are like sandwiches filled with hundreds of billions of dollars of “rotten mystery meat”.
[q]So, why are the Big Boys still reporting record profits?[/q]
Because there is a lot of money to be made in investment fees, and the sub-prime mortgage problem isn’t that large on the balance sheets.
Investment banks aren’t nearly as stupid the cited article makes them out to be.
The thing about credit default swaps is that they allow you to make bets with credit. Suppose you are a big investment bank, and a year ago you look at sub-prime mortgages, and think to yourself, this is a total mess, there is going to be an explosion. Well then, you buy a credit default swap on a sub-prime mortgage company, and when that company goes belly up, you end up making a huge amount of money.
The thing about derivatives is that someone wins the bet, someone loses the bet, the total affect on aggregate money supply is zero, and you don’t run into any sort of crisis unless someone can’t pay, and we are nowhere near that level.
Personally, I think that CDS’s *add* financial stability since it gives people a financial incentive to “look for stupidity.”
[q]The seller of the credit default insurance can claim “I know the credit will never default; I can book the premium I collect as pure profit and don’t need to book a loss reserve.” At the same time, the buyer of the credit default insurance can claim “The credit will default within a few years so I
can amortize my profit, net of the premium I paid, to my expected date of default.”[/q]
This is total non-sense. The risk managers will keep a really tight control over the credit default swaps you issue. Also since CDS’s are generally very liquid instruments, there is a market price which you can value against.
Generally in investment banks, the quants who write the models tell the traders how much something is worth. It doesn’t go in the other direction.
Anonymous*, I agree that the result of the repayment of (or default on)a loan can be simply a diminution of M and, since it occurs inside the United States, that the result is deflationary particularly inside the US. That’s what happened on a grand scale in Japan after the real estate bubble popped.
I’m implicitly assuming that the Fed will act to maintain the monetary supply at a constant level. It no longer steers by the stars of monetarism, of course, but if there were perceptible economic effect, it would react to increase liquidity.
Anonymous ibid:
Very good point. Although Fed action to increase liquidity at the margin is normally consistent with reducing the funds rate. The Fed increases liquidity via expanding the monetary base, which will tend to correlate with easier short rates.
Whereas maintaining the funds rate at this stage is consistent with allowing some marginal deflationary effect associated with credit contraction, up to a point. Beyond that point, the fed ‘put’ gets executed, with a lowering of the funds rate. The question is, how far will they allow marginal credit contraction before they feel the need to do this?
Also - the contraction of credit and M has no effect on the monetary base unless the Fed decides to make it so.
“Trading has surged in put option contracts on European and US stock indices…” http://www.financialnews-us.com/?contentid=2348417008&page=ushome
IMO the dollar reaction was a short covering rally. The USD is heavily heavily shorted and was technically very oversold. A short term technical bounce was expected. Long term the dollar is absolutely a credit story, but credit of the US Federal Government. Often neglected in discussions, as the unfunded liabilities “become funded”, the fiscal deficit will very much call into question the viability of long term bond holders. It is worthwhile to reflect back to an earlier testimony by Ben Bernanke in addressing a presented question as to why foreigners continue to buy 30 year treasuries. To that question he answered, he doesn’t know. That answer is food for thought for everyone reading this forum for if the top banker cannot rationalize the purpose of foreign creditors purchasing long term treasuries, then the dollar is absolutely a credit market play.
Interesting to think about the impact of this kind of price correction, across the spectrum, if it happens: “…”The current prices are being driven by speculation rather than physical issues,”… Should that be the case, then oil prices could fall almost as quickly as they have climbed. James Cordier of Liberty Trading Group said he expected oil to be back near $60 a barrel in the autumn…” http://news.bbc.co.uk/2/hi/business/6920159.stm
“the dollar is absolutely a credit market play”
still not seeing why that should lead to a conclusion that the Euro - or Europe - is an equity market play.
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- or that the USD/United States is necessarily a credit market play.
“In… Managed Futures: Changing Course: Becalmed No More… Barron’s notes that Red Sox principal owner John Henry’s commodity fund is suffering a three year, 40% decline… But… In 2007’s second quarter, the portfolio surged 25%. Ironically, Merrill Lynch… ended a long-term relationship with Henry in April and pulled its mostly retail investors’ assets out of his fund - almost exactly at the portfolio’s lowest point…” http://www.bloggingstocks.com/2007/07/28/red-sox-owners-futures-fund-is-tanking/
“still not seeing why that should lead to a conclusion that the Euro - or Europe - is an equity market play. ”
I wondered about that too.
Euro markets are outperforming
vs.
Euro interest rate spread will continue to widen vs the dollar