Thursday, October 8, 2009

Sneak Attack on U.S. Dollar?

or is it the result of an on-going process that started back in March?

Politico thinks this is a "sneak attack" on U.S. dollar this week.

People at Politico are not stock market or forex traders, that's for sure. Current U.S. dollar decline is mild, compared to what has transpired since March this year.

Not to be deterred by the lack of perspective, however, Politico sets to find out...

Whodunit? Sneak attack on U.S. dollar (Eamon Javers, 10/8/09 Politico)

"It’s the biggest mystery in global finance right now: Who conducted a sneak attack on the U.S. dollar this week?

"It began with a thinly sourced but highly explosive report Monday in a British newspaper: Arab oil sheiks are conspiring with the Russians and Chinese to quit using the dollar to set the value of oil trades — a direct threat to the global supremacy of the greenback.

"Is it true? Everyone from the head of the Saudi central bank to U.S. officials scrambled to undercut the story, but no matter.

"With the U.S. economy on the ropes and America by far the world’s biggest debtor, investors aren’t feeling as secure about the dollar as they used to. And the notion of second-tier economies ganging up on Uncle Sam didn’t sound so far-fetched.

"For American officials, the possibility of the dollar losing its long-term dominance in global commerce is a nightmare scenario because it would likely mean sharply higher interest rates at home and a declining ability to finance the U.S. debt. No one believes it could really happen right now, but stories like the British report this week make it seem incrementally more likely."

While trying to undermine the Independent story by casting doubt on Robert Fisk (a highly respected veteran journalist, in my opinion), the writer concludes:

Whodunit? "No one knows."

I think I have a suspect, or an event that may have contributed to the rapid decline of the U.S. dollar. Not the decline of U.S. dollar this week, but since its recent peak back in March when the U.S. dollar index was near 90.

The U.S. Federal Reserve.

It is probably just a coincidence, but it's a little more interesting answer than "no one knows".

Take a look at this chart. This is a year-to-date daily chart of the U.S. dollar index (DXY). Red arrows on the chart indicate big negative flows out of the Fed's central bank liquidity swaps, as shown on their balance sheet. The weekly change of the swaps is shown in the table, with numbers in red corresponding to the arrows in the chart. The location of the arrows is approximate, as we don't know exactly which day of the week the Fed unwound the swap.

That's foreign currencies going back to the foreign central banks, and U.S. dollar coming back to the Federal Reserve. The Fed is not saying which central banks got how much, or what foreign currencies the Fed was and is still holding.

Where did those returning dollars go? My guess is they went to agency bonds and agency-backed MBS, thus preventing the decrease in the accommodative balance sheet. It could have gone to Treasuries to support the auction.

The dollar decline coincides very well with the stock market advance since March low. In fact, right after a sizeable chunk (over $50 billion) of dollars came back, the stock market bottomed and started the furious ascent as U.S. dollar cratered (the left-most arrow in the chart).

For fun, here's another set of charts - the top is the above DXY-Fed swap chart, vertically flipped, and the bottom is S&P 500 index.

Where is the Federal Reserve buying those agency bonds and MBS from? They are not saying. It's a trade secret. Again, my wild guess is from foreign central banks and U.S. financial institutions who get to dump them on the Fed at face value. (Well, that's how the Fed accounts for them, at face value.)

In the beginning of March, the foreign currency swap balance on the Fed's balance sheet was $375 billion. In the October 8th balance sheet, it was down to $50 billion, with about $7 billion U.S. dollar swapped back. That's a significant size for the past 2 months, and sure enough, U.S. dollar resumed the descent.


Post a Comment