What’s next for the USD?

Okay. I concede to loving it. Nothing like a good old-fashioned short squeeze to turn me on financially. I am old enough to remember those great days in which smart, no remorse investors, played the game in pork bellies or corn. Chicago was the financial far west. Short squeezes in commodities were awesome, despite their questionable underlying ethics. ¿Are markets ethical the other way around anyway? ¿Who can talk for POMO desk ethics?

Fortunately, I was too young to be directly involved at the time, but I found those trading techniques exhilarating. I say fortunately, because sailing can compensate for the lost adrenaline, but age is irreversible. I have my crew working hard to prepare the next ORC world sailing championship taking place in ¡Barcelona! That should fill in the adrenaline lost when missing pork belly trading.

Short squeezing the USD is for adults only. Forget lean hogs, iron ore, or copper. They are childs play. EURUSD and USDJPY are the central pillars of the financial universe. Volume remains gigantic, even as liquidity is seriously impaired in most markets. Ten year JGB’s are the paradigmatic example: there is no market without the BOJ as a counterparty!

That’s not the case in the two main currency crosses. Even POMO desks fear both trades. You can corner the JGB market if you own the BOJ balance sheet, but even printing JPY at will, leaves you short of a real control of the USDJPY. The same thing goes for superMario. In the end, even controlling the EUR base money supply, he ends up imploring or jawboning participants to iinfluence currency prices. Well, now that think of it, he never really does that, because “the price of the euros is not a target for monetary policy in itself”. Ha ha. A stunning actors studio representation indeed. A better liar than Michael Corleone in the final scene of the film.

The size of the actual USD short squeeze is mind-boggling. As Confucio said, there is beauty in all things. you just have to see it. Admittedly, it does help to be long the USD, it’s tough to see the beauty of it when you’re being massacred. I’m still there in large size, but no leverage. I wish I had remained leveraged all along. In retrospect, the strength of the move was clear. As I grow old, I become more and more risk averse. I should have been leveraged all the time.

The following charts sum up the USD short squeeze parameters. First, we have to remember one of the consequences of Heli-Ben’s QE. Easy money made the USD the carry currency of choice. Emerging markets have added 2.5 trillion in USD debt over the last five years. They must be lots of panic hedging as I write. The BIS chart says it all.2-BIS-dollar-credit-to-nonresidents-by-geography

Next, let’s see how USD reserves are being used up, as BRICS and emerging countries spend them to alleviate the smaller inflow of USD (Triffins dilemma in place, as US crude oil production influences balance of payments decreasing the dollar outflow), and their currency weakness as well. The Real and the Rouble are a case in point. Chart courtesy of the daily shot.dollarreservesdwindle ds13h

SuperMario is a lucky guy. He is clearly of the superior species, remember he even worked for Goldman Sachs and helped fix Greece. He is now boasting  his abilities to move the markets in strength. In truth, it’s the second time the FED bails him out of nowhere. ¿Remember the “whatever it takes” gamble back in 2012? We will never know for sure, but I am of the view that without QE3 he wouldn’t have tamed the CDS levels of the periphereal countries.

Fast forward three years, nearly all FOMC members are voicing an urgency to lift rates, and this comes in a context of NIRP and QE for the ECB. Napoleon once said, “I have plenty of clever generals but just give me a lucky one”. He would hire Dragui for sure. Jordan or Yellen wouldn’t even be considered for the post.

Now we know why we got here (EURUSD at 1.048 as I write). Where we are going, from now on, is the trillion dollar question. As Mark Twain once wrote, prophesy is a good line of business, but it is full of risks. In fact, we all know there is only two kinds of forecasts … lucky or wrong. I’ll do my best to fit in the former cathegory. Having said that, I think USD strength still has a time to go. ¿Why?

1.- The rest of the world is imploding. The US economy is nothing to write home about, and a very substantial weakening is already in the data for the first quarter. Only lagging indicators, like payrolls, still show some strength. But the rest of the world is really a lot worse off. China is falling off the cliff, Abenomics is a disaster, it’s third arrow nowhere to be found, and Europe is the first debt sustainability accident waiting to happen. There is really no other viable option to greeking greek debt. It will be a serious haircut, one of the kind they will give you if you attend an Indian cremation ceremony.

Minor but sound currencies’ CB’s are fighting desperately to depreciate them, and will do whatever it takes to prevent revaluation. That leaves SEK, NOK, SGD or NZD as unlikely strong bulls. In any event, they are unable to cope with the huge money inflows of a flight to quality bid when debt write downs become all too apparent.

I am not comfortable holding USD only, but we have run out of alternatives. I still hold a medium size position in SEK (50% of underlying total portfolio assets) and plan to remain there. But I cannot use SEK alone. I have begun a position in SGD but am really tiptoeing in, because I think USD strength has still further to go. You just have to hold USD whether you like it or not.

2.- In a world of ZIRP or NIRP in other currencies, it is one of the few reasonably safe ways to pick up medium term yield. South Korea, Australia, New Zealand, Singapore or India are pretty much the short list for other alternatives. Nowhere near enough safe havens for a lot of money that will panic for shelter in the global debt meltdown. The next chart makes it very obvious (unless you want to play russian roulette in the Rouble or the Real to name just two).amazing ds12h

 And look at the Treasury-Bund 10Y spread. Still surprised by the strength of the dollar upsurge?

Treasurybundspread ds11h

3.- QE policies and the likes, are down and out in the US. AS Churchill said, you can always count on the Americans to do the right thing, after they have explored all other alternative options. The US has already run the course of easy money and multiplied its money base by a factor of five. Even Krugmanites are beginning to consider it is more than enough. NIRP and QE are  out of the realm of possibilities.

Tue enough, I do not think we are going to see relevant continued rate increases (the economy is very weak), but a token rate rise is all that is needed to encourage herd behaviour, and I think it’s likely that we shall get that. If we don’t, it means we are a lot closer to the final debt meltdown, and it will pay to hold dollars in that situation anyway.

In due time, the Fed will have the privilege of opting for hiperinflation or allowing the global debt meltdown. Once we get to a point of no return, it will be either print again and destroy the USD (the reserve currency after all), or “laissez passer”. I hope they will go for the french option. In the meantime the USD will be king. We will live interesting times. And they’re getting closer.

4.- The Chinese Yuan is in a precarious position. I see  USDCNY  above 6.40 by year end. The rest of Asia will be pressured to devalue further against the USD. South Korea is generating some loud noises of discomfort already. All in all it points to USD strength continuing, or at least consolidating, in Asia and Europe. The CNY and the JPY are important wild cards today. I expect a stable JPY, and a devaluation in the CNY, but it’s really anybody’s guess.

yuan bands ds19feb

That’s about it all in the currency arena. You want to stand clear of the euro, have some USD exposure, and try to diversify your currency risk with some SEK or any other solid currency. If you are very brave you can get yourself some JPY. The country is bankrupt, but the currency is massively undervalued.

I would avoid euros and yuan, lever moderately if at all, and try to pick up some yield in ZIRP currencies with decently steep yield curves. Australian Bonds and US treasuries look like acceptable risk to me. You can even try to position yourself at the far end of the curve, but no durations above 5/6 years, as I see it. I think there is some room for curve flattening, but we live an unstable environment.

If the USD continues to rally, CB’s will all try to soften it, and they have proved they can coordinate efficiently. At this stage though, I think it will take more than words and concerted intervention to achieve that. The FED would have to embark on another round of money debasement using the appropiate acronym for the new program. I doubt they will do that. If they do, buy hard assets inmediately. If they don’t, hold on to your dollars and avoid any kind of credit risk in corporates and sovereigns. Hold tight and watch, it’s going to be the hell of a ride.

A strong dollar is also a negative for equities globally, particularly US equities. I painfully built a massive short in the SP500  again. Stops around the 2090 level. This is the big short, you have to be there and keep trying. More on this next week.

There is some substance in this cartoon. If you think global debt is a mess, just think about entitlement contingencies. And give pension fund future returns a thought. But above all, smile and be happy. We lived the great inmoderation, and spent it all, why blame Madoff?madoff-cartoon