Since last March, the monetary supply spigot has inflated asset prices in an all-out assault on the deleveraging-induced increase in monetary demand, especially in liquid safe haven currencies, like the USD, in which much of the “bubble debt” was denominated. If liquidity injection has masked solvency risk in the short term, a belief I hold, then the resurgence of dollar demand outpacing supply should catalyze mean reversion back to reality.
As the Fed became hawkish in reactionary policy to the summer 2008 oil bubble/energy crisis, the monetary spigots closed for the dollar and credit tightened. This catalyzed a freezing of credit markets that unmasked years of bubble default risk that had been hiding behind the veil of low interest rates and excess liquidity, culminating in a risk asset crash in the fall of 2008.
The reactionary policy of central banks and governments in 2008-2009 re-opened the monetary floodgates, a supply increase that outpaced the increasing deleveraging-based monetary demand. The injected liquidity also loosened credit markets, allowing monetary demand and safe haven demand to fall, and increased investor perception.
The next cycle in this reactionary and interventionist game that central banks are playing involves a resurgence of the monetary demand side offsetting the supply. At this stage, an increase in interest rates or another liquidity extraction tool isn’t necessary to catalyze a rush to liquidity. The deleveraging and credit tightening is already there and has been continuing, even into the face of a massive rally. This status quo merely needs to offset what’s left of monetary supply increase.
As the Fed’s QE winds down (the Tsy purchases portion is complete, the Agency debt purchases portion is all but complete, and the Agency MBS portion is about 70% complete), the supply of USD is drying up, in the face of a tight credit environment and surging default rates. The balance of the MBS purchases may provide liquidity to run markets up another 10% or so, but the already-deteriorated credit environment that is now the status quo may provide sufficient demand to offset the injected supply, well before the supply actually dries up.
The EUR/USD cross is a great indicator of the fight between dollar supply and demand, in my opinion. The euro is the second-most liquid currency in the world and represents a riskier, higher-yielding version of the international reserve currency, the dollar. A declining euro against the dollar represents a rush to liquidity and safety, whereas a rising eurodollar indicates risk chasing.
The Fed’s hawkish policies in summer 2008 sent the eurodollar in free fall, from 1.60 in mid-July to 1.46 a month later. This sell-off was a significant foreteller of the liquidity crisis to follow, as it cause (hawkish Fed policy) was also the catalyst for the subsequent mean reversion (which, in the case of a significant asset bubble, manifested in a drastic credit crisis and deleveraging-induced asset crash).
In the current scenario, the EUR/USD has fallen sharply, from 1.51 in December to about 1.44 currently. This has occurred without Fed tightening in response to inflationary concerns and with very limited hinting of liquidity extraction. The implication here is that (lack of) cash flows on the real economy level are inducing deleveraging that is causing a rising demand for dollars that is offsetting the balance of QE-generated increasing supply. This cause could be a potential catalyst for the subsequent mean reversion, as in 2008, with the recent eurodollar selloff forecasting a possible second leg down in the cross around February-April and a concurrent highly-correlated asset sell-off.
The EUR/USD cross shows significant pivot points around its 200DMA. The August 2008 breakdown of the eurodollar through its 200DMA was a great short point in both the EUR/USD and risk assets. After a retest of the 200DMA in December, the cross again sold off sharply, before finally breaching the moving average in May 2009. From there, both the EUR/USD and risk assets surged for the rest of the year.
Since its fall from December highs, the EUR/USD has spent the last three weeks or so consolidating the selloff in a bear flag formation hugging the 200DMA. A breakdown of this bear flag should send the cross pummeling through its 200DMA and carry trades and other short-USD/long-risk trades reversing. Hard.
This bodes poorly for equities and other risk assets.
2010 will the be the year that marks the beginning of the global sovereign debt crisis, which will manifest in various bond and currency crises, as public balance sheets lever up to allow for coordinated private balance sheet deleveraging. But not before the second wave of private balance sheet deleveraging hits. This will be a great buy point for sovereign debt crisis plays, such as precious metals and commodities. But before the ubiquitous theme in finance shifts to sovereign credit risk, the inflated marks to myth on balance sheets will face unwinds and writedowns, as real, tangible cash flow reveals an underlying economic landscape unworthy of the valuations permitted by the massive influx of global liquidity in late 2008-present.
The injected liquidity will come and the longer-term sovereign credit crisis theses will be vindicated. But this liquidity will be reactionary. Complacency and conviction in the illusory recovery is too high, and the Obama administration’s political capital too depleted, for significant further liquidity without a significant (and eventually hyperinflation-inducing) increase in interest rates.
The V-shaped recovery thesis is pervasive among the finance community currently, and the credit crisis is being marked off as a one-and-done liquidity crisis. The mean reversion will be the catalyst for the permanence of the “Bernanke put,” as the credit crisis is unmasked as a much more secular, structural, and sizable problem (because of its nature of concerning solvency risk rather than liquidity risk). This “put” will allow for the inflationary reprecussions of liquidity injections and credit easing, but the next wave of deleveraging will occur before the policy in reaction to it can be instituted.
The EUR/USD is an important carry trade, as well as liquidity indicator and forex cross. A breakdown through its 200DMA could foretell much more weakness in the cross for 2010 and a subsequent decline in equities and other risk assets. The decoupling of the eurodollar cross, as well as other risk assets and yield/liquidity carry trades/crosses, from the Fed’s actions will occur as idiosyncratic sovereign credit risk manifests and individual structural imbalances drive future price direction. Because of this, the Eastern European debacle, coupled with the reactionary and soon-to-be extremely dovish policies from the ECB, should send the euro sinking well after the risk asset selloff/deleveraging resurgence, and into & during the sovereign credit crisis. Because of this, the December 2009 top in the EUR/USD at 1.51 may turn out to be a multiyear top for the pair.
I personally am short from November and December 2009 at a cost-basis around the 1.505 level and will be adding to my short position on a 200DMA breakdown. This is in concordance with various other dollar-bullish, risk-bearish positions I have. I am additionally back to net-short in the spectrum of equities, for what it’s worth.