Why The U.s. Dollar Is a Heat-Seeking Missile

As the U.S. dollar rises sharply in tandem with gold, the odds of another global financial crisis go up. Editorial Director, Justice Litle discusses why…

It’s a funny thing about crisis – you can never be sure what the next catalyst will be. The really bad trouble always seems to spring from a place no one was looking.

This is a big reason why so many investors are caught off guard. They check the obvious places, but forget to check the odd places. (Or else they shrug and dismiss the possibility of crisis entirely.)

What’s worse, our global financial system is even more prone to crisis now because everything is so connected. When one financial system sneezes, another catches cold… or pneumonia… or worse.

As you well know by now, the eurozone is engulfed in systemic crisis. But did you know that a crashing euro has the potential to unleash a fresh new round of fiscal avalanches all around the world – even in countries that have no exposure to the euro at all?

The reason why has to do with the U.S. dollar. The surging U.S. dollar.

Dark Riders

On Friday we talked about how gold has gone parabolic. As the chart above shows, the U.S. dollar is going parabolic right along with it.

When gold and the dollar rocket higher at the same time, that’s a very bad sign. When the two get together like this, they are dark riders of deep fear and concern.

The dollar-gold parabolic pairing is rare. It happens as a function of last-ditch safe haven buying. When things get really bad, many investors want to seek shelter in gold, the last “neutral currency”… and the rest want to pile into U.S. Treasuries.

Right now we can say the U.S. dollar is rising for at least three reasons:

  • Because the euro plunged into freefall (sending the $USD higher).
  • Because U.S.-based investors are pulling their dollars from emerging markets.
  • Because overseas investors are buying U.S. Treasuries (along with gold).

Squeezing the Shorts

Now here is the problem with this situation. The higher the dollar rises, the more the shorts get squeezed.

And who are the “shorts” in this instance? Anyone who has borrowed cheaply and heavily in U.S. dollars, with an eye for investing the proceeds elsewhere.

Take our good friend Hugo Chavez, for example. Chavez is the fiery leftist president of Venezuela – a man who, just to give you an idea how he thinks, recently hired some 200 people to manage his Twitter account.

Chavez is also – how to put this tactfully – a bit light in the brains department. The man is just not that smart.

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And so, it was no surprise last year when, somewhere in the general vicinity of the dollar’s bottoming out phase, Chavez decided that Venezuela should issue dollar-denominated bonds.

This meant that Venezuela sought to borrow in U.S. dollars, assuming it would have the ability to pay those dollars back more cheaply – with lesser value inflated dollars – at some point down the road. Chavez cackled about the move at the time, thinking he was taking advantage of the despicable yanquis and their forever shrinking imperialist currency.

With the dollar now rocketing higher, though, Venezuela’s setup is looking like a very bad deal. To borrow in a foreign currency is to live or die by the fluctuations. For every tick upward in the buck, Venezuela’s potential payback costs go up.

The Asian debt crisis of the late 1990s – also known as the “Asian contagion” – was largely centered around dollar-denominated debt. Thailand had borrowed heavily in dollars to spend money on things like needless construction projects.

When the value of the baht plummeted, Thailand found itself unable to pay its U.S. dollar debts. Other Asian nations, lacking enough spare dollars to cover their scheduled payments, found themselves in the same spot… and the contagion was on.

A Heat-Seeking Missile

Now fast-forward to the present day. Asia is not the one at risk of a dollar shortage this time. They learned their lesson on the last go round, which is why so many Asian central banks have huge dollar surpluses.

The trouble is, others have taken the old Asia playbook and run with it. Many non-Asian countries, not just Venezuela, have borrowed heavily in U.S. dollars on the assumption of paying the money back cheaper.

What’s more, a number of exporters – particularly in Europe – have done the same thing. These exporting companies assumed that getting leverage against the greenback was a sure thing… a one-way bet. The dollar was going down and down when they effectively made a long-term wager against it (by borrowing in dollars). Never did they imagine such a sharp reversal of the trend.

So the faster the dollar rises, and the more sharply it rises, the more pain these “short dollar” players feel. Nor is this even to mention the world’s hedge funds, which have collective access to trillions of dollars worth of leverage… and have deployed much of that leverage in anti-dollar fashion.

Hopefully now you are getting a sense of why the rising dollar is a heat-seeking missile. As it climbs ever higher like a stage five rocket, it gets closer to exploding a whole new level of crisis.

You can get additional information about the U.S. dollar when you sign up and read my fellow Editor Adam Lass’ investment commentary.

A Dangerous Feedback Loop

What’s more, this new crisis has the potential to run on a dangerous feedback loop (just as most all leverage-fueled cock-ups do). As the pressure gets too intense, various countries will decide to buy back their short dollar exposure, either by retiring the dollar-denominated debt or purchasing $USD in the open market to hedge their risk.

This, in turn, creates more buying pressure for the dollar… which pushes the greenback higher still… and so on.

If you’ve ever wondered why markets can run wildly to high and low extremes that seem to make little fundamental sense, this is a big part of it. At a certain point, it stops being about factors like “yield” and “intrinsic value” and more about things like “sentiment” and “plumbing.”

In a nutshell, sometimes the feedback loop takes over – and there isn’t much anyone can do about it.

Equities can play a role too, through the leveraged nature of investment funds. If a large hedge fund is heavily invested in long equities with plenty of leverage, and the value of those equity positions starts to decline (i.e. stocks go down), the fund might need to sell stocks and cover some of its short dollar exposure at the same time, in order to “stop the bleeding” and reduce risk.

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If just one fund takes the course of action described above, it should be no problem. If enough large funds do it simultaneously, however, you can have an immediate problem (of the type that fuels a 1,000 point drop in the Dow, for example).

On the equity side of the feedback loop, this means selling begets more selling. On the dollar side it means short-cover buying begets more short-cover buying. Like the ouroboros, the fat tail feeds on itself.

Be Careful Out There

This kind of thing is not reason enough to sidestep markets entirely. There are few “set and forget” type investments in the world, and central bankers everywhere are working hard to make cash in the mattress a bad idea.

But you want to be careful out there. If you can, cultivate the ability to go short as well as long, either through options and ETFs or individual equities. Learn when to be tactical in your deployment of capital, not just strategic.

And learn to take overly rosy forecasts with a grain of salt. Every projection has hidden risk, and that risk should be brought up front and dealt with. (The good news being, sometimes the risk is also opportunity.)

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