Friday, November 21, 2008

Dollar Strength Sustainability

Coincident with the passage of the Paulson Plan in early October, the top prime brokers (MS, GS, JPM) issued margin calls on hedge funds which raised the average margin required from about 15 percent to about 35 percent. At a time of fragility in global markets and global confidence, this was equivalent to the sudden contraction of global market liquidity by a trillion dollars or so. A huge sell off in quality assets followed as hedge fund managers struggled to meet the margin calls.

Because hedge funds are unregulated, and prime brokerage credit isn’t well reported for aggregation, there is no obvious way to compile exact data. Nonetheless, it would be rational to assume that simultaneous global margin calls on a vast cross-section of hedge funds would have a dramatic effect on global markets. Hedge funds accounted for well over half of all market transactions in 2007, so are a huge driver of maket trading and liquidity.

Trillions of dollars of value were wiped off the balance sheets of the world’s investors over the next few weeks as forced selling forced prices lower and lower. Adding to the selling pressure, many hedge funds were simultaneously raising cash for redemption demands of investors also squeezed by margin calls by their creditors.

I’m sure none of this was intentional (wink, wink). I’m sure there was no coordination among the prime brokers (nudge, nudge). I’m sure it would never occur to anyone in the Wall Street prime brokerage banks that manipulation of leverage could create profitable trading opportunities (cough, cough).

The result was a collapse in global prices for equities, debt and commodities. FIRE SALE! Everything must go!

As the margin calls got met, the dollar strengthened. It strengthened hugely against the pound. From $2 to the pound earlier this year, Sterling has slid to below $1.50. This is likely because there are such a lot of hedge funds and private equity funds here in London, all struggling to meet their margin calls in New York.

At the same time, we observed a huge expansion in the monetary base as the Fed doubled its balance sheet and Paulson doled out taxpayer largesse to Wall Street. The banks began to accumulate massive reserves and Treasury yields crashed lower, especially at the short end. Treasuries gained value as the prime brokers parked the incoming margin cash in the safest, most liquid asset - the primary collateral for all interbank obligations too. These reserves and Treasuries are just sitting in the Fed and not contributing one iota to the stimulation of the economy.

All of this is interesting recent history. Now what happens when some of these trends reverse?

What happens to the global markets when the deleveraging stops? What happens when there are no more global margin calls on the surviving hedge funds? Will anyone want to buy dollars when they don’t need them to repay dollar debt?

Will there still be inflows to US Treasuries when few need a place to park cash for short term liquidity? What will prop up demand for the Treasuries then?

What happens when banks begin to use reserves to lend or speculate in the now crashed assets available globally at fire sale prices?

With most of the growth still projected to occur outside the USA, will some of those Treasuries be sold to take advantage of the many equity investment deals on offer? How will that affect the dollar?

We are observing huge swings in asset markets. We are observing huge swings in foreign exchange markets.

I’m not going to make any recommendations, but I predict we haven’t seen the end of volatility. The rapid rise of the dollar, the massive demand for Treasuries, are hugely convenient for the US Treasury as it finances the expansion of the Fed balance sheet and the giveaways to the corporate welfare queens on Wall Street and elsewhere in the last days of the Bush administration. It seems unlikely, however, that the conditions can be long sustained.

When they reverse, we may see a fair sized bounce in global equity markets, a loosening of credit conditions in global debt markets, a revaluation of commodities, and a revaluation of the mighty dollar. Many will call the bottom and pile back in.

I wonder how long that will last . . .

Hat tip to FTAlphaVille where the team gives me much to think about every day and the analysis of trends is superb. Picks for this week include:

M3, where are thou?

Fill your boots!

Dollar *danger* ahead

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