There are a lot of casualties in the form of much lower resource stock prices in this current war between paper money and tangible assets. Oil is down 23% from its high. Gold and copper are off nearly 25%. Confidence in the resource boom itself is a casualty too. What is really going on on the ground?
One answer: the simultaneous liquidation of three massively leveraged trades. Those three trades are/were energy, commodities, and the dollar. For the last three years, leveraged speculators (hedge funds mostly) have been long energy and resources and short the U.S. dollar. Those trades are now being wound up. The de-leveraging of the financial markets (forced by falling asset values and tighter credit) has led to a sudden and simultaneous exit from all three trades. The result?
Traders and institutional managers have taken profits in resource and energy stocks and sold. More important, the massively popular "short the U.S. dollar trade" seems to be over (judging by the action on the U.S. dollar index. Combine the profit taking and the short covering and you have what looks like a resurgent dollar and resource stocks (and underlying commodity prices) in free fall.
It's also possible the speculators are simply being liquidated themselves. With credit drying up, how many hedge funds will go out of business this year? We mean they are being liquidated in the financial sense, not in the sense that Stalin liquidated the Kulaks. And besides, the liquidation of the Kulaks, mostly peasant farmers, led to mass starvation in the Soviet Union (not a brilliant strategy). The liquidation of leveraged speculation from the global economy (at least for this cycle) might actually be a good thing, provided no one is taken out back and shot. It will lead to less speculation and borrowing and more saving, real investment, and real capital formation.
What's strange about the dollar's rally is that it's taking place as America's fiscal position deteriorates. How can a currency rise when its foundation continues to crumble?
Doug Noland at the Credit Bubble Bulletin reports that the U.S. government racked up a US$102.8 billion deficit in July. Deficits are nothing new for the American government. But the alarming evidence is that spending is up (27% year over year) while tax receipts are down (5.8%). More on this in a moment.
To wax historical for just a moment, the U.S. dollar's breakout reminds us of the German offensive in the Ardennes in December of 1944. The Germans were slowly being hemmed in all over Europe by late 1944. The last thing the Allies expected was an attack. Hitler ordered one though, sending Panzer divisions through the Ardennes (as he did in 1940).
It nearly worked. The attack caught the Allies by surprise and forced the Americans to rush the 101st Airborne into the French town of Bastogne to hold out until they could be resupplied and reinforced. Hold out they did. Eventually, the German advance was repelled. But it shocked everyone in the Allied command that an opponent so clearly on the strategic ropes could come so close to reversing the momentum of events.
There are at least four reasons we can think of that explain the U.S. dollar's resurgence (although none of them suggest permanent new strength). The first is mentioned above: the short-dollar trade is being covered. A lot of institutions were short the dollar. The suddenness and swiftness and simultaneity of the short covering explains the explosiveness of the rally (and the similar carnage in commodity prices).
Second, there's an emerging trading thesis that as Europe and Japan post negative second quarter growth, America's economy will bottom out before the rest of the world, making the dollar and U.S. stocks and bonds better investments. This thesis is that all the world is a recession, but America is closer to exiting it. It's not our favourite explanation. But it's possible someone believes it and is trading on it.
A third and likelier explanation is that official money supply around the world has ceased growing as quickly. Global M2 growth is notoriously hard to compile and track. But with banks distrusting one another, the contraction in global credit is showing up in lower prices for nearly everything. It's financial asset deflation on a global scale, in all markets and all asset classes.
Finally, there is the possibility that foreign central banks are selling their own currencies and buying dollars. It's a case of competitive devaluations designed to increase exports to the U.S. and out-inflate the Fed. It also goes by the name of currency manipulation.
Are any of them true? Are all of them true? We reckon that the prospect of global recession is boosting the dollar. The short-covering and deleveraging by speculators is another big factor. Markets move in cycles, too.
But in the scheme of things...we'd continue to view this dollar rally with deep distrust. Changing attitudes currently support the dollar. But the facts underlying the currency don't support it one bit.. That to us is the best reason to sift through the rubble of the resource market for shares that will excel during the next phase of this battle Royale between paper currencies and real assets. More on hyperinflation (and whether we've already had it) tomorrow.
Dan Denning
The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by Ross on 18 August 2008:
My guess is the latter (manipulation), has had the opportunity for the first time in years to carry the day due to the former (excessive leverage) being unable to sustain any defence or call the bluff Soros-sterling style.
The perverse can be seen in equities too with several Aust property stocks positively jumping out of the sin bin in the last month in full face of a recession. Be it equities, currencies, or commodities those leveraged positions are being attacked an punished.
The narrative for the kiwi's rise against the AUD is ridiculous, as is the pound's ability to push back against the Euro. I am no backer of the AUD in the medium term but I back the USD dead dog bounce theory and will be holding onto to the select equity portfolio.
Comment by Curt on 19 August 2008:
The dollar may hold for a while, but eventually the fundamentals will come to light and the dollar will just as suddenly lose its gain one day. Predicting that day is not easy, but I'm not going to risk it. The weakness in Europe and Japan are primarily due to losses from borrowing money to the US that we cannot pay back. Foreign nations will soon begin to reduce lending to the US and that will pull the legs out from the dollar.