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Today, we have excessive speculation in favor of the dollar and against everything else.

The most destabilizing element for the dollar is the relationship between the dollar and the euro, and to a lesser extent the Japanese yen. This interest rate cum bond yield arbitrage is bound to prove particularly destabilizing for Eurozone markets as well.


Dollar bulls are simply ignoring the reality that the ECB must act.

Record long positions in the dollar had been building up for some time, long before the current stampede started. The dollar bulls of today are likely to be the last buyers, leaving only profit-takers and other sellers to dominate tomorrow’s markets.

  • In recent years, the interest rate differential between the euro and the US dollar has been growing. The arbitrage opportunity has also been exploited for some time. An important element of it has been the financing through shadow banks, which is lending activity that is not reflected in bank balance sheet statistics.
  • According to the Financial Stability Board, which monitors shadow banking, in 2007 identified shadow banking totaled $29.2 trillion, which by 2015 had increased to $34.2 trillion. It should be noted that the FSB’s statistics only cover 27 reporting jurisdictions, some of them minor, excludes China, and is not much more than a stab in the dark. However, of that $34.2 trillion total, shadow banking taken up by collective investment vehicles in the fixed interest market (including hedge funds, fixed income, mixed investment funds and money-market funds) is recorded as having doubled to $22 trillioni.
  • The activities of this group now dominate shadow banking. It is an activity that has been building since the 2008 financial crisis. As long ago as May 2015 the ECB also warned us that the rapid growth of shadow banking was a risk to financial stability in the Eurozoneii. It will be noted that all figures published by both the FSB and the ECB, besides only being a guide, are horribly out of date and much will have changed by today. But we can surmise that what we are now seeing is simply the culmination of speculative trends that have been growing for some time.
  • If the ECB was worried over three years ago about the rapid growth of shadow banking, it should be terrified now.

It must raise interest rates pretty damn quick, but it cannot do that without collateral damage in Portugal, Italy, Greece, Spain, (remember the PIGS?) and even France. These spendthrift governments have taken full advantage of a zero or near-zero cost of borrowing. And Italy is now rebelling even before any rise in interest rates, and before the ECB’s money-printing to buy Italian debt is due to cease in December.

  • It is no longer credible for the ECB to claim that the Eurozone is only in the early stages of recovery, when the US economy is clearly moving towards overheating.
  • In fact, the Eurozone economy has been like the curate’s egg; good in parts. Countries such as Germany, the Netherlands and Finland, have been doing well, but others, such as France, less so. Unemployment in the PIGS has remained stubbornly high, particularly for the young. But these are fiscal and structural problems, not monetary ones.
  • The ECB will undoubtedly have to bite on this bullet, tell the PIGS to put their own houses in order, and increase rates to stop destabilizing the global economy.
  •  ECB monetary policy should at least indicate the start of monetary tightening, bringing forward the timing of interest rate rises.


As Alasdair Macleod recently wrote in GoldMoney:

... the real problem has been under-reported, and that is the strains between the mega-currencies: the dollar, the euro and the yen. Could they be the leading players in the next credit crisis, and if so how will the tragedy unfold? You only have to note the disparity in bond yields, particularly at the short end of the yield curve, to see what is moving money. Two-year US Treasuries yield 2.74%, while the two-year German bund yields minus 0.55%. Two-year JGBs at minus 0.12% are also out of whack with USTs. You do not get disparities like this at the short end of the yield curve without moving massive quantities of short-term money. Putting currency risk to one side for a moment, a Eurozone bank, insurance company or pension fund is taxed on short-term investments in bunds through negative yields, while being offered a tempting and potentially increasing yield on similar risk USTs. Tempting, isn’t it?

Obviously, we can’t ignore currency risk. For simplicity, we will assume that fully matched risk insurance more or less eliminates the profit opportunity. It is possible to use out-of-the-money currency derivatives to cap the risk, and indeed, that’s one reason why OTC foreign currency derivatives stood at over $87 trillion in the second half of last year.

... Maximum profits are obtained by taking a naked punt, and here, the trend is your best friend. If you feel sure the dollar is going up against the euro, not only will a euro-based financial institution gain more than three per cent by holding two-year USTs over equivalent sovereign risk two-year bunds, but there is the juicy prospect of a currency gain as well. We will also note that the Fed still plans to raise interest rates while the ECB does not. That should ensure currency risk is kept safely at bay.

Euro-based financial institutions must be sorely tempted. Furthermore, the dollar stopped falling in April and since then its trend has been up. Talk in the market is of dollar shortages as emerging-market governments may be forced to cover dollar liabilities, which coupled with Fed-induced interest rate rises makes further dollar gains against the euro, and even the yen, appear to be a racing certainty. Convinced yet?

We can be sure that euro-based traders have been salivating over the prospect, particularly with Italian risk soaring and therefore a further reason to sell euros, which are by far the largest component in the dollar’s trade-weighted index. Hedge funds based in Europe and the US must also be keen on this trade, for the same reasons. The only question remaining is how to maximise the opportunity. Fortunately, banks and dealing intermediaries are queueing up to lend against high quality short maturity USTs, either directly or by way of reverse repurchase agreements. A bank loan for a credible customer will secure gearing of eight or ten times, and a reverse repo even more.

Let’s stick with ten times. Finance costs are based on euro or yen money-market rates, which for three-month euros is minus 0.3%, and for yen 0%. For ten times gearing, before fees we can therefore expect a gross return of 30% per annum in euros by buying two-year USTs, or 26% in yen before exchange rate gains and price changes. It is not much less investing in 13-week Treasury bills for cash players on the same geared basis.

Little wonder this is becoming the biggest game in Financetown. The attraction of these differentials between the major currencies is why the US Government has encountered no problem financing its budget deficits. And so long as the ECB and the BOJ insist on negative and zero rates, and the ECB continues printing money to buy Italian bonds, it can go on for ever.


That is the dollar bulls’ case. For balance we need to introduce a note of caution. Whenever we see a sure-fire way to make grillions of dollars, experience tells us it is time to do the opposite.

  • Vide equities in 1999-2000.
  • Vide residential mortgages in 2007-08.
  • Vide the growth of shadow banking in 2007-08 to finance speculation.