"The dollar doesn’t have to go south if all the economies reflate at the same time.”

I like William Gross, so here's a chance to quote him from Bloomberg:

"By Ye Xie

Dec. 11 (Bloomberg) -- The dollar fell to a six-week low against the euro and yen as the cost of borrowing in the U.S. currency tumbled, signaling less demand for year-end funding.

The greenback also dropped after a report showed the U.S. trade deficit unexpectedly widened in October. The Swiss franc dropped against the euro and yen after the central bank reduced its main interest rate to a four-year low of 0.5 percent.

“Dollar liquidity and funding concerns are starting to fade,” said Shaun Osborne, chief currency strategist in Toronto at TD Securities Inc., a unit of Canada’s second largest bank. “These factors have been important sources of support for the dollar in the past few months.”

The U.S. currency fell 1.7 percent to $1.3243 per euro at 8:40 a.m. in New York, from $1.3023 yesterday. It dropped 1.6 percent to 91.28 yen from 92.76. The euro traded at 120.77 yen, compared with 120.78 yen.

The cost of borrowing in dollars for three months in London fell to the lowest level in more than four years. The London interbank offered rate, or Libor, that banks say they charge each other for such loans slid 0.1 percentage point to 2 percent, the lowest level since September 2004, British Bankers’ Association data showed. That’s still one percentage point above the Fed target, up from an average of 16 basis points in the seven years to August 2007, when the credit freeze began.

“From a fundamental basis, there’s a case for avoiding the dollar,” said Adrian Schmidt, a London-based senior foreign- exchange strategist at the Royal Bank of Scotland Plc, the fourth-biggest currency trader. “For the moment the dollar’s on the back foot.”

How interesting.

"The ICE’s Dollar Index, which tracks the greenback against the euro, the yen, the pound, the Canadian dollar, the Swiss franc and Sweden’s krona, fell 1.2 percent at 84.449, below the 55-moving-day average of 84.5, as traders took advantage of the low liquidity to test how far it may fall, Hardman said. They will drive the dollar to $1.345 per euro this year, he said.

The dollar has gained 11 percent against the euro in 2008 as the credit-market seizure and $980 billion of losses on mortgage-related securities worldwide led investors to repatriate overseas investments to the U.S. and seek funding in the greenback.

The yen gained versus all 178 currencies tracked by Bloomberg this year as the global recession encouraged Japanese investors to bring funds back home and global equities plunged.

Japan’s currency jumped 21 percent versus the dollar, 34 percent against the euro and 66 percent against Brazil’s real as the financial crisis prompted investors to reverse carry trades, in which they purchase higher-yielding assets funded in countries where borrowing costs are lower. Japan’s benchmark rate of 0.3 percent is the lowest among major economies.

The U.S. trade deficit expanded 1.1 percent to $57.2 billion in October from a revised $56.6 billion in September, the Commerce Department said today in Washington. The gap was projected to narrow to $53.5 billion from an initially reported $56.5 billion in September, according to the median forecast in a Bloomberg News survey of 70 economists.

The U.S. budget deficit in November swelled to $164.4 billion, from $98.2 billion in the year-earlier period, as the government used taxpayer money to shore up the financial system by buying stakes in banks, the Treasury Department reported yesterday. Government revenue fell 4.2 percent, while spending soared 24 percent."

Let's see what Gross says:

"The dollar may extend its decline as the U.S. government increases its budget deficit by spending “trillions of dollars” to revive the economy, said Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California.

“There’s some risk” for the dollar to weaken, Gross said in an interview on Bloomberg Television yesterday. “It is fair to say other economies are doing much the same thing. The dollar doesn’t have to go south if all the economies reflate at the same time.”

Let's hope for "reflation" ( Another term. Yikes. ) , I suppose.

"Yet, in response to this crisis, the Federal Reserve reacted like Bagehot on steroids. "

Via the WSJ, Richard Fisher of the Dallas Fed:

"Again, some historical context. The basic manual for a central bank’s response to a panic was written in the early 19th century by two Englishmen, Walter Bagehot and Henry Thorton. Bagehot’s prescription to counter a panic was as follows: “The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man’ whenever the security is good.” He wrote of how, during the Panic of 1825, the Bank of England “lent by every possible means and in modes … never adopted before.” Also bearing in mind the advice of Thorton, who in 1802 wrote that “it is by no means intended to imply that it would become the (Central) Bank to relieve every distress which the rashness of (financiers) may bring upon themselves…. The relief should neither be so … liberal as to exempt those who misconduct their business … nor so scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or ruinous may be their state.”

Central bankers are generally considered the most laconic genus of the human species. Yet, in response to this crisis, the Federal Reserve reacted like Bagehot on steroids. We have not quite lent “to this man and that man.” But beginning with the announcement on December 12 of last year of our term auction facility, we have reached deep into our tool kit to “lend by every possible means and in modes … never adopted before.” We have been neither “scanty” nor “slow.” In rapid order, the Federal Reserve has stretched out the terms with which we lend to bankers; accepted new forms of collateral; broadened access to our lending window to securities dealers and one particular insurance company—AIG—whose failure was deemed by the Federal Reserve Board to present a risk to the financial system; opened a window for financing commercial paper; backstopped money market mutual funds; and, recognizing that we are inextricably interwoven with a global economy, established swap lines to help meet the dollar-funding needs of 14 central banks, ranging from the European Central Bank and the Bank of England to the Banco de México and the Singapore Monetary Authority, the total of which now aggregates to hundreds of billions of dollars. And our staff and policymakers have provided substantial intellectual input into activities of other regulators, such as the FDIC and the Treasury, as they develop innovative means and modes of recapitalizing the banking system, dealing with the mortgage crisis and restoring economic growth."

I'm fine with a lot of this, although not all their moves, and I endeavor to follow Bagehot.

But Bagehot also tried to put in rules and terms to avoid these kinds of crises. Let's use Bagehot on steroids to reduce the chances of this or a similar event occurring again.

" The irony is that Japanese regulators were once hugely protective of retail investors"

Yves Smith on Naked Capitalism about PRDC's in Japan:

"This Times Online story is frustratingly vague about the exact nature of these complicated and risky foreign exchange products sold to Japanese retail investors. While the size of the problem ($90 billion) may seem not all that bad in comparison, say, to subprime exposures, recall that these trades are likely to be unwound in a compressed period of time when currency markets are already volatile, thus increasing the potential for havoc.

The irony is that Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them. That attitude clearly went out the window.

From the Times Online:"

Please read the story. Here are my posts, with Yves thrown in:

Don said...

See John Gapper on FT here:

http://blogs.ft.com/gapperblog/2008/10/mrs-watanabe-and-the-sudden-rise-of-the-yen/


"The accounts showed that it was common for Japanese retail investors to be offered leverage of 20 times or more for their cash. In other words, they could deposit the equivalent of $1,000 and take trading positions of $20,000. A lot of them had used the opportunity to buy higher-yielding foreign assets.

The trade worked fine for Japanese investors as long as currencies remained stable and they could in effect switch yen into higher-yielding assets denominated in other currencies. But the sharp rise in the yen - and comparative fall in the value of these foreign assets - is probably landing Mrs Watanabe and her friends with big losses.

Here, to expand the point, is a prescient piece from FT Alphaville a year ago."

Don the libertarian Democrat

October 30, 2008 1:05 AM

And:

Don said...

"The important thing to know about Mrs Watanabe is that, temporarily at least, she has all but stopped flapping her wings"

Who is Mrs. Watanabe?

"Mrs Watanabe is crude shorthand for Japan’s $15,000bn pool of savings, the deepest in the world and worth more than the annual economic output of the US. These vast resources are somewhat apocryphally marshalled by Japanese women, who have traditionally held a firm grip on family finances."

Let's see:

1) Rising yen
2) Lower interest rates
3) Next bubble

David Pilling in the FT:

http://www.ft.com/cms/s/0/0df30044-a5f4-11dd-9d26-000077b07658.html

"The yen carry trade has not been the only cheap source of liquidity in recent years. But Ashraf Laidi, chief currency strategist at CMC Markets, reckons it has been the biggest. He quotes figures suggesting that Japanese households alone, discounting savings mediated through life assurers and other institutions, have mobilised $500bn in outbound funds. That leaves aside speculators, who have borrowed unknowable amounts of yen to invest abroad, often on highly leveraged terms.

Just as state bank bail-outs risk moral hazard, more recklessness and the need for future bail-outs, so the unwinding of the carry trade carries with it the danger of the next great bubble. In Japan, the central bank appears to have reacted to a rising yen and sinking stock market by contemplating the uncontemplatable: a rate cut. Even the rumour of such has provoked a mini equity rally and a weakening of the currency.

This is poison for the BoJ. It hated having to keep rates low, fearing that cheap money can cause bubbles in real estate, in capital investment and in the carry trade. Its sightings of inflationary danger everywhere provoked mirth among outside experts. But few are laughing now."

And so:
"If Japan really is about to reverse course towards zero interest rates, it will once again become the source of almost free money for anyone with an appetite to invest. Worse even than that, says Mr Laidi, is the potential for an even more dangerous dollar carry trade. The Federal Reserve has been desperately cutting rates, and lopped another half point off again on Wednesday. The nearer US interest rates approach zero, the greater the incentive to move dollars into higher-yielding assets elsewhere.

These gyrations do nothing to solve the underlying problem, which is that Asia has an excess of savers and the US and Europe an excess of spenders. Unless that is solved, the world seems condemned to repeat the swings of recent years, as capital is arbitraged between countries where money is cheap to those where it is expensive."

Problems:

1) Dollar carry trade

2) Asia saves, the West spends

3) Here we go again

Is this real?

Don the libertarian Democrat

October 30, 2008 1:27 AM

And:

Don said...

Following an earlier comment about Japan, if you have domestically:
1)Low interest rates
2)Stagnant stock market
3)Stable exchange rate
4)Low inflation
Doesn't it make sense that you would try and invest overseas? And after the tech bubble, doesn't it make sense that you would look for bonds that would provide you higher yields?
Naturally, if any of these variable change significantly, you could be in trouble. So when the story says:
"The products combine exposure to foreign exchange, interest rate differentials and domestic inflation"
it's not saying anything profound.
And when we read this:
"The PRDC's complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility."
it's a little hard to credit, since I just described the investment's worth and problems in a few short lines?

Don the libertarian Democrat

October 30, 2008 10:04 AM

And Yves:

Yves Smith said...

Don,

The shortcoming in the list above is 'stable currency". In a world of floating currencies (or mainly floating, and Japan was not one of the ones maintaining a dollar peg) the FX risk is huge, although for extended period (perhaps up to a couple of years with not too much movement) it can look low.

And if you read the stories on Japanese retail currency traders, they were as frenetic last year as day traders in the tech bubble here.

The yen was in fact cheap, so the risk was that despite the pickup in yield, you would lose far more due to a fall in the higher-yielding currency. When I was a kid, no one would EVER think of making deposits in higher-yielding currencies, everyone understood that the high yield was a big big signal that a price fall was in the cards.

October 30, 2008 6:35 PM

And me again ( the dummy ):

Don said...

Yves, Thanks. Great point. I was just about to mention these PRDC's on a post about securitization. I think that you make my case, and that we're both on the same page.

I agree that the assumptions seem crazy, my only point was that you would have thought the risks you just rightly pointed out should be easily explainable, even if the products inner workings are complex. From your comments, I was trying to understand how even you were having a hard time with them, and I now see that it's the risk as much as the complexity. I hope I've understood you now, and that my point is clearer.

Don the libertarian Democrat

PS Your blog is great. I'm learning so much from it, but I won't blame my mistakes on you. Take care

October 30, 2008 7:14 PM