US dollar crisis

The seven stages of a dollar crisis

This old missive from Bill Fleckenstein is worth putting on this blog. The Fed is currently jawboning the dollar, saying how they will drain the excess liquidity. All at the same time while unprecedented quantitative easing is taking place and the interest rates are kept at zero. Those who believe record low treasury yields guarantee little or no inflation need to look further at the history of United States during World War II, when government debt and inflation skyrocketed, while long term interest rates were very low.  As a result, treasury investors lost money.

7 small steps to crisis

• Step 1. Nobody notices or pays attention that the dollar is falling.
• Step 2. Folks wake up, but they either don’t care or rationalize dollar weakness as a good thing.
• Step 3. The central banks now know they have a problem, but the bankers think the market will obey them. It will, for a while.
• Step 4. The dollar now tests everyone’s resolve by resuming its decline. The currency markets will not respond to jawboning by finance ministers.
• Step 5. In this step, the finance ministers are forced to take action. (Think about it. Even if they’d stated that they wanted the dollar to go up, nothing either explicit or implied indicates they’ll do anything about what’s happening. That will come next.) When they do take action, the market will do what they want — but only for a while.
• Step 6. The ministers take some additional action, but it won’t be enough, and the currency markets won’t do what the ministers want.
• Step 7. Finally, we’ll have a full-blown crisis, and that will be the end game.

Stocks and dollar

Thanks to the Fed promising to keep interest rates at zero for some time, the US dollar has
already partially replaced Yen as #1 carry trade funding currency. As a result, the anticorrelation
that developed between stocks and the dollar is worth noting. The chart below illustrates
SP 500 index vs inverse US dollar index. While both could rally sharply on positive news like
better than expected jobs number, eventually the currency trade should prevail. Don’t be surprised 
if stocks correct sharply early next week.