-- Posted Wednesday, 10 September 2008 | Digg This Article
| Source: GoldSeek.com
Rick’s Picks
Wednesday, September 10, 2008
“Phenomenally accurate forecasts”
Houston, we’ve got a problem. Mere days after the U.S. government announced the biggest corporate bailout in human history, investors have already stopped acting relieved. The persnickety S.O.B.s sent the Dow Industrials tumbling 280 points yesterday, wiping out nearly all of the gains that initially had greeted the news. We never thought the good times would last, but bailout hype should have been good for more than the 18-hour short-squeeze that we got. Actually, it was a little worse than that, since the stock market had one more thing going for it yesterday – oil prices dropping toward $100 – but failed to convert it into gains.
Oil’s latest plunge took its toll on bullion as well, but not without creating a crystal-clear price target for December Comex Gold that we will use as a minimum downside objective. It and an equally compelling target in the S&Ps have been identified in the Touts section of Wednesday’s Rick’s Picks. Through it all, the dollar was somewhat quiescent, if not to say cryptic. Since the greenback has generated quite a bit of discussion in the chat room, and because a strong dollar seems almost inexplicable in the light of the Fanniefreddie bailout, I am reprinting a monograph that I wrote several years ago that considered the possibility of a short-squeeze on the dollar. That such a thing could occur seems counterintuitive with the U.S. Government pledging trillions of dollars it does not possess in order to prop up the banking system. But there is a certain logic to it, so see if you don’t agree.
When Debtors Must Settle in Cash
Is the dollar susceptible to a short squeeze? I pursued an answer to that question years ago without reaching a definitive answer. Now, I am heartened to see that my pen-pal George Paulos and his colleague Sol Palha have written an illuminating treatise on the subject at freebuck.com that is closely similar to mine both in its logic and its speculative details. My original premise was that, in a global financial crisis, short-term lenders would not let debts roll over - that they would demand that borrowers settle up immediately in cash. Facing liquidation as an alternative, the borrowers would try desperately to get the money from somewhere. That in turn would send dollar lending rates -- and therefore the relative value of the dollar -- instantly skyward.
This scenario poses a paradox as far as I'm concerned, since it would seem to flatly contradict something I've asserted here many times - that the dollar is intrinsically and fundamentally worthless. How, one might ask, could the dollar soar in value if it is not worth anything? The short answer is that, when we consider equity shares, questions of "value" do not enter into the short-squeeze dynamic - that the short-squeeze itself is purely a creature of precipitously urgent demand - of panic, that is. Thus might a fundamentally valueless greenback be bid up to the moon by borrowers facing a creditor firing-squad.
Consumer Will Say 'Uncle!'
Mssrs. Paulos and Palha pose a somewhat different scenario, one in which the demand for dollars grows more subtly before it begins to mutate into a short squeeze. The trigger is the consumer seeking to pay back installment loans that by then will have reached unsustainable levels. "Sooner or later, consumers are going to say, I can't take it anymore," stop borrowing new money and attempt to pay off their existing loans. This will have the effect of actually buoying the U.S. dollar, as it will effectively be a short squeeze."
They go on to further explain:
"A dollar short-squeeze would be functionally similar to a general deflation, but could unfold much faster. Deflation is a relative scarcity of cash and/or credit that causes a general price decline in a wide range of products, services, and assets. In other words, cash becomes more valuable during a deflation. It would be triggered by some event that sucks enough liquidity out of the system to cause a chain reaction and serial debt-defaults. Deflation is almost always accompanied by recession; the deeper the deflation, the deeper the recession.
A Scary Scenario
"This is a scary scenario and one that few people see as a risk factor. In fact, in 2003 we witnessed the exact opposite effect as almost every asset class went up in dollar terms due to a weak dollar. There were a number of reasons for this, but it was largely the result of a vast increase in credit that was chasing almost every product and asset in sight. In essence, this was the effect of a large number of people and investors going short the dollar by putting more credit into circulation and using it to buy stuff."
Mssrs. Paulos and Palha see many potential catalysts for a squeeze on the dollar, including a sudden rise in interest rates that would send real-estate speculators scrambling for cash, an unwinding of derivatives-market leverage, or an act of terrorism. In the end, though, they say, the squeeze would subside and the dollar would head lower because of continuing deterioration in the U.S. economy. "The irony of the situation is that those who are convinced that the dollar is slowly dying are probably right, but their collective action makes their investment positions untenable."
Would Gold Bugs Be Impaled by Spike?
Just so. And that is why I have given the matter so much thought; for if many of us have sought to hedge the risk of a falling dollar with precious metals, Eurobonds, energy and natural resource stocks and other investables, we could conceivably be done in by a short-squeeze that pushes the dollar to unimaginable heights relative to other assets, albeit fleetingly.
My response to Mssrs. Paulos and Palha was as follows:
This is a conundrum for which I've sought answers for more than a decade, George. My initial inspiration was a book called The Incredible Eurodollar, although the two professors who wrote it would likely have been baffled by the notion of a global short-squeeze on the dollar. I ran my scenario by a dozen or so finance and economics professors at top business schools and each replied, more or less, "What on earth are you talking about!?" Surprisingly, veteran floor traders who were familiar with the phenomenon of the short-squeeze seemed equally clueless.
But you know what? Your thesis is absolutely inarguable, for, as you assert, virtually all borrowing that is denominated in dollars represents, essentially, a short position against the dollar. Given that the dollar has been the currency of choice for all manner of borrowing during the past decade - including, as you point out , a derivatives market whose notional value is estimated at well over $100TR (i.e., at least three times global GDP) -- the existing short position against the dollar is practically galactic in size.
A World Massively Short the Dollar
So, yes, there is a huge global short position against the dollar, and it is indeed susceptible to a short squeeze. But I think your argument goes slightly awry when you say, “This is something that is not sustainable; sooner or later the consumer is going to say I can't take it anymore and stop borrowing new money and attempt to pay of their exiting loans. This will have the effect of actually buoying the US dollar as it will effectively be a short squeeze.”
In fact, a short squeeze is never the result of rational and deliberate thinking such as you've implied, but of panic triggered by margin calls after a stock goes parabolic, threatening to wipe out short speculators in mere hours. Nothing so precipitous would impinge upon the consumer, however. Though technically insolvent, he could still make minimum monthly payments on revolving charge accounts and car loans, and his mortgage could go into delinquency for several months before waxing fatal. Nor would there necessarily even be a spike in interest rates - at least, not one caused by urgent consumer demand for loans, since this implies the consumer would be borrowing to pay off other borrowings. Both in theory and in fact, consumers could and would repay their loans only by increasing savings - a process which, given the magnitude of debt needing to be repaid (including mortgage debt that would have come to exceed the value of millions of borrowers' homes) would be epochally deflationary.
The Endgame
The foregoing is not meant to suggest that a squeeze on the dollar is impossible or even unlikely. Indeed, under the circumstances, it cannot be ruled out. But if a short-squeeze does occur, its locus will be in the derivatives markets, where most debt must be rolled, on average, every eleven days (if memory serves). This is where we get the interest-rate spike. But it would be so steep as to preclude significant amounts of borrowing, and the spike would therefore detumesce as rapidly as it rose. Bottom line, it would cause no lasting, upward revaluation of the dollar, only the impalement of borrowers for a relatively short period. At some point thereafter, the revelation of the dollar's intrinsic worthlessness would determine borrowing rates, as well as the price of gold and silver.
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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2008, Rick Ackerman. All Rights Reserved. www.rickackerman.com
-- Posted Wednesday, 10 September 2008 | Digg This Article | Source: GoldSeek.com
