The End of the Dollar’s Super-Cycle

We live in an age of asset bubbles, but they don't continue indefinitely, as will prove true for the strong U.S. dollar.
Christopher WhalenMay 4, 2017
The End of the Dollar’s Super-Cycle

What do the U.S. residential housing market, the stock market, and the dollar have in common? They all represent bubbles created and driven by the aggressive social engineering of the Federal Reserve’s Federal Open Market Committee (FOMC).

Christopher Whalen

Christopher Whalen

We live in an age of asset bubbles rather than true economic growth. The investment world is skewed by the latest round of monetary-policy experimentation by the Fed, including years of artificially low interest rates and trillions of dollars in “massive asset purchases,” to paraphrase former Fed chairman Ben Bernanke.

These bubbles are caused and magnified by supply constraints, not an abundance of credit. Whether you look at U.S. stocks, residential homes in San Francisco, or the dollar, the picture that emerges is a market that has risen sharply — more than the underlying rate of economic growth — due to a constraint in the supply of assets and a relative torrent of cash chasing the available opportunities.

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Since the middle of 2014, the value of the dollar against major currencies has risen sharply, suggesting a shortage of liquidity or at least a relative preference for dollars vs. other fiat currencies.

OpinionThe vast flow of foreign direct investment drawn into the United States and then into asset classes like residential and commercial real estate illustrates the abundance of global dollar liquidity and the relatively scarcity of assets. Even with the FOMC’s supposedly accommodative policy, key measures of market liquidity continue to suggest price and/or structural constraints, both in the United States and overseas.

Looking at the effective cost of dollar credit, for example, illustrated by the notorious London Interbank Offered Rate (LIBOR), the cost of borrowing dollars in Europe has risen steadily risen since mid-2015. Do the good folks on the FOMC appreciate the degree of fundamental demand for dollar credit?

American lenders face a market with new origination volumes down 25% to 30%. Meanwhile, the reinvestment of prepayments on $1.7 trillion worth of mortgage-backed securities (MBS) held by the FOMC is essentially taking up new bond issuance by Fannie, Freddie, and Ginnie combined.

The FOMC should adjust its portfolio now to accommodate private market demand for yield. And there is no need for actual sales. Simply ending the Fed’s reinvestment of mortgage bond prepayments would allow the interest rate markets to find a natural level and give the Fed a more accurate picture of demand upon which to adjust supply.

Ending reinvestment of the Fed’s MBS portfolio would lead to a net monthly runoff rate in the high-double-digit billions of dollars. Or to put it another way, it is time for the FOMC to get out of the way of the private market. Shrink the Fed’s bond portfolio and credit the reserve accounts of the banks.

It seems that many market indicators, such as the dollar and LIBOR, suggest a market that is either schizophrenic or dysfunctional. Our guess is the latter, in part due to excessive prescription-based regulation of traditional banking and finance, particularly low-margin money-market businesses that are being abandoned by the big depositories like JPMorgan and The Bank of New York Mellon.

There are seismic changes in the worlds of trading cash securities and collateral lending — changes that see a host of non-banking firms returning to this traditional nonbank space. We wonder how much of the upward price movement is caused by legal and regulatory changes occurring over the same periods.

The clear question from all of this: What happens when this latest dollar super-cycle ends? Given that zero or negative rates elsewhere are driving much of the emigration into American assets, why should the dollar ever sell off?

Regarding the prospect of a drop in the dollar, Megan Greene of John Hancock Financial Services tweeted that the only way she could see it happening in the short run is if “everyone else gets in trouble and the Fed opens swap lines” with other central banks to supply quantitative easing.

We hear that, but all things do come to an end, including the FOMC’s seeming ability to painlessly levitate the fortunes of heavily indebted nations on a sea of easy dollar credit. That works really well when the dollar is strong; otherwise, not so much.

Christopher Whalen is chairman of Whalen Global Advisors and a former senior managing director for Kroll Bond Rating Agency. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is reprinted here with Whalen’s permission.