The Breakdown - The Dollar Wrecking Ball

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, July 6th, and today we are talking about the dollar-recking ball. Now, before we get into that, a quick note. There are two ways to listen to the breakdown podcast. You can hear it on the Coin Desk Podcast Network, which comes out in the afternoon and features both the breakdown as well as other great shows, or you can listen to it on the breakdown-only feed, which comes out every evening.

Starting point is 00:00:46 Wherever you listen, if you are enjoying the show, I would so appreciate if you took the time to leave a rating or a review. It makes a huge difference, and I appreciate each and every one. Lastly, a disclosure, as always. In addition to them being a sponsor of the show, I also work with FTX. So, yesterday we caught up on all things crypto, and since then, the craziness has just continued. It was announced this morning that Voyager is seeking bankruptcy protection, and I'm sure that something will cover a little bit more as it gets sussed out. But today, we are talking macro, and specifically we are talking about King Dala.

Starting point is 00:01:23 So an important term as we get into this, the DXY or Dixie is an index of dollar exchange rates against a basket of international currencies. It's heavily skewed towards reflecting strength or weakness against the euro and the Japanese yen, with the Chinese yuan making up the next most significant weighting in the basket. So when we talk about the Dixie, it going up means the dollar is getting stronger, and the reverse means, well, the reverse. On Tuesday, the Dixie surged above 106, which is its highest level since March 2002. The dollar moved around 1% against most major currency pairs on Tuesday, which is a gigantic move for foreign exchange markets.

Starting point is 00:02:02 Now, there are many reasons that bank analysts and others are citing for this large move. There's the safe haven trade, with the dollar being seen as a safe asset, there are concerns over the European energy crisis, there were high levels of currency future volumes. Another part, however, is the dollar's role in debt servicing. A definition of money you'll see from folks like Brent Johnson and Mike Green is that which cancels debt. In those terms, the U.S. dollar is still by a wide margin,

Starting point is 00:02:30 the most used quote-unquote money in the world. We often focus on dollar-denominated reserves as being an indication of the U.S. dollar status, and over the last decade, the use of U.S. treasuries as reserves has been somewhat declining. That said, the use of U.S. dollars for international finance is still incredibly strong. According to the New York Fed, over half of all cross-border loans, international debt securities, and trade invoices are denominated in U.S. dollars. This represents a huge amount of U.S. dollar debt that is originated and serviced outside of the U.S. economy. The important thing to note is that this gigantic debt burden is why U.S. interest rates and currency policy matter so much around the world. It's why you see a rate hike at the Fed and all of a sudden

Starting point is 00:03:15 an emerging market economy can blow up. It's why the dollar can go up and cause a bankruptcy wave on the other side of the world. When the Fed, Treasury, and markets combine to change interest rate levels or foreign exchange levels, they aren't just changing the cost of money domestically. They're changing the cost of servicing debt all over the world, and recently, that cost has been going up at record speeds. So instead of just talking about the immediate news, let's dig into this dollar wrecking ball concept. Raul Paul of Real Vision wrote about this in both March and April 2020, just as the pandemic was taking hold. At the time, people were talking about the Fed's money printing as something that was going to destroy the dollar, but Raul didn't

Starting point is 00:03:53 agree. First thread from March of that year. Quote, I'm now 100% focused on the U.S. dollar, which is a wrecking ball. I think that the authorities have no chance to catch up on what is happening in markets. One by one they are shutting down. All liquidity has gone as key parts of the global financial architecture have stopped functioning entirely. The net result is going to be a scramble for dollars unseen in our lifetimes. The 1930s was the last time we saw this as money poured into the U.S. forcing an eventual devaluation versus gold. This time, the very dollar system is at risk. The way that it is going to play out is via dollar's strength, not weakness. There is simply not enough dollars being generated as the world shuts down. There is no funding

Starting point is 00:04:33 mechanism to alleviate it. I don't think swap lines are going to work. There is no way to create the $15 trillion needed offshore and also provide for the dollar shortage onshore in the U.S. At the end of all of this, we will need to create a new system from scratch. The global central banks have been telling us this for a long time now. It will take time to play out, and central bank balance sheets are going to explode to levels never imagined. We've created the perfect storm. An unimagined global financial, economic, and potentially humanitarian crisis that is going to take everything we've got to stop it. He followed this up in April. The dollar wrecking ball. I hear the narratives that the Fed is printing money and that it is going to cause a dollar collapse.

Starting point is 00:05:12 I worry that this narrative is very wrong. My strongly held view is that the dollar is the pinnacle of all the macro issues we face. The Fed have undertaken unprecedented printing as we know, and the balance sheet is growing exponentially. But it is not that simple. We live in a relative world where the dollar standard is the very cause of many of the issues we now face. There are simply not enough dollars available in the world to service all the debts, and thus a debt deflation remains the big risk. The expansion of the balance sheet is in fact correlated to the rise of the dollar, not the fall. You see, the biggest problem the world faces is the dollar. We are in a vicious doom loop where slowing growth causes the dollar to rise,

Starting point is 00:05:49 which causes slower growth, which causes the dollar to rise, as all borrowers play musical chairs to get access to the dollars to service debts. Dollar swap lines, QE, jawboning, have nothing to stop this, nothing. The issue here is that swap lines can't help the weakest sovereign borrowers, as they have no reserves. And the $13 trillion short is held mainly by corporations, which struggle to get access to dollars due to the fact that they are suffering massively weakened cash flows from trade tariffs, collapsing commodity prices, slowing world growth, and a shrinking U.S. trade deficit. The global system is just not set up to deal with this. Now, when Raul was writing all of this, what was happening was that commodity prices were plunging alongside industrial and

Starting point is 00:06:27 economic shutdowns, and this was squeezing commodity producers. We're effectively in the reverse regime now, where we have strong commodities prices, and that is squeezing finished goods producers. Basically, we're in a bit of a trap. Brent Johnson in April of this year wrote, despite all the bailouts, all the stimulus, all the QE, and all the helicopter money, the Dixie is up 25% since 2008 and flat over the last two years. Yes, the dollar is an absolutely horrible currency, but all the others are even worse. And whether a rising dollar is the cause, or whether a rising dollar is the effect, its correlation with slowing global growth and global financial crises is extremely clear. Will it be different this time? Maybe, or maybe not.

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Starting point is 00:08:38 When you trade NFTs on FTX, you pay no gas fees. Download the FTCX app today and use Referral Code Breakdown to support the show. So let's try to bring this back to a discussion of what is happening right now. Where we started, that Dixie was up to its highest point in 20 years. However, the big question and topic of discussion really for the last few months is whether this represents U.S. strength or just weakness in the other currencies, namely the euro and the Japanese yen. Put differently, are people fleeing risk markets for dollars,

Starting point is 00:09:10 or are they fleeing other currencies for dollars? or is it some combination of both? So with that question in mind, let's look at the euro. The euro fell to its lowest level in two decades on Tuesday. For a while, it looked like it was heading to one euro to one dollar parity, but it ended up stopping just short. In total, the euro was down 9% against the dollar so far this year. Now, the background of this is pretty clear. Eurozone inflation hit a record 8.6% in June across the entire economic zone. Some areas were hit harder, such as Spain, at 10.2%. The big story here is, of course, energy inflation, which hit 41.9% for June compared to 39.1% in May.

Starting point is 00:09:49 Unsurprisingly, this is related to Russia's war in Ukraine. That said, there's also a policy dimension to this as well. Despite all of this inflation, the ECB still hasn't raised interest rates at all. With the central bank's key interest rates still slightly negative in nominal terms and deeply negative in inflation-adjusted real terms, the ECB faces in some ways an even more difficult problem than the Fed. It has to hold together the monetary union as well as managing monetary policy. Spreads between interest on German and Italian debt have blown out to 2%. Now, the ECB appears to believe that they should enforce a 0% spread between Eurozone sovereign debt. To that end, they announced last month they would create a program to purchase weaker sovereign debt. Many commentators point out that this

Starting point is 00:10:31 looks suspiciously like doing more QE. And whatever it actually is, the market is super skeptical. Charlie Bielo writes, Eurozone inflation has moved up to 8.6% its highest level ever. Meanwhile, the ECB is still holding interest rates at negative levels. This is perhaps the greatest disconnect between easy monetary policy and unabated rising prices that the world has ever seen. But what about Japan? Japan has been attempting to peg rates at 0.25% all the way out to the 10-year bond.

Starting point is 00:11:04 This is part of the policy of yield curve control that they've had since 2016. Now a quick note on this term yield curve control. QE quantitative easing, which has been the Fed strategy over the last 10 years, is about injecting liquidity by purchasing bonds on the open market. This brings the prices of those bonds up by creating a new source of demand, and in so doing reduces longer-term interest rates and borrowing costs. Importantly, though, when the Fed does this, they aren't pursuing a specific long-term rate. yield curve control, on the other hand, is when a central bank sets a specific long-term interest rate

Starting point is 00:11:37 target and buys as much as it takes to actually get there. During the last month, the yen has dropped to a 24-year low against the dollar, down 4% in June and overall 16% for the year. The Financial Times wrote, following a week of setting fresh 20-year lows, the yen continued its descent as traders bet that the Bank of Japan will remain the only major central bank to maintain ultra-loose monetary policy, despite its counterparts in the U.S. and Europe, entering an interest rate-raising cycle. Also from F.T., quote, on Friday, the Bank of Japan, Ministry of Finance and Financial Services Agency, issued a rare joint statement expressing concern over the yen's steep slide against the dollar. The yen has fallen more than 20% against the dollar over the past 12 months.

Starting point is 00:12:21 And this brings us back to the original debt servicing concern. Jim Bianco in April of this year wrote, the biggest story that no one is talking about, is the incredible pressure building in the Japanese government bond and currency markets. What happens if it blows up? The Bank of Japan has been operating with yield curve control since September 2016. This Japanese government bond intervention is coming with a high cost. The Japanese yen has been collapsing. A weakening yen is very bearish for the U.S. 10-year treasury.

Starting point is 00:12:50 Japan owns more U.S. treasuries than any other country, even China. To continue buying U.S. treasuries takes more and more yen, because their currency is weakening against the dollar. So, the BOJ can prevent the 10-year Japanese government bond from rising or the yen from collapsing, but they cannot do both. For now, the BOJ picked preventing the 10-year Japanese government bond yield from rising. But if the yen keeps weakening, will the markets force them to abandon yield curve control? A couple more economic spotlights before we head out.

Starting point is 00:13:19 Much of the focus during this Eurozone weakness has been on Germany. They are under pressure from increases in natural gas prices that are leading to limits on industrial production. In May, Germany printed its first trade deficit in 30 years. Indeed, its consistently high level of export surplus had led it to be referred to as the engine of Europe. It now appears that that engine is grinding to a halt. In May, they saw a trade deficit of 1 billion euros compared to a surplus of over 15 billion euros a year ago. Yasmin Fahimi, the head of the German Federation of Trade Unions, said over the weekend, entire industries are in danger of collapsing permanently because of the gas bottlenecks, aluminum, glass, the chemical

Starting point is 00:13:58 industry. Such a collapse would have massive consequences for the entire economy and jobs in Germany. In the UK now, inflation is also at record levels. Inflation hit 9.1% in May, which was the highest level in 40 years. Energy and fuel inflation are already excessively strong, and food inflation is forecast to rise to 15% over the summer. Unlike the ECB, the Bank of England has already aggressively hiked rates. They completed their fifth straight rate hike in June, bringing their key rate to 1.25%, which is a 13-year high. Alongside this, the pound has fallen over 10% year-to-date. But finally, to wrap up dollar strength in the U.S., in other words, how does the dollar

Starting point is 00:14:38 fit in, and is dollar strength actually good for us? This is probably a whole different discussion, but just one little note on it from Lynn Alden. She writes, As a reminder, it is historically very hard for U.S. corporate profits to grow when the dollar is strong. The Dixie moved down in 2021, along with stimulus, was helpful, but now with the dollar spiking and stimulus gone, there's little reason to expect great earnings reports overall. In short, even in the U.S., there are reasons to be concerned about the dollar wrecking ball. As you guys can probably tell, this is a big topic, something we're going to need to return to

Starting point is 00:15:12 over and over again. For now, I want to say thanks again to my sponsors, nexo.io, chain aliasis and FTCS. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. other. Peace.

The Breakdown - The Dollar Wrecking Ball

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