Currency crisis ahead? Part 1- Potential short squeeze on the US dollar

October 27th, 2009

Share |

Jimmy Rogers had been saying that he expects a currency crisis soon, maybe this year or next year. While we agree with Jimmy Rogers, that in itself is not particularly insightful. The difficulty is in predicting the timing of the currency crisis.

As we explained the dilemma of the world’s major creditor nations in What if the US fall into hyperinflation?, it is clear that the current status quo is an accident waiting to happen. The question is, in what form this accident will look like. Already, the rise of the Australian dollar and Brazilian real is described as “bubbles” by some pundits.

Unlike short selling of stocks, there is an unlimited supply of US dollars (which is the world’s reserve currency) that can be borrowed at effectively zero interest rates to be ‘shorted.’ Since the exchange rate of currencies are relative, shorting the US dollar is the same as going long on other currencies. As we said before in Return (and potential crash) of the great Aussie carry trade, this state of affairs is indeed a paradise for speculators.

Indeed, shorting the US dollar is so popular that central bankers of the creditor nations must be getting nervous. What if, the selling momentum gathers steam and snowball into a US dollar crash? There will be hell to pay should that happen. Possible outcomes of such a scenario include more bank collapses, trade war, hyperinflation and so on (see What Happens If the Dollar Crashes). Therefore, we expect coordinated central bank intervention in the currency markets soon to thwart such an eventuality. The longer they wait, the closer the point of no return will arrive. If coordinated actions are not forthcoming, individual unilateral actions will be taken (e.g. Brazil recently announced a tax on speculative capital), which is less desirable because the outcome tend to be more messy, unpredictable and contradictory to the objectives of other nations.

What will happen to the financial markets when central bankers really do that?

For speculators who are taking advantage of the higher and higher interest rates in Australia (i.e. borrow are zero in the US, buy AUD and then collect the higher interest yield), a rising US dollar will result in an instantaneous loss. Rising interest yields in Australia will not cover that loss since it has to be parked for an extended period of time to bear the returns. Therefore, speculators will pull their cash out of Australia immediately to buy USD. That in itself will result in the USD appreciating further, resulting in further losses for the existing speculators who have yet to pull their cash out, prompting them to panic and rush for the exit. For the speculators who are punting on the stock market, they will liquidate their stocks and rush for the exit too. The same can be said for the commodity markets, including gold and silver. This is a classic short squeeze, which will occur when the momentum and sentiments are at the extreme.

But this is just a better outcome. In the next article, we will talk about a possible Black Swan in November that may trigger a real currency crisis.

Tags: ,