Abaci's Common Sense Investing

This isn't my favorite topic for obvious reason - one pays no interest and the other barely pays interest. But since most people can't be convinced to buy stocks perhaps it's good time for a change of topic

Have you ever noticed that American dollar is only currency that is called 'gold' in Chinese when it's not? You never hear (in Chinese) British Gold or Euro Gold. It seems the USD is the next best thing to gold.

The USD has started an uptrend, just like gold, since the collapse of Lehman last year, and it's stayed strong even when the US economy looked like it's heading into a tailspin, and amid the massive creation of money supply via everyday rescue and stimulus package's' and a close to zero federal rate.

The easy answer to this abnormality is that people flight for security in times of uncertainty. The US economy sucks and is shrinking but still it's the biggest economy in the world, and with the biggest army. The only other nations comparable are Russia and China, both communist and with currency control, hence it's not hard for most to make the choice. What about Euro? Well, as much as the high cost and unionized workforce is plaguing the US, the same hurts even more across Europe. And Europeans also fare generally less well than fellow Americans on creativity and technology front.

But this answer seems too easy and ignores something deeper in the working. I recently read an Economist article that provided better insights and together with my understanding here's a slight more difficult answer.

I'll start with the background. Globalization has lead to more emerging market countries, notably China and others in Asia, earning USD from selling exports. These USD ended up in various central banks' reserves and were not converted back, as most governments were still haunted by past trauma of the Asian financial crisis and the heavy foreign currency debt. So this time around they all loaded up USD as buffer for the bad times. Of course at the same time they also didn't want to their currency to rise too much and thus selling these USD was a big no no.

These USD then found their way naturally in the US treasury bond. As foreign trade increased and reserves soared, more treasury bonds were purchased which drove down the yield. During this time there was the bursting of the IT bubble and Alan Greenspan's monetary easing. I think everyone understood this well. So I'd just say both factors combined and the result was an extra low interest rate in the US, second to only Japan.

Out of cheap financing, a housing boom and a consumer spending boom was born. The housing boom was more devastating because it's also self-reinforcing, as higher prices led to more speculative buying.

Extra low interest also meant extra low return for lenders. American bankers then got creative and repackaged all kinds of loans into AAA securities and started selling overseas to those who had to buy USD but weren't satisfied with treasury return. Local US banks then eased its lending standard because lousy loans could always be sold. This part you now know very well too so I'll skip. I'd just add many US banks also provide USD financing to entice overseas buyers.

The low interest rate also helped grow the eurodollar / eurodollar bond market, i.e. borrowing dollar on non-US soil, mostly in Europe. As more companies/investors took advantage of the lower rate USD borrowing, this became self-reinforced as when borrowers converted the USD proceeds into local currencies to use, this drove down the USD and made borrowing USD more attractive as it's a currency that had low interest and was depreciating too!

So much for the long-winded background! Let's guess what's been happening since last year.

First the US banks got into trouble as the housing market deflated. But this was seen to be domestic only and hence USD fell even more as most people moved to other currencies with a higher interest rate when US was cutting rates. Then it became obvious that all the repackaged loans sold to Europe would go sour too, hence most European banks and investors would suffer as well, and probably as much too. These USD assets became illiquid or substantially worth-less. However much of these securities were financed by USD loan given by US banks at the 1st place (originally a nice hedge and leverage to enrich return). So Europeans suddenly found they were very short of USD. Of course it didn't help the US lenders were all in deeper trouble and needed that USD even more urgently.

Naturally the Eurodollar borrowing market ceased as the lenders, both US and European banks, or actually everyone, was short of USD! Normal commercial lending was affected at this point. So every asset class had to be sold to repay those USD loan, and hence USD had nowhere to go but up abruptly. The case was also worsened as borrowing was gradual over years but repayment was almost immediate. This was similar to the YEN unwinding every once in a while but of much broader scale, and with the difference that the original US lenders were also scrambling for the same USD like the borrowers. That's why we had a very high LIBOR vs US fed rate and the USD swap arrangement between the FED and ECB late last year. There's USD shortage everywhere.

What about all the monetary injection by central banks and the fiscal stimulus packages? I think evidence is the former is not enough to counter the size of the credit crunch, and the effect of the latter is not yet felt. Meaning - credit is still not enough so de-leveraging has to go on. This has been a rise or normalization of long term US treasury yield lately, which suggests maybe inflation or worst insolvency of US. But this is universal as I think credit spread for many European countries are rising as well, meaning everyone is having just as bad prospect.

What does these mean? The strong USD isn't going away soon! It's lucky we are in Hong Kong and most of us are automatically invested in USD via the peg. But I do think the tide will turn. I'll try organize my thoughts and tell you next time, and cover gold too.