Yellen’s Financial Disaster

Yellen’s Financial Disaster

Yellen and the Yellenettes are gathered for their last concert of the year today, and everyone is wondering just what song they’ll sing: the 5th Dimension’s “Up, Up and Away” or the Beatles’ “Let It Be.”

Me, I’m betting on the latter.

While I’ve been right on every meeting but one since 2012, the chance certainly exists with this particular Fed meeting that I am wrong for the second time. At this point, the market is 100% confident that I am wrong and that the Fed will announce its second rate hike in the last decade.

I understand why the market believes that. It’s convinced that U.S. economic conditions warrant a rate hike, and that our economy can withstand the negative impacts (on consumers, on businesses and on the government) of marginally higher interest rates.

I get it. And it makes some sense, if you believe the U.S. economy truly is healthy (and I don’t believe that).

But there remains a very good reason why the Fed won’t, shouldn’t and can’t hike rates, assuming the Fed is paying attention to this reason.

And if the Fed isn’t … well, then you will want to adopt the brace position fairly soon, because we could be in for a globalized financial disaster.

I’ve detailed many times (so I won’t rehash them here) all the factors that show the U.S. economy is no beast, despite the media- and market-fueled belief to the contrary. I’ll just say, as I routinely do, that quantity in the jobs market is not a replacement for quality, that we’re creating far too many low-wage service sector jobs that do not support a middle class, and that U.S. consumers are so indebted to credit card companies and home equity lenders that rising rates have the power to kill the consumer, which has been the primary driver of GDP growth here at home. (Moreover, President-elect Trump’s economic agenda will likely prove recessionary.)

But there’s another quite substantive — and largely overlooked — factor at play right now that, if mismanaged, could cause a massive global meltdown.

The Unexpected Shortfall

A shortage of U.S. dollars.

That sounds oxymoronish. Given that the Fed has printed money at a fiendish pace since the Great Recession, how in the world, one might rightly ask, can the world be short on bucks?

Because of the outsized dollar demand that has occurred overseas and the necessary hedging activities that occur as a result.

With U.S. borrowing rates at or near zero for nearly a decade, companies overseas have taken on trillions of dollars in dollar-denominated debt. The issue here is that these companies generally sell their goods and services in local currency, yet must repay their debts in dollars.

That creates a currency mismatch that companies generally hedge away in the forex market by shorting their home currency and going long the dollar. The play is simple: If the local currency falls in value, then their currency trade will be worth more money, and they can use those profits to pay their dollar-debt obligations.

This is where potentially devastating problems arise…

Feeding the Dollar Rally

If U.S. interest rates rise, overseas companies face two significant worries that raise the cost of repaying their dollar debts:

  1. As they roll over their dollar debt, the higher interest rates, even if just marginally higher, imply higher interest repayment costs.
  2. As U.S. rates rise, the local currency falls in value relative to the dollar, which implies a company must redirect ever more of its income stream to debt repayment … which means that companies will look to short ever-larger amounts of local currency against the dollar to hedge their dollar-debt obligations.

That’s where we come to the problem of a dollar shortage.

Despite the money printing, there is not an endless supply of greenbacks floating around the world. As companies increase their hedging activity, demand for dollars escalates, and, again, there’s not an unending supply necessary to meet those hedging needs. That’s even more viscous than it first appears because rising demand for dollars for hedging purposes puts additional upward pressure on the dollar, which then necessitates even more hedging.

At some point, the currency to hedge isn’t available, and a company, or many companies, will face a debt-repayment crisis that reverberates globally.

Exacerbating the problem is that banks are reticent to lend to overseas borrowers when the dollar is rising because they realize the risks they’re assuming on their books by lending to a company confronting currency-mismatch problems.

And that’s where the Fed comes in.

Fed Rates on Hold

I have to believe the Fed realizes this problem exists.

I have to believe Fed governors recognize that by raising interest rates in America, they could unwittingly unleash a global rush for dollars that exposes and amplifies the dollar shortage … which then causes debt defaults in various places around the world … which then pulsates through the global economy.

Those pulses would, of course, land upon our shores with great destructive power.

The American press and American market commentators act like the Federal Reserve is and should be concerned only with America. But in a world where the dollar is the global reserve currency, the Fed doesn’t have the luxury of focusing its attention solely on the U.S.

The Fed is truly the central banker to the world at this point, and it has an obligation to consider and address its actions in the context of global impacts.

Raise rates, and the Fed could very well be the proximate cause of the next great global recession — or worse.

The Fed, already blamed for so much else, doesn’t want that blood on its hands, too.

So, my bet is that the Fed won’t raise rates in December. It will wait to see how Trump’s economic plan takes shape and the impacts of that plan on the global economy. Only then will the Fed have a true indication of what its next move must be.

Until next time, good trading…
Yellen’s Fed Financial Disaster
Jeff D. Opdyke
Editor, Total Wealth Insider