It All Starts With The Dollar...

Jeremy Rudd, an economist at the Federal Reserve, wrote a few years back that, "Mainstream economics is replete with ideas that 'everyone knows' to be true, but that are actually arrant nonsense."

I have found this to be true in numerous respects. One such idea is the notion that currencies are 'national' in origin and that exchange rates are thus the result of differences between countries.

This seems like it should check out- the US Dollar is a United States entity, the Japanese Yen is a Japanese entity, thus the dollar / yen exchange rate should be a function of differences between the United States and Japan- right? Wrong.

Understanding the flaws in this line of reasoning is pivotally important if one is to understand how the global economic system works and how to invest effectively.

The truth is that there is really only one currency in the world- the US Dollar.

This is what the "$65 Trillion in Missing Debt" refers to:

I will unpack in further depth what "FX Swaps" are in a future post and why they are crucially important, but for now just appreciate that swaps are a way to glue together the entire dollar system. In short, the global economy is run by a handful of enormous, 'universal' banks, and these banks transact with each other by using dollars. FX swaps are simply a tool to translate 'foreign' currency into dollars.

As such, picture the monetary system as looking like this, with a central node that affects the conditions of all the other nodes on the periphery:

The central node is the network of global banks and FX swaps are how this group of banks becomes one entity. The dollar's exchange value is simply a representation of the 'health' of this central node: when the dollar strengthens this is a sign that the core of the monetary system is under stress.

There are many ways to infer stress in this central node: one is via the 'repo market'. GCF repo is a market in which financial institutions lend money to one another. Large institutions borrow at the Triparty repo rate (TRP) and lend to smaller institutions at the GCF rate, making money on the spread between the two.

A wider spread means that the large banks that are intermediating this market make more money. As such, we can use this spread as an indicator of financial stress. Think of it in these terms: a larger spread (higher GCF repo rate) means that the large institutions need more incentive to lend money. Spikes in the GCF repo spread thus indicate that these institutions are scared of 'something' that is going on in the monetary system.

Note below how the relationship between this spread and the value of the US Dollar (purple line is the GCF repo rate and the blue line at the bottom is the spread):

The GCF repo rate and spread to the triparty rate increases drastically heading into 2017 and then falls drastically in 2017. Now notice how the dollar spikes in value during 2014-2016 and then collapses in 2017:

Simply put, there is a very strong correlation between the dollar's exchange value and monetary conditions; because only a handful of people understand this, it provides an incredible opportunity for investors.

Even the largest hedge funds in the world still simply think of the dollar as being a function of interest rate differentials. But let's utilize this same period to show how inaccurate this is:

Interest rates were decreasing as the dollar went up, and the spike in rates at the end of 2016 was followed by a decrease in the dollar, completely contrary to mainstream theories.

We can show this same phenomenon with rates differentials. Note how an increase in Mexico's interest rates vs. the US' (green line) should correspond to an increase in Peso's exchange value (red line). However, it appears there is actually an inverse correlation:

This can be demonstrated with a host of other currencies throughout the world- there is 'something' that causes the dollar to spike in value regardless of national conditions.

For example, note the correlation between Brazil's currency (blue line) and Russia's currency (red line) vs. the dollar:

Despite completely different national dynamics, the dollar rose and fell against these currencies in almost completely lockstep. This same dynamic can be illustrated with currencies throughout the world.

The reason for this close relationship is that the monetary system is globally integrated, as I described earlier. Stress in the 'central node'- which can be inferred by metrics like the GCF repo rate- is transmitted globally, resulting in an increase in the value of the US Dollar. The dollar is the globally currency, and every large financial institution is reliant upon short-term dollar borrowing. When stress manifests, dollar lenders require more of the non-dollar currency to incentivize them to lend.

For example, imagine you are a dollar lender and the borrower is a Japanese institution. If you feel confident about the future, you may be willing to lend $1 for 100 yen. However, if you suddenly become less confident (more "risk-averse"), you may now demand 120 yen in order to lend your dollar.

As simple as this sounds, it is this phenomenon that forms the foundation for our monetary system: financial institutions need to constantly roll-over short term borrowing and there are times when this becomes much more difficult. During these periods, the dollar becomes more valuable and asset prices (e.g. oil) fall.

Because the dollar is so intimately tied to monetary conditions and these conditions can be inferred, I have found that trading the dollar is one of the most effective ways to profit in markets. UUP is a index that tracks the dollar and there are options available for those who wish to aggressively multiply their money.

Stay turned as I unpack more about how to understand the dollar and the broader monetary system in future posts!