Jurassic Park and the Strong Dollar

I was doing some research over the weekend when I came across a quote from San Francisco Federal Reserve President John Williams that put the current state of financial markets and global monetary policy into perfect perspective: We are living in Jurassic Park.

Williams said he is starting to think that artificially low interest rates could be a sign that there are possible changes in the US economy that the Fed doesn’t fully understand. “I see this as more of a warning, a red flag that there's something going on here that isn't in the models, that we maybe don't understand as well as we think, and we should dig down deeper and try to figure this out better."

I couldn’t help but think about Jurassic Park when I read this quote. John Hammond, the billionaire founder of a bioengineering company creates the ultimate theme park. He was able to clone dinosaurs by extracting their DNA from preserved mosquitoes of that time period.

Since there were gaps in the DNA, Hammond and his scientists decided to fill in those gaps with the DNA of frogs, much like Bernanke “filled in the gaps” post crisis with an unprecedented interest rate environment as well as multiple rounds of quantitative easing. To avoid breeding outside of the Jurassic Park labs, all of the dinosaurs were cloned to be females. The only problem was that they used West African bullfrogs, which can change their sex in a single-sex environment, allowing the dinosaurs to breed on their own, outside the lab. Oops.

At the very least, Williams is beginning to think that the Fed and other central banks may have used the equivalent of the West African bullfrog to throttle markets and attempt to help the global economy and we are about to discover the unforeseen consequences.

 

To See The Financial Forest and Trees

Financial markets work very similar to a natural forest. In a natural forest, there is a continual competition for available resources for growth. As the growth in a particular area reaches critical mass, the increased competition leads to small wildfires that clear the land and allow for a new round of reseeding to take place.

 

All of this is a very natural and necessary process. If the people in charge of forests focus on eradicating the wildfires, which are a necessary and healthy aspect of this homoestatic process, they only delay the inevitable, and make the eventual wildfire larger in magnitude and damage.

If financial markets were left to their own devices, they would readily adapt to the random shocks that occur. However, since the Crisis, markets have not been able to move unencumbered and central bankers have been hell bent on avoiding shocks, or small wildfires, at all costs. You can’t eliminate economic shocks and attempting to do so only creates excesses in the system that have no way of naturally balancing themselves.

Eventually, any system will adapt even to unusual stimuli, and like the West African bullfrog,  will change its own sex if need be to survive. Many believe that the largest wildfire in California history, which burned 200,000 acres in San Diego county back in 2003, was the result of an increased focus on eradicating small wildfires that often occurred in that area.

So the $64,000 question is what will be the West African Bullfrog or the Cedar Fire for the financial markets? It won’t be any one thing; it will be a confluence of events that build up over time and are sent over the edge by one seemingly innocuous headline or event. I can also promise you that those events will be readily apparent, if you’re paying attention. Like I discussed last week, the events leading up to the Financial Crisis were well spread out and very apparent to those who were willing to pay attention to what was happening in the present.

 

The Dollar, The Euro and Emerging Markets

One of those events could turn out to be the USD’s strength over the last 18 months. This event could well be the beginning of the markets trying to realign themselves, with or without central banking cooperation. The Fed hasn’t even tightened yet but the mere threat of raising rates a mere 25 basis points, coupled with the massive easing policies of the rest of the globe, have led to a monster move in the Greenback, which I believe is just the beginning.

A strong USD has many implications across multiple markets. No markets are more impacted by the USD than emerging markets. This topic has been well covered.

But I want to encourage you to look beyond the obvious implications of a strong USD and consider the knock on effects, which few people consider.

The USD hit the bottom of its 2-year trading range in early May 2014 and has since rallied 21%. Emerging market equities are crashing down over 20% on average, emerging currencies have lost 10% and bonds are down 3% over that same time frame.

If the USD is able to close above par, there is no ceiling until the $113.00 area. That move would be an additional 17% from here, and the impact that could have to emerging markets is chilling.

Beyond the emerging market asset class impact consider what the impact of a strong USD might have on not just emerging market economies but other economies that depend on emerging consumers. The conditions in the economies around the world have deteriorated from just a few months ago. And with the exception of India, emerging economies have slowed the most.

The IMF recently downgraded all of their forecasts for global growth and this slowdown is probably not temporary. Keep in mind how critical emerging markets are in the grand scheme of things. They are worth 60% of gross world product and since 2000, they have accounted for 75% of global growth.

Not to mention that over half of Eurozone exports go to emerging markets. This means that there are further severe risks to Eurozone growth and inflation should the USD move higher from here.

There are many trade ideas that can flow from this line of reasoning. We are currently SHORT the euro, via FXE, in the TWR trade ideas, as one way of implementing a trade on this theme. Although we’ve only been in the trade for 2 weeks and we are profitable, the real profitability of this trade idea will be realized in the future as the strength of the USD continues to exert its pressure on markets.

As John Hammond proudly states throughout the movie regarding the development of Jurassic Park from the laboratories to the cafeteria menu, he “spared no expense.”

We have yet to find out just how much its going to cost us for the 7 years of global easing policies we have enjoyed since the end of the Financial Crisis. My guess is that when the bill comes, we will discover that the world's central banks have spared no expense.