The US Federal Reserve (Fed) and European Central Bank (ECB) have created a very dangerous situation.
Throughout the last six years, there has been a sense of coordination between the Fed and ECB. This was evident both in terms of where capital went as well as how it was delivered via monetary policy.
For instance, when the Fed released its discount window documents in 2011, it became clear that most of the funds from QE 2 actually went to foreign banks located in the EU.
Similarly, when the EU banking system was close to imploding in 2012, the Fed coordinated with the ECB to announce QE 3 in an effort to prop up the EU banking system and calm overseas jitters to aid the Obama administration in its re-election campaign.
In short, from 2008 to 20414, the Fed and ECB worked together.
However, at some point this relationship was set to fracture. True, global Central Banks want to work together to maintain stability… but when every Central Bank is engaged in the competitive devaluation of its currency, at some point the relationship between Central Banks would become fractured as they individually had to choose to aid themselves over each other.
That point is today…
The Euro comprises 56% of the basket of currencies against which the US Dollar is valued. As such, the Euro and the Dollar have a unique relationship in which whatever happens to the one will have an outsized impact on the other.
This relationship first began to run off the rails in June 2014 when the ECB cut interest rates to negative. Before this, the interest rate differential between the Euro and the US Dollar was just 0.25% (the US Dollar was yielding 0.25% while the deposit rate on the Euro was at exactly zero).
While significant, the interest rate differential was not enough to kick off a complete flight of capital from the Euro to the US Dollar. However, when the ECB launched NIRP, cutting its deposit rate to negative 0.1%, the rate differential (now 0.35%) and punitive qualities of NIRP (it actually cost money to park capital in the Euro) resulted in vast quantities of capital fleeing Euros and moving into the US Dollar.
Soon after, the US Dollar erupted higher, breaking out of a multiyear triangle pattern and soaring over 25% in a matter of nine months.
To put this into perspective, this move was larger in scope than the “flight to safety” that occurred in 2008 when everyone thought the world was ending.
The reason this is problematic?
There are over $9 trillion in borrowed US Dollars sloshing around the financial system. And much of it is parked in assets that are denominated in emerging market currencies (the very currencies that have imploded as the US Dollar rallied).
This is the US Dollar carry trade… and it is larger in scope that the economies of Germany and Japan… combined.
In short, when the ECB cut rates to negative, the US Dollar carry trade began to blow up. The situation only worsened when the ECB cut rates even further into negative territory in September 2014 and again last week bringing the rate differential between the US Dollar and Euro to 0.55%.
Now, the Fed is talking of raising interest rates. Even a symbolic rate hike to 0.3% or 0.5% could trigger a complete implosion of the $9 trillion US Dollar carry trade.
If you think this is just fear mongering, you’re mistaken. The Treasury Dept. issued emergency kits to employees a few months ago in anticipation of systemic volatility during the rate hike. Similarly, the Fed boosted the size of its market operations department in Chicago case the NY Fed loses control of the system when rates increase.
In short, we could very well be on the eve of another systemic crisis. The financial elites have been preparing for this for months.
Smart investors are preparing now. The August-September correction was just a warm up. The REAL drop is coming shortly.
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Best Regards
Graham Summers
Chief Market Strategist
Phoenix Capital Research