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As currency players have become more and more focused on bashing the Euro they are in danger of taking their eye off a potentially far
bigger story i.e. how the FX market is as dangerously unbalanced as it
was in 2008. Yet, after yesterday discount rate hike and resent FOMC
comments we should be on notice that this precarious equilibrium is
coming to an end and has the potential to turbo charge, as well as,
significantly broaden the mild $ rally (the broad $ index is only 7%
off the lows) we have seen to date. Even if you aren't a major player
in the FX market this should concern you as a $ rally particularly a
rapid one is potentially horribly corrosive for a whole swath of assets
especially commodities that have a significant weak $ premiums already
built into their price.

Those of you have been reading my comments for some time know I'm a big fan of David Roche's book New
Monetarism, which help me catch the explosive 2008 $ rally. As is the
case today, the foundations of 2008 imbalances in the FX markets were
created by an over supply of $s relative to Euros and Yen. Back then
supply imbalance had built up over years as US banks ballooned their
balance sheets. While European banks didn't shy away from leverage the
important difference from an FX perspective was that the US recycled
their newly created cash aboard via the government and current account
deficit whereas, with the Eurozone the imbalances were largely recycled
internally. This equation was sustainable until the US consumer stopped
spending in the face of the housing slowdown and the supply of $'s to
the rest of the world started to fall. This process would has been
enough on its own to gradually rally the $. Unfortunately, everything
was turbo charged by the collapse of the US banking system, which
virtually overnight chocked $ funding. Indeed, the $'s rally was only
arrested when the Fed stepped in to offer liquidity via $ swaps.

If the Fed had merely acted to stop the collapse of the banking system,
then the FX story might have stopped there. However, they went further
and attempted to reflate the balance sheet of US inc.  As a result the
Fed massively expanded their balance sheet relative to their peers as
the attached chart shows. This naturally led to massive relative $
oversupply and renewed weakness, which in turn fuelled enthusiasm for
all the weak $ reflexivity trades as it did in 2007/08 and guaranteed
the FX market moved once again into a position of precarious imbalance.


This is all fine as long or until something comes along as it did in 2008 to alter the supply of $'s pitching over this fragile
equilibrium. That brings me back to the latest FOMC comments and in
particular those that relate to shrinking the Fed's balance sheet. In
an ideal world the majority view will prevail at the board and we will
get nothing dramatic with only "gradual asset sales".  In this
scenario, as the Fed's balance sheet shrinks I would expect the $ to
continue its gradual appreciation but across a broader range of
currencies not just the Euro. This is a benign outcome for most assets
as they should be able to look through $ strength although I would
expect commodities especially, gold that have benefitted from the weak
$ premium to struggle. However, just as in 2008 when the $ rally
started gradually given the precariously unbalanced market the move
this year could gather enormous momentum and become far more corrosive
for asset prices. Strong data especially, employment (I believe we will
see a mid 8% unemployment rate by June even before census hires) could
easily be the trigger for such an acceleration as it makes the bond
markets that will already be struggling to digest high base driven
headline inflation extremely restless. In that scenario it's possible
the hawks on the FOMC prevail and we "begin a program of asset sales in
the near future to ensure that the Federal Reserve's balance sheet
shrinks more quickly". That would catapult the $ significantly higher
triggering a repeat of 2008's deleveraging.