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Recent market volatility suggests that most global investors were carrying a short position in the U.S. dollar and U.S. bond market whether they knew it or not. In a great post at Minyanville, Vince Foster presents the most plausible theory I've seen, namely that the unwinding of these positions is the root cause of current market swings. The U.S. Federal Reserve's quantitative easing (QE) program has broadly impacted markets in two ways: it pushed U.S. Treasury yields lower and weakened the U.S. currency. As long as the Fed was intervening in markets, investors could be reasonably confident that the dollar would remain weak, and that interest rates would remain well below the level of inflation.
The gold market is the best example of how QE evolves into a U.S. dollar short position. In simple terms, bullion is a hedge against devaluation of the dollar – the gold price reliably moves higher when the dollar declines.
In hindsight, it is no coincidence that the gold price peaked in October of last year. That was when Abenomics caused a sharp rise in the dollar against the yen. Dollar up, gold price down – and suddenly, the cracks began appearing in the great precious metals investing story.
Gold investors, perhaps unknowingly, owned a short position in the U.S. dollar – they were relying on a weak dollar to make their gold investments generate returns.
Global equity investors were similarly dependent on the Fed's efforts to push interest rates lower by intervening in fixed income markets. In forcing rates down, the Fed made the relatively higher cash flows from equities (in the form of corporate earnings) more attractive as an investment. To put it another way, the Fed effectively lowered the discount rate, which increased the present value of cash flows from equities, high-yield bonds and other, higher-risk investments.
Now, the sharp jump in U.S. interest rates has changed the math. The discount rate for all cash flow from investments is now higher – which means everything is worth less.
This explains how equity investors, owned an implied short position in U.S. Treasuries along with their stock holdings. Stock prices were dependent on low interest rates engineered by the Fed.
This mass short position – in Treasuries and the dollar – is now being unwound, at least in part, as the Fed threatens to withdraw. Three month T-Bills (ie. money market funds ) are rallying, and we're starting to see disturbing headlines like "Cash Is Tight : 6 More US Muni Bond Sales Postponed."
Hopefully, this is an adjustment phase for markets and not a crisis, though the distinction depends on whether or not a big investor gets stuck, and is unable to unwind a leveraged position. Most likely, once asset prices adjust to the new interest rate environment, things should settle down.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
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