US Dollar is the New VIX… and There is a Problem
The VIX Index is broken. It no longer provides an accurate measure of the amount of leverage in the financial system. This poses a problem because central bankers, regulators, policy makers and economic forecasters all use the VIX as a the central measure of leverage. In short here is how the dollar becomes new risk index ->
- The US dollar is used as the base currency in international lending.
- In order to operate long supply chains (i.e. iPhones made in China and shipped to US) working capital is needed.
- This working capital is financed by the banks and denominated in US dollars.
- Since manufacturers (like Foxconn) finance in US dollars but pay salaries in local currency (Yuan), when the dollar rises profit margins decrease.
- The declining profit margins cause the banks to lend less.
- This creates a forced deleveraging that is NOT captured by a rising VIX.
- Therefore the higher the dollar rises, the greater the probability of a forced deleveraging similar to 2008
Since the US election, investors have not had to worry about a stronger dollar causing a forced deleveraging. In fact, the US Dollar Index peaked at 103.21 on the first trading day of 2017 and has subsequently fallen -2.6%. But while the dollar fell something curious happened with bond yields…they climbed and broke the nearly perfect correlation they had with the US Dollar.
There are plenty of guesses as to why this divergence has occurred – Chinese selling of Treasuries to defend the Yuan is the most compelling guess to BK.
But the bigger questions is this –> Why is this a Problem?
In fact, BK has stated that a lower/stable dollar and gently rising bond yields were the key to further equity market gains. The problem occurs when this divergence becomes wide enough to attract international investors. Just like when one travels abroad and hopes for a weak foreign currency to “get a deal” international investors play the same game. In particular, with the Bank of Japan pegging yields at historic lows the interest rate differentials between the two countries eventually will cause money to flow into the US Dollar.
The risk is that this divergence adds pressure to a violent snap back rally in the US Dollar – especially if the economic data continues to improve. Investors may initially misinterpret the rising dollar as a positive signal, but lurking beneath the surface is a deleveraging monster.