Friday, November 18, 2011

Will the Dollar Rally?

From Daily FX:

Back in September of 2008, the credit markets began to seize when news that Lehman Brothers had lost access to its credit lines and thereby would be forced to close shop made the headlines. The normal operation of the capital markets depends on the availability and circulation of credit. Banks frequently require short-term funds to cover obligations for overnight up to a few months when there is not enough cash on hand to cover liabilities or they are unable to liquidate positions to raise the necessary capital. Normally, it isn’t difficult to raise this capital through the open market at very low cost; but when there is a risk of falling short of mandated reserves, banks will generally hold cash rather than lend it out. For those that come up short, such a situation can spell a quick end.

These are the financial dynamics that we need to watch for now. We are already seeing the signs of real trouble building up. The most pressing concerns are still across the Atlantic as European banks are attempting to cut their holdings in Euro Zone government debt to shore up their balance sheets and meet reserve ratios that have been pushed up to 9 percent by regulators and have to be met by the middle of next year. Yet, we are seeing the strain spread to the US and the rest of the world. Gauging the global strain, the demand from European banks for funds in the US (struggling to find it in the EU), the Fed reported today that its swap lines to the region rose to $2.25 billion. Domestically, the Libor-Overnight Index Spread (a favored gauge for the cost of short-term money) rose to its highest since June of 2009. The kindling has been stacked. If there is a spark - like an influential bank failing (perhaps on the same level as MF Global) – credit markets could freeze and leverage dollar liquidity.