What the Approaching Dollar Liquidity Crunch Implies About Gold

Jeffrey Snider of Alhambra Investment Partners just published a piece at Talk Markets and at Seeking Alpha, "Huge Repo Warning", wherein he alerts us to a sudden and severe US dollar shortage, the likes of which we haven't seen since 2008. He monitors the Repo fail rate, which tracks failure to deliver on contracts for people buying the dollar: (click on images to enlarge)

This measure of dollar shortage has just now leaped past the September, 2011 spike to the 2008 crisis level. This reflects problems in the US. But it may not all be fears over the US.

This January 12 article from the Wall Street Journal may go a long way toward explaining the disruptive dollar shortage - it is titled "Chinese Consumers Race To Buy Dollars As Yuan Slides".

During the weekend, ICBC received an urgent notification from China’s central bank warning of a dollar shortage, he said. The tight supply means ICBC customers applying to change yuan for dollars on Tuesday have to wait four days to complete the transaction, rather than the normal one day, he said. Another person who works in retail banking at a leading Hong Kong bank in Shanghai said she estimates the amount of U.S. dollars bought by Chinese residents in December is roughly double what it was in June, the last peak.

These jams come and go, but Snider, who has been watching this dollar thing like a hawk for awhile, seems to think the magnitude of this latest liquidity crunch is an urgent warning for stocks. His conclusion:

It is difficult to accept this level of fails as anything else other than a liquidity warning as all the prior versions had been ...  And it’s not like repo is the only indication of a desperate financial shortage.

In fact, that is the growing consensus among the deeper, internal eurodollar indications. From swap spreads to cross currency basis swaps to countries literally begging for dollars, they all point to the same imbalance – a dollar shortage.

It seems yet another warning that the financial world is “on the clock”... With a countdown already in place from whatever the PBOC had been doing in January (and this very well could be related to that), it would be truly a bad sign if those clocks synchronized especially heading into the final two weeks of a quarter and the typical window dressing illiquidity space. I would not be surprised at all if this surge in repo fails was the starter pistol firing to sound the beginning of dollar run #3

To illustrate what he means by "dollar run #3" I drew a comparison between some previous episodes of dollar shortages he graphs in his article and the related actions in the stock market. I use the NYSE composite as a broader average and a lead group, as it peaked early in the present decline.

Dollar hoarding looks to be a growing problem and very tightly correlated to the timing of severe stock market sell-offs. Bouts of dollar hoarding have precisely accompanied each of the two global stock sell-offs of our current downturn, not to mention the possible foreshock to the bear turn back in October, 2014. Snider sees the late 2014 event as just that, a foreshock. He notes the rising dollar back then along with the top in a lot of markets - think CRB dropping off a 3 year plateau, European banks, the US transports. He pegged the October dollar hoarding run as "a clear warning sign".

There seems to be a growing propensity for safe haven scrambles developing.  And the
rocketing repo fails shown above strongly suggest the aforementioned run #3 will be underway in the downward megaphone progression pictured above.

This megaphone progression has been the defining characteristic of every major US bear market  since 1850. You can look at all seven of these cases in an article at my web site. I gave it an alarmist title similar to Snider's "Huge Repo Warning" - "An Important Market Message Is Now Blaring". Both our alarms sync together very well. We are approaching the upper reaches of the megaphone in what is probably a bear market rally, just as the most severe dollar crunch since 2008 arrives.

This all has a huge bearing on gold in that, in any flight to safety, massive amounts of money get divided between many things, but the USD and gold are the two main players. So it behooves us to consider the relative size of these two markets:

The size of the investable gold market including miners is about $2.6 trillion. The vast majority of forex trading, about 85%, trades the USD. This pictograph clearly shows that, when there is a traffic jam in the dollar, it is a big traffic jam. If we were to picture the $700 trillion derivatives market in the above graph, there would not be room on the page to show it. The trading turnover in the dollar is around 6.5%, for gold it's about 2.7%. If you do the math, that's roughly 4 times the supply/demand tightness factor for money wanting into gold, everything else being equal.

When things are not normal, as in the current, dangerous dollar shortage, it could divert much more flight-to-safety inflows into gold's already much tighter market for new money. The popularity of the dollar as a safe haven the last couple years is greatly helped by the simple fact that it has been in a rip roaring climb, and gold - not so much. But the dollar climb is seriously weakening, especially since the whole Fed rate normalization scheme of the last couple years is now being called out on the carpet. The Fed is viewed more and more as being caught in the same boat as the rest of the central banks. And the dollar may become more and more viewed as just another currency and not so much a safe haven.

This all may go a long way toward explaining the sudden rejuvenation of the gold markets since January. The dollar transaction fail amount shown above is $883 billion - that's 18% of the whole forex market and about 3 days worth of trading. This current illiquidity could result in major moves in gold if we embark soon on the next leg down in a bear stock market, as this massive dollar trade tries to squeeze into the much smaller gold markets.

What's even more compelling in relative market size in this diverter valve movement is a look at the gold miners. The $2.6 trillion "investable gold market" includes the miners, but that is a miniscule $200 billion. The higher quality miners are viewed as a superior way to invest in gold as they provide good leverage to the gold price in their operating results. The miners also provide some insurance against any possible government interventions into gold ownership and pricing in an economic crisis, as happened in 1933, when FDR confiscated all US personal gold at $21.67/oz and then declared it worth $35/oz. The owners of the miners didn't care:

So the gold industry rightly sees more than its fair share of safe haven inflows if there is any USD/gold change. Considering the dollar/gold miner market size ratio is about 22, we could say that good things can come in small packages:

Add to this the extreme low we are at in this age for investor exposure to gold in this time of building currency disarray, and you have a formula for a possible dollar/gold tsunami:

The major currencies of today will go by the wayside before our unsustainable debt situation is cleared up, as all preceding currencies have done - except for gold:

The massive and pressing dollar shortage problem could soon be a gold shortage problem. The sharp jumps in the gold miners we are seeing could have a lot of follow through.