My reason is simple: As risk ebbs and flows, the amount of traders buying U.S. dollars also ebbs and flows – only in an opposite direction.

So that means, when the S&P 500 tested new lows and bounced sharply, the U.S. dollar did the opposite – the dollar tested new highs and fell back sharply. We watched this happen this past week. Then on Thursday stocks collapsed again. Stocks tumbled to new lows not seen since 2003, and dragged down the euro right alongside. Of course, the U.S. dollar index broke out to a new high.

These tight correlations often are simply risk, ebbing and flowing. But maybe we should look deeper to understand the true driving forces behind recent trends. If you look closer, you can see why these correlations are more dollar-bullish than you might think.

What “Tight Coupling” Really Means

Over time, the market process can consistently produce extremely efficient interaction among human beings in the marketplace, in the business place and in life.

I try to make it sound simple. I try to boil it down to the big ideas. But really the entire process and all that goes into it is extremely complex.

I’m in the middle of a book by Richard Bookstaber titled Demon of Our Own Design. He’s devoted an entire chapter to an idea known as “tight coupling.”

That idea alone explains the correlations I just mentioned. Tight coupling also explains why the financial system crumbled, why the global economy is sinking, and why the U.S. dollar is back in vogue.

Tight coupling is the design and labor that goes into building a house. Tight coupling is how rock climbers scale a mountain-side. Tight coupling is an idea that helps to explain the detailed processes that go into complex, everyday functions. It also explains why disruptions of these detailed processes can happen.

Tight coupling exists throughout the financial markets that currency traders stress over nearly every single day.

A good example would be the recent subprime-mortgage backed securities fiasco. Before the entire credit system went boom, there were quite a few things strung tightly together. These things supported the trend of issuing subprime mortgages, bundling them up with other assets and selling them to investors.

But then home prices started falling. Suddenly borrowers couldn’t afford loans. Bundled loans became less attractive. The market for this newly-created product froze up. Losses started piling up for investors in these bundled assets.

And then investors isolated from these assets began losing on their investments. This happened as the tightly coupled financial industry became unwound and asset values of good assets and bad began deteriorating together.

Propagate is a good word here – it means to cause to spread out and affect a greater number. Bookstaber used this word on occasion to explain how market participants add to the complexity of the financial system, and how that can lead to accidents which can trigger a vicious downward spiral of asset prices.

And that’s all well and good. Even if you’ve not yet grasped the idea of tight coupling yet, you understand what’s happened with the subprime market by now. You also know that relatively solid assets have been impacted once subprime derivative participants, and the market, were no longer able to handle the complexity of what they created.

Decoupling Loses Out to Tight Coupling

I’m trying to think back to when the consensus believed the global economy would be fine without the United States economy, should the U.S. fall into a nasty recession or something. Maybe it was as recent as the middle or the end of 2007 that global bulls still clung to this hope that things had changed.

In hindsight we realize that’s all it was: Hope. No change, despite what was talked about. The global economy did not decouple from the United States. Now many investors are suffering because they ran for greener pastures without understanding what and where they were consuming.

Emerging markets became the investment story. The growth potential was huge. And besides, everyone sought to get away from dreary U.S. investments and put their money into more lucrative investments. Of course, more lucrative implies more risky.

But why not? The global economy was chugging along. The developed world was more than willing to buy China’s cheap stuff, and China was happy to produce it. China was demanding raw materials, and small resource-focused economies were thrilled to meet China’s appetite.

The diagram above is pretty clear: Emerging market economies provide the stuff to make things. Then China makes the things to sell to the developed world. And finally, the developed world supplies the global capital necessary to keep the circle going.

As it was, emerging economies invested more heavily into their export-centric model. China invested heavily into their export-centric, cheap labor model. This gravy train was paying off before a wrench got thrown into the mix.

United States Loses the Ability to Absorb Surpluses

As just mentioned, emerging markets (and China) invested primarily in their export-centric growth model. (Can you blame them?)

But they also neglected to invest in their domestic sectors. And instead, they took their leftover capital – the capital not already put towards building exports – and shoveled it into the U.S. in exchange for safe investment returns.

The problem arose when the U.S. could no longer find places to channel these trade surpluses that overseas economies were pumping into U.S. capital markets.

So they created all sorts of new derivative products… all sorts of new investment avenues… in hopes of allowing liquidity to flow efficiently. But of course, as is the case with tight coupling, the complexity of new initiatives (and even routine processes) opened the door for error.

Asset bubbles inflated and popped. Investors realized they had little understanding of new financial instruments. Consumers watched their stock market and housing wealth evaporate. Spending across developed nations retreated. The export-centric growth models suffered as global liquidity vanished.

And this is a process that cannot be stopped effectively. Naturally the cycle will find its end. And unnaturally “officials of last-resort” will try to come in and stem the unraveling. But that just makes things more complex and increases the likelihood of unintended consequences.

It is for all these reasons that so many markets – dependent upon the continued flow of liquidity – have become so extremely correlated now that global capital flow has morphed.

This has created a trading trend primarily towards risk-aversion and away from risk-taking. In other words, a race towards safety.

It is my feeling that risk-aversion is here to stay, as this cleansing cycle runs its course. And I’m of the opinion that US capital markets remain the deepest and most efficient in the world. The United States maintains the largest capacity to produce wealth. Risk-aversion will continue to steer capital back to the United States. And this supports the beginnings of a dollar bull market in the making.

Have a great weekend,
John Ross Crooks, III

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