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"The natural reaction to market breakdown is to add layers of protection and regulation. But trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crisis rather than extinguishing them because safeguards add even more complexity, which in turn feeds more failure. Trying harder means sinking deeper into the quicksand.”

            Richard Bookstaber                                                                            

FX Trading –Dollar Bulls Now Owe It To Tight Coupling
I received an email from a reader that contained an interesting fact:

Seven separate assets currently maintain an 85% correlation (or better) with the S&P 500 over the last six months.

Included in that group is Reuters/Jefferies CRB Index, emerging-market bond spreads, and not surprisingly, the euro. I’ve been consistently discussing the tight correlation between the currencies and stocks. The reason I’ve cited has been simple: as risk ebbs and flows, buying of US dollars ebbs and flows … in an opposite direction.

So that means, as witnessed earlier in the week, when the S&P 500 tested new lows and bounced sharply, the US dollar did the opposite — tested new highs and fell back sharply. Then on Thursday stocks collapsed again. They tumbled to new lows not seen since 2003, and dragged down the euro right alongside. Of course, the US 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, and ultimately, why these correlations are more dollar-bullish than you might think.

Tight Coupling – Not Just a Two-Person Strategy to Prevent Hypothermia

I’ve talked about the market process plenty of times before. Specifically how it’s able to consistently, over time, 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”. And that idea alone explains the correlations I spoke about earlier … it explains why the financial system crumbled, why the global economy is sinking, and why the US dollar is back in vogue.

Tight coupling is the design and labor that goes into the construction of a house. Tight coupling is an expedition of rock climbers scaling a mountain-side. Tight coupling is an idea that helps to explain the detailed processes that go into complex, everyday functions; and why disruptions of these detailed processes often occur.

As we concern ourselves, tight coupling exists throughout the financial markets that we 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 together tightly that kept supported the trend of issuing subprime mortgages, bundling them up with other assets and selling them to investors.

But then home prices started falling. Then borrowers became unable to afford loans. Then bundled loans became less attractive. The market for this newly-created product froze up. Then losses started piling up for investors in these bundled assets. And then investors isolated from these assets began experiencing losses 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 – whereas it means to cause to spread out and affect a greater number –  and is used by Bookstaber on occasion to explain how the complexity added to the financial system by its participants can lead to accidents that in turn 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 and understand 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 US 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 US. Now many are suffering for running hastily in search of 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 US 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, China makes the things to sell to the developed world, and the developed world supplies the global capital necessary to keep the circuit unbroken.

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 neglected to invest in their domestic sectors. And instead, they took their left-over capital – the capital not already put towards building exports – and shoveled it into the US in exchange for safe investment returns.

The problem arose when the US could no longer find places to channel these trade surpluses that overseas economies were pumping into US capital markets. As mentioned earlier, all sorts of new derivative products were created … all sorts of new investment avenues became accessible … 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 have watched their stock market and housing wealth evaporate … spending across developed nations is retreating … export-centric growth models are suffering as global liquidity vanishes …

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. What this has done is create a trend primarily away from risk-taking and towards risk-aversion.

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 US. And this supports the beginnings of a long-term dollar bull market in the making.