Is This How The Next Global Financial Meltdown Will Unfold?

I have long maintained that the structural imbalances of debt and risk that triggered the Global Financial Meltdown of 2008-2009 have effectively been transferred to the foreign exchange (FX) markets.

This creates a problem for the central banks that have orchestrated the “recovery” by goosing asset bubbles in stocks, real estate and bonds: unlike these markets, the currency-FX market is too big for even the Federal Reserve to manipulate for long.

The FX market trades roughly the entire Fed balance sheet of $4.5 trillion every day or two.

Currencies are in the midst of multi-year revaluations that will destabilize the tottering towers of debt, leverage and risk that have propped up global growth since 2009.

Though the relative value of currencies is discovered in the global FX market, there are four fundamental factors that influence the value of any currency:

1. Capital flows into and out of the currency (and the nation that issues the currency).

2. Perceived risk, specifically, will this currency preserve my global purchasing power (i.e. capital) or erode it?

3. The yield or interest rate paid on bonds denominated in this currency.

4. The scarcity or over-abundance of the currency.

If we dig even deeper, we find that currencies reflect the income streams and assets of the issuing nation. Consider the currency of an oil exporting nation that has seen both its income from selling oil and the underlying value of its oil in the ground fall by more than 50%.

Why shouldn’t that nation’s currency decline in parallel with the erosion of income and asset valuation? As a nation’s income and asset base decline, there is less national income to pay interest on sovereign bonds, less private income to tax, and a reduced asset base for additional borrowing.

This is especially true if the nation issued debt and/or currency profligately in good times. Recall that debt and currency are one in the same: if someone trades euros for a U.S. Treasury bond, they don’t just own a bit of sovereign debt–they own the currency of the nation that issued the bond (in this case, the U.S. dollar).