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Dollar, Euro Duel to Become Lesser of Two Evils

Tuesday, 07 September 2010 10:22 AM Current | Bio | Archive

Most serious investors are worried about what's going on. 

Equities cheap relative to current earnings, bonds expensive relative to history, equities 'cheap' relative to bonds, China and emerging markets going great guns and powering world growth, consumption levels very high in some countries as a proportion of income, debts very high in some places, companies lowly indebted relative their history, lots of cash everywhere doing nothing etc., etc. 

Who knows where we are and how it all will move forward.

Interesting times that feel somewhat extreme and may, who knows, well dissipate into nothing important — or may explode.

I am a general believer in the wisdom of crowds, although cautious when that builds into crowd momentum. That makes me thinking whether we can go back in time and remember some parallel trends in markets and how the trend reversed?

I am particularly keen on the government bond and equity trends as they both seem extreme and outside normal bounds. Does this pattern tend to be representative of the wisdom of crowds phenomena and predict a looming “event” that we all sort of know is coming, or is it more often than not reversed so a madness of crowds thing.  The point is that today is extreme and probably, there is no major point looking at more moderate past histories.

All that said and back to today’s real world, the Association of German Banks just said that Germany’s 10 largest lenders may need to raise about 105 billion euros (US$135 billion) in fresh capital because of new regulation.

They would be obliged to raise this amount of fresh capital to reach the estimated 10 percent Tier 1 capital ratio set to be proposed tomorrow by the Basel Committee on Banking Supervision. And yes, the just released numbers show that German July industrial orders fell 2.2 percent month on month, compared to forecasts of a 0.5 percent increase and a 3.2 percent gain in June.

Continuing in the eurozone, The Wall Street Journal reports that Europe's recent “stress tests” of the strength of major banks understated some lenders’ holdings of potentially risky government debt. It argues that some banks “didn’t provide as comprehensive a picture of the institutions’ holdings as European regulators claimed. Some banks excluded certain sovereign bonds from their tallies, and many reduced the sums to account for ‘short’ positions they were holding.”

The report quotes representatives of several banks as saying that they were simply following the guidance provided by the Committee of European Banking Supervisors …

So, around the end of July, when the EUR/USD was trading around $1.30, many investors asked themselves whether we were seeing the return of some of the forces that came to dominate the latter half of 2007 and the early months of 2008.

We all noted that despite the mounting problems within the U.S. housing market three years ago, the FOMC’s sharply easier monetary policy settings in the second half of 2007 fed directly into a  sharp rally in commodity prices, relative stability in the equity markets, declining long term yields and a fresh slide in the dollar.

However, I was unwilling to commit wholeheartedly to such a view because of quite how anemically gold had performed through June and early July. It seemed to me that if we were returning to an environment where investors were harboring concerns about inflation, which is just another word for currency debasement, then we would also expect to see gold putting in a strong performance as it did in the second half of 2007.
Now, since the end of July it seems that, maybe, the last piece of the puzzle has fallen into place given that gold has gained about 7.5 percent against the dollar over the subsequent weeks.

At the same time, a wide range of other commodity markets have continued to trend smartly higher, driven on either by Russia’s ban on grain exports through until the end of next year or by the prospect of an extended period of policy accommodation in the United States, which remains the implication of the Fed Funds futures strip, Japan and elsewhere.

Meanwhile, most major equity markets have achieved a degree of stability while the yield on many benchmark bonds have moved towards historic lows, although I suspect that this pattern could well reverse smartly in the weeks ahead.
Given all this, it seems, at least to me, reasonable to suppose that the focus of the markets is starting to move away from trying to decide which of the major nation blocks has the worst structural problems (You know “Is the dollar the best-looking horse in the glue factory?” argument) to instead trying to work out which central banks look, relatively of course, the most hawkish.

With the European Central Bank’s Jean-Claude Trichet stating last week that "risks to the outlook for price developments are slightly tilted to the upside," it could be argued that the ECB’s position stands in slight contrast to the clearly dovish stance of the Bank of Japan and the apparently split view of the Fed’s FOMC on their Aug. 10 meeting over the need for additional stimulus.

If this wearily familiar picture is an accurate one, then it does indicate several simple outcomes for the currency markets.

Over and above possible demand for the euro, which is highly dependent upon how seriously investor’s take Mr. Trichet’s comments, it also suggest continued demand for a range of commodity currencies and, arguably, emerging market currencies as well.

On the flip side it suggests weakness in currencies that could be used as funding vehicles. At its simplest, this clearly concerns the dollar and possibly even the British pound. However, it is also arguable that the Japanese yen should fall into this category.

Although this might seem a surprising call given China’s increased interest in Japanese government paper this year as means of widening its diversification program and, more generally, the Japanese yen’s increasing role as a “safe haven” along with the lack of any meaningful support for a multilateral intervention program, I believe there is some evidence to support this view.

Firstly, we took notice of the article published in the China Securities Journal last Friday, seemingly based upon conversations with a number of unnamed reserve managers, which noted: “It is unlikely that China will increase purchases of Japanese bonds in the coming months because the Japanese yen might weaken at any time.”

Secondly, with the Bank of Japan easing monetary conditions and the Ministry of Finance (MOF) making it very clear that it is uninterested in allowing its currency to strengthen, and I take the MOF warnings seriously, it could be argued that conditions are surprisingly similar to those prevailing at the beginning of 2002, right at the start of the “carry trade” that defined so much of the past decade.

Indeed, today, there are many other comparisons we could make. Although it is far too early to make the call definitively, I’m starting to wonder whether we are not that far off a significant turning point in the Japanese yen.

While it is certainly true that, when looking at N.Y. flows, we continue to see net outflows from the euro it is also true that we continue to register selling from the dollar at the same time with net holdings of the dollar are approaching levels last seen in July.

Similarly, while we continue to register net outflows from the Greek bond market that yields (10-year at 11.91 percent at the moment of this writing) again close to its pre-crisis levels that saw a high of 12.43 percent, albeit at a much reduced pace, as well as from the Italian and Portuguese markets along with further inflows into German paper, we must also recognize that the U.S. equity market remains firmly “out of favor” with international investors although we have seen some modest inflows of late. It seems that these flows illustrate only too clearly the quandary facing the currency markets at present.

On the one hand investors clearly remain concerned about the sovereign debt burden of a number of peripheral eurozone nations and, as a result, are still keen to reduce their exposure to the euro as a result.

On the other, they also have little faith in the outlook for the U.S. economy and are reducing their exposure steadily.

Perhaps this goes a long way for explaining why investors have it so difficult for choosing between the euro and the dollar.

Whatever, it’s time to watch out, once again.

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Most serious investors are worried about what's going on. Equities cheap relative to current earnings, bonds expensive relative to history, equities 'cheap' relative to bonds, China and emerging markets going great guns and powering world growth, consumption levels very...
Tuesday, 07 September 2010 10:22 AM
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