So Much For Black Monday
Friday was perhaps the single most dangerous day for the markets since the ides of August. The Dow had dropped 366 points. All of the warning signs – credit default swap spreads, the structured finance indices, the VIX (implied volatility), and JPY-USD – all collectively indicated a Defcon-5 Monday, especially when the yen strengthened dramatically on Sunday night to 113.26 per USD.
On Sunday night, all Asian markets – even the previously blind Chinese markets – dropped more than two percent. The dollar strengthened significantly against both the euro and the GBP, to 1.415 and 2.025, respectively – and it appeared that the global currency rebalancing was finally nigh. And gold hemorrhaged about three percent.
US markets opened with a haphazard downward skid. Volatility broke through 24, and it seemed that my prophesied Second Round of volatility was imminent. Then Fed governor Randall Kroszner pronounced that the Fed would “not let [the credit crisis] damage the economy.” The Dow gained 150 points in the next hour: the party assuredly would go on. The dollar retreated again, and spot gold came back (to 756 currently).
The Politics of the Euro (and the dollar... and the sterling)
The G7 currency meeting late last week was not particularly relevant in and of itself. However, G7 statements are an effective barometer by which the currency speculator can measure the sentiments of all the major state actors, and how they plan to alter the short-run value of their respective currencies.
The markets had widely expected some kind of rebuke to the United States for allowing the dollar to slide at the fastest pace in living memory. However, there was none. There was only an empty whine at the Chinese to allow for 'accelerated appreciation' of the yuan.
Concurrently, Fed governor Fred Mishkin argued, in the face of widespread snickering, that “CPI excluding energy and food is the best measure of inflation.” In light of the European Central Bank's decision to raise interest rates to head off inflation, the Fed's myopia is more self-evident than usual. It is true that energy costs are significantly more damaging to EU economies because much higher energy taxes tend to transmit a higher price of oil much more quickly throughout the EU production chain, but because the euro has appreciated so much relative to the dollar (oil is denominated in dollars), oil has not risen nearly as quickly in EU terms as it has in USD terms. This means that higher-end, petro-intensive exports (Germany) are not being hurt by euro appreciation – and German consumers can enjoy a massive surge in purchasing power in the meantime. French and Italian exporters, on the other hand, are suffering disproportionately from a higher euro, as is their tourism industry. But for now, Germany wants the euro to keep appreciating, European central bankers want currency market share from a depreciating dollar, and the United States wants a depreciating dollar so that its banks can inflate their bad debts away. The G7 statement reflected that.
The UK was missing in action from all this. As forex traders are well aware, the sterling has had an incredible bull run. However, confidence in British banks has nosedived. Gordon Brown was initially planning on a snap election, so he strong-armed Mervyn King into an idiotic bailout of the imploding Northern Rock. The Bank of England has lent a stunning $33 billion to Northern Rock when nobody else would, and it will be on the hook for more in the coming months.
Meanwhile, UK flagships Barclays and Royal Bank of Scotland, characterized over the past several years by sloppy management, hubristic LBOs and reckless spending, established $30 billion worth of credit conduits with the US Federal Reserve, presumably because the Bank of England overextended itself bailing out an institution that was not too big to fail (Northern Rock). This is all the more galling considering that barely a month ago, RBS completed a ludicrous $100 billion buyout of ABN Amro, a 46 percent premium over ABN Amro's share price.
To paraphrase the Ghetto Boys: “Damn it feels good to be a banker.”
Meanwhile, after his needless bailout of NR, Gordon Brown took fright from a new batch of UK polls and called off the election. So now there has been a completely needless bailout, and it didn't even buy Brown the election. Very sad (if you're a UK taxpayer). The UK is also suffering from one of the worst real-estate bubbles of any Western economy (even worse than the one on this side of the pond). Combined with a state apparatus larger and more bloated than “Sick Man of Europe” Germany, the UK economy is not going to see any substantial new investment flows for some time. Short the GBP if you haven't already.
The markets have also been watching for reactions to Hank Paulson's super-SIV “Master Liquidity Enhancement Conduit” detailed last week, and had taken the Fed's overt reticence as a vote of no confidence – implying that the Fed's patience was running out, and that the Fed might be getting tired of pumping “temporary” liquidity to keep Citigroup's shambolic balance sheet from taking all its “SIV-positive” debt onto its balance sheet (which would probably tip Citigroup into technical insolvency).
However, there might be something to the Fed Reticence Hypothesis. An “anonymous Fed official” - alarm bells should be going off in your head – voiced support for the MLEC, and stated that Fed silence should not be taken for the lack of support it apparently was. Of course, if a Fed official is too scared to go on the record supporting MLEC, that speaks for itself.
Nonetheless, the Fed is clearly internally divided about this – I would guess that an insufficient majority does not favor MLEC – but all political actors favor devaluation. As far as Joe Speculator is concerned, the watchphrase remains, “Damn the dollar, full devaluation ahead!” However, its time could well be running out. Pronouncements from “anonymous Fed official[s]” are unheard of, and anonymous leaks are the hallmark of a minority within a bureaucracy. If anything, this piece of information should confirm perceived Fed pessimism regarding the MLEC.
So where does this leave the speculator?
That, my friends, is a good question.
The Bottom Line
Times are very uncertain, the fall in volatility notwithstanding. The Fed has been largely a bystander in the current mess, indicating internal division over the course of the dollar. If they resolve their divisions, it would presumably be in favor of the dollar's value, at the expense of current liquidity, the financial sector, structured finance, et cetera.
However, even if they did, the banks will still get their way, because every other political institution has the same short-term focus that they do – especially with an election year coming up. The dollar will continue to fall, the euro to rise.
Re-establish long positions in euros. Maintain your long position in gold.
Short the USD, GBP, and CAD.
I hope you enjoyed our latest newsletter. Please e-mail me at <alex.forshaw@gmail.com> if you have any questions, comments, or insights.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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