Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?

``The more creative we get, the wider the diameter of our searchlight, the less likely we are to get blindsided. More things can happen than will. But more things will happen that we don’t expect. The best thing of all: tomorrow’s headlines will be full of interesting things that nobody could have ever predicted today would happen tomorrow.”-Josh Wolfe, Forbes Nanotech

Of course the debate about decoupling is mainly semantics.

Similar to the polemics of Market Failure premised on imperfect competition, some of such arguments are noticeably fallacies predicated on absolutes. Since a country has interactions with other nations (even communist countries) then linkages results to connections or correlations, which varies on the scale or degree of transactions involved. Since under such context, there is hardly anything as a perfect correlation, there would likewise be no perfect decoupling.

Since today’s globalization trends translate to increased collaboration through trade or financial channels, this should extrapolate to more linkages, thus heightened correlation. So, the argument of decoupling essentially boils down to its definition.

Decoupling defined in the economic context (wikepedia.org) ``refers to the lessening of correlation or dependency between variables.” (highlight mine)

In the financial markets, our observation is that decoupling is basically measured in the context of correlations of price trends among securities or markets.

A trend maybe said to be positively correlated when there is a (answers.com) ``Direct association between two variables. As one variable becomes large, the other also becomes large, and vice versa. Positive correlation is represented by Correlation Coefficients greater than 0”. (highlight mine) The movement of Asian markets relative to the US markets in 2000-2002 is an example of strong positive correlation.

A trend maybe said to be negatively correlated when there is an (answers.com) ``Inverse association between two variables. As one variable becomes large, the other becomes small. Negative correlation is represented by correlation coefficients less than 0.” (highlight mine)

My favorite example would be that of Zimbabwe, an African country that has been on sordid streak of economic, political and social despondency, as discussed in our April 9 to 13 edition, [see Zimbabwe: An Example of Global Inflationary Bias?]. The country’s inflation rate has incredibly soared to stratospheric levels at 14,841% (Bloomberg) in October albeit its stock markets continue to fly! Now relative to the correlation between economic health and stock performance then it can be said that Zimbabwe’s case signifies negative correlation or a decoupling.

Or let us take another example in Saudi Arabia’s major equity benchmark the Tadawul, shown in Figure 4, as a representative for Gulf Cooperation Council (GCC) whose other members include Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (UAE), where most of Gulf member bourses have been on an uptrend.

Figure 4: Bloomberg: Saudi’s Tadawul: Recovery Amidst Global Decline, Will it last?

We dealt with the potential “bottoming” of Saudi’s benchmark last May 28 to June 1, [see Could China’s Bubble Last Longer than Expected?], today the GCC bourses appears to have “defied gravity” or “decoupled” or has been “less correlated” relative to the ongoing global infirmities among its counterparts.

Our suspicion is that speculations on the fate of the GCC’s extant dollar peg (except Kuwait) which has resulted to greatly enhanced inflation pressures have been the primary driver of this seeming recovery. You see, the feasibility of the US dollar peg is now being questioned as the US dollar continues to fumble.

Investors appear to bet on the unplugging of the US dollar peg soon, where GCC member countries would be compelled to revalue their currencies to the upside. Hence, the expected strengthening of the region’s currency has provided incentives for investor to bid up on GCC equity assets. Again, expectations on monetary policy adjustments almost similar to the thesis underpinning China have become crucial drivers to global capital flows.

This excerpt from the Economist magazine’s recent article “Time to Break Free” (highlight mine) underscores our analysis,

``Nowhere are the dilemmas more acute than in the Gulf, where virtually all the oil-rich states peg their currencies to the greenback. The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation. When the Gulf states meet on December 3rd in Qatar, they should agree to loosen their ties to the dollar.

``The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff.

``Soaring oil prices have brought the Gulf Arabs huge riches. Their real exchange rates, as a result, ought to rise. The simplest way to do that is for the currency to strengthen, but the peg prevents nominal appreciation. Worse, the dollar itself has been falling. The result is rising domestic inflation. Some smaller Gulf economies now have inflation rates of around 10%...

``A big uncertainty is what such a shift would mean for the dollar. In the short term, the effect on the Gulf states' appetite for greenbacks would not be dramatic, since the dollar would have a big weight in any basket. And there should not be a sudden sale of the oil exporters' dollar reserves. The worry is that the end of the Gulf states' dollar peg would send jittery investors into a panic. That risk is real. But with oil prices rising and the dollar falling, the dangers of inaction are greater. The Gulf states need to get rid of their dollar peg now.”

So while decoupling critics rightly argue that financial market activities could reflect on the technical economic, financial and trade interactivities that may result to higher correlation, one very important undefined outcome is how financial markets would react to forward monetary policies in response to today’s tensions which could affect the mobilization of money flows. As a Wall Street axiom goes, money flows where it is best treated.

Or will today’s financial market’s turmoil lead to a meltdown of the financial system as some would suggest, and thus pave way for a global deflationary depression scenario?

We doubt so, since the degree of exposure to the present systemic leverage cannot be applied similarly to all regions/countries ergo the relative effects will be different.

As an example the Philippines with its primordial markets have an infinitesimal degree of derivatives exposure compared to the US, so how can the effects be the same? While a recession in the US may affect trade, remittances or capital accounts and result to an economic growth slowdown, deflation is unlikely to happen since there has not been much debt built into system following the Asian Crisis. Moreover, our government is likely to undertake more inflationary policies on the account of “voter” demands.

Our favorite guru Dr. Marc Faber thinks such “deflation” scenario as unlikely. Dr. Faber writes (emphasis ours),

``With the propensity of the Fed and the ECB to flood the system with liquidity and to take “extraordinary measures” whenever problems arise, deflation is a remote possibility for the foreseeable future.

``So, before worrying about deflation, I would worry about inflation accelerating strongly in the years to come — especially if the US economy stagnates. But let us assume that at some point in the future deflation follows. What then? In my opinion, deflation could only be triggered by one event: a total collapse of the existing global credit bubble. And the only event I can think of that would trigger such a debt collapse would be a third world war. The failure of a large bank — say, Citigroup — wouldn’t do the trick, because the Fed would immediately bail it out (unless Ron Paul is US President).

``Now, in a debt collapse, where would you rather have your money? In bank deposits, in CDs, in dubious commercial paper, in bonds, in money market funds — all of which would experience soaring default rates — or in physical gold, ideally in a safe deposit box? I think that, particularly in a debt collapse, physical gold would shine, as people the world over would become extremely concerned about, not the return on their money (interest), but the return of their money. This would be particularly true of Asian central banks, which now have less than 2% of their reserves in gold but hold massive quantities of all kinds of debt securities.”

Now could the prospective easing policies initiated by global central banks alleviate the pains of today’s gridlock in the financial system or preclude a crisis?

It depends, as Austrian Economist Frank Shostak explains, ``As long as the percentage of wealth generators as a percentage of all acting individuals is still large enough Fed policy makers can get away with the policy of “rescuing financial markets”. However if this percentage falls to below 50 per cent then there is not going to be a sufficient amount of real savings to carry all the activities in the economy, a deep economic crisis emerges.”

As you can see conventional impressions or deductions can also be misplaced.

Figure 5: Rude Awakening: Emerging Markets Priced Safer than US Financials

Another example--Who, in the past, would ever discern that the biggest US financial companies would be perceived as “riskier” than emerging market bonds?

The cost of insuring US financial companies as exemplified by Merrill Lynch has become unbelievably higher today than Brazil’s sovereign bonds as shown in Figure 5. The chart likewise shows that the cost of Brazil bonds has painstakingly been on a downward trend overtime, which suggests of signs of strength rather than luck.

Eric Fry of Rude Awakening writes (emphasis ours), ``Buying five years of protection against a Brazilian default used to cost much more than buying five years of protection against a Merrill Lynch default.

``But now that Brazil has become as crisis-free as the U.S. financial sector has become crisis-prone, CDS prices have flip-flopped. Merrill CDS prices have jumped above those for Brazilian government debt! In other words, CDS buyers consider a Merrill Lynch default more likely that a Brazilian default.

``Maybe CDS investors have got it all wrong...or maybe the U.S. finance sector is in much deeper doo-doo than most investors believe. The "doo-doo" interpretation seems more plausible.

``CDS pricing is not necessarily indicative of future trends, but neither is it NOT indicative...Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance...”

While past performances or activities may have relative predictive value to future outcomes, they may not be so linearly correlated.

Plainly said, past performance may indicate future trends, but then again they may not. So under such premise, if today’s “safer” emerging market bonds become a definitive future trend, then these could be reckoned as signs of “decoupling” from past patterns, where investors would opt for emerging market assets than for US “riskier” dollar denominated assets. Otherwise, present trends could merely be indicative of an aberration, meaning a temporary phenomenon.