Sunday, August 10, 2008

Global Economic Slowdown And Central Bank Interventions PUMP UP The US Dollar!

``Economists, when faced with a conflict between theory and evidence, discard the theory. Stockbrokers discard the evidence.”-Andrew Smithers and Stephen Wright, authors of "Valuing Wall Street"

In one of our back issues (see Global Markets: The End Of The World? Or Overestimating Global Consequences?) we discussed how falling oil and commodity prices reflect the weakening of global economic growth as well as how contracting US current account deficits imply the tightening of liquidity in the global financial marketplace which tends to bolster the US dollar and elevate general risk levels.

Moreover, we also discussed of the rotating absorption points of the global inflationary background (see Relative Economic Growth, Lack of Access to Capital and Global Depression) where we said,

``But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

``Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

``Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.”

Well the subject of our analysis has been revealed in the markets see figure 1…

Figure 1: US Dollar Soars!

The US dollar index skyrocketed last week to record one of the biggest gains in years over the currencies of its major trade partners!

As a reminder we are dealing here with the US dollar index (+3.3%) in relative terms of the Euro (-3.43%), Japanese Yen (-2.26%), Canadian Loonie (-3.65%), the British Pound (-2.74%), Swedish Krona (-2.69%) and the Swiss Franc (-2.91%), and NOT of the Philippine Peso. Note that a weekly 2-3% move in the currency markets, especially applied to a broad universe of relative currencies are rare or signifying “fat tail” high sigma events, and can be particularly devastating, since future currency markets are largely based leveraged contracts.

But overall, the gain of the US dollar had been broad based and equally reflected in Asia but at a much subdued clip. It has even reversed the huge advances made by the Philippine Peso earlier in the week which ended the week at a loss (down .26%).

This fantastic run by the US dollar also seem to coincide with the outbreak of war in Georgia.

Some claim that this is about the turning point in the interest rate cycle. This means that the deteriorating economic conditions apparently ricocheting across the globe will compel global central banks to cut rates thereby reducing the yield premium seen in many of the world currencies relative to the US dollar.

Doomsters, on the other hand, interpret this as signifying the world segueing into a “deep” recession, where emerging markets will likely account for the proverbial “last shoe to drop”.

However, James Turk of says this is all about central banks in a coordinated effort to prop the flagging US dollar, ``So central banks were accumulating dollars over the past three weeks at a rate far above what one would expect as a result of the US trade deficit. The logical conclusion is that they were intervening in currency markets. They were buying dollars for the purpose of propping it up, to keep the dollar from falling off the edge of the cliff.”

Meanwhile, Brad Setser of the Council of Foreign Relations calls it the “quiet bailout” which can be deduced from the strong surge in the Fed’s custodial holdings (New York Fed holds in behalf of foreign banks). Writes Mr. Setser (highlight mine),

``Right now there are only three countries adding to their reserves at a rate than could explain this kind of growth: China, Russia and Saudi Arabia. Of course, a large country that isn’t adding to its reserves is shifting funds over to the New York Fed — but the rapid increase in the Fed’s custodial holdings suggest at least one of the countries now adding to the foreign assets at a rapid clip is making heavy use of the New York Fed’s custodial accounts.”

``And it is striking that all the increase went into Treasuries.”

So in a sense, yes we agree that decelerating fundamental conditions spreading over to the world have had a considerable contribution to the recent outstanding performance of the US dollar, although what could be seen as different is in the interpretation of “doom” relative to the perspective of a “bailout”. The former means a destined condemnation, while latter means somebody is being saved or rescued by someone which in effect doesn’t translate to a disaster for both parties.

Nonetheless, the remarkable ascent of the US dollar (candlestick chart in the main window) came at the expense of oil (pane below main window) and commodity (CRB index-lowest pane) prices but in the face of a vertiginous rollercoaster ride in the US equity markets (represented by the S&P 500-line chart) which appears to have broken out of the consolidation phase and had practically outperformed most of the MAJOR global benchmarks.

One notable feature in the chart is that the inflection points of Oil, the US dollar index and the S&P appears to be in simultaneous fashion, but in inversely correlated. The US dollar-Oil correlation seems more accentuated.

Of course, there is a great distinction between a market operating under “bailout” conditions and that which is ascertained by unalloyed market forces. A market distorted by government interventions basically reflects artificial price signals whose eventual outcome (success or failure) would be revealed once the applied stimulus fades.

So yes, given the technical picture and the yield arbitrage, the US dollar may likely see a sustained rally over the interim against its major trading partners but this should signify a cyclical rebound (similar to 2005) within a secular bear market instead of a major reversal.

However, we don’t see how the same principle should apply to the Philippine Peso which should recover from the bogeys of falling food and fuel prices as discussed in Tale of The Tape: The Philippine Peso Versus The US Dollar and Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso.

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