Phisix: A Tug of War Between the US Dollar and US Markets Determines Outcome

``And of course, one of the new rationales to justify the dollar trend of late is this canard: A tumbling dollar is “really very good” for the US economy. Yeah, sure it is! Can you imagine how much better off the average US citizen would be if the dollar fell to something like 40 on the US dollar index? Heck, in a world where Mr. US Consumer imports more goods than he ever did in the past, imagine if his global purchasing power was cut in half. That would be just dandy wouldn’t it! Where do they come up with this nonsense?” - Jack Crooks, Black Swan Capital

While Glorietta 2 will take our markets down for over the short-term, one potential variable with far greater risk influence is the recent turn of events in the US markets.

As the investing public widely knows, July’s market downturn had been an offshoot to the recent seizure in the global credit system that has led to a bout of liquidity driven selling prompted by the commonly touted “subprime” losses.

Following the coordinated efforts by global central banks to restore or normalize the liquidity flows in the global financial system, the markets have shown strong signs of recovery to the point that many global equity indices have succeeded to surpass previous highs. This astounding pace of rebound has somewhat restored confidence into the marketplace.

Yet, regardless of the stream of successes in the equities front, we pointed out how the global credit markets have failed to completely normalize which posed as the proverbial “Damocles sword” over the recent bacchanalia.

The justification from which has lent the global markets a considerable upside momentum had been

1.) the expectations that the vigorous global economy would continue to cushion the US economy from a hard landing as evidenced by the robust performances of industries with substantial exposure to the global economy, and

2.) the “don’t fight the FED” arguments or that investors would continually be shielded from steep losses by the “Bernanke PUT” or the tendency of the US Federal Reserve to keep injecting liquidity into the system to buoy the financial markets and keep the Main Street from falling into a recession.

Such positive spin has concomitantly been reflected in the performance of the US dollar index which has evinced of continued infirmities (drifting in uncharted lows) in the face of potential inflationary actions by the US FED.

US Dollar Woes: Exodus of Foreign Investors in August

Yet, the somber part shows that where US had been heavily dependent on foreign central banks as a backstop to bridge the capital flow gaps from its current account deficits, the recent turmoil has prompted these stopgap actors to visibly reduce their holdings on US dollar assets. The US requires around $70 billion dollars a month or about 25% to 30% of portfolio money to fund commercial papers market during the last two years.

According to the US Treasury International Capital flow for August the US recorded a negative $69.3 billion capital flow where both foreign public institutions and private investors shied away from supporting US denominated assets as shown in figure 2. Leading the pack of the exodus included major Asian trade partners as Japan and China.

Figure 2: Yardeni.com: Net Security Purchases By Foreigners Turns Negative!

This from the Ambrose Evans-Pritchard of the Telegraph (highlight mine), ``Asian investors dumped $52bn worth of US Treasury bonds alone, led by Japan ($23bn), China ($14.2bn) and Taiwan ($5bn). It is the first time since 1998 that foreigners have, on balance, sold Treasuries….

``Central banks in Singapore, Korea, Taiwan, and Vietnam have all begun to cut purchases of US bonds, or signalled an intent to do so. In effect, they are giving up trying to hold down their currencies because the policy is starting to set off inflation.”

So, from an orderly adjustment comes the heightening risk where the US dollar could unwind violently.

Black Monday’s 20^th Anniversary: A Sympathy Decline?

Friday, October 19^th was the 20^th anniversary of the fateful Black Monday Crash, the worst ever one-day decline experienced by the US markets which resonated around world, where the Dow Jones Industrials tumbled by 22.6% in 1987!

The anniversary appears to have undesirably been met with a “sympathy” decline in the US markets where the Dow Industrials fell steeply by 366.94 points or 2.64%, S & P 500 39.45 points or 2.56%, and the Nasdaq 74.15 points or 74.15%.

The aggregate losses over a weekly scale were remarkably broadbased which can be seen in Figure 3.

Figure 3: S & P: Week on Week performance by Sector

While figure 2 tells us that most of the damages were associated with the industries DIRECTLY linked to the US housing recession and sectors affected by slackening domestic consumption, which has been as expected, we are alarmed by the steep falls in the previously globally levered sectors as the information technology and the energy sectors and the consumer staples with overseas revenue exposures of 56%, 56% and 47% respectively (revenue weightings according to the Sam Stovall of the S & P).

Week on week the financials continue to bleed heavily down 7.62%, followed by consumer discretionary, Utilities, Materials and Industrials with losses of over 3%.

Could it be that foreign selling in the US securities has PRESENTLY spilled over to equities as part of the diversification out of US dollars?

Figure 4: Yardeni.com: Foreign buying of US Equities still positive but dropping steeply!

Foreign support for US equities has mostly emanated from Europe and the Rest of the World, where Asia had been a marginal net buyer since the start of the year.

However, the sharp drops in the degree of buying in August comes mainly from Europe and the ROW and has steeply dragged down the overall 12-month sum and the 3 month annual rate as shown in Figure 4 courtesy of Dr. Ed Yardeni’s Yardeni.com.

In others words, given that the US dollar trade weighted index is now trading at its ALL time lows as shown in figure 5, there is that big chance where the outflows which began in August could be a START of a new trend and not merely an aberration.

A Tug of War Between the US Dollar and US Markets

Figure 5: Netdania.com. US dollar index at All time Low

Where in contrast to the precipitate drop last July which had been spurred by liquidity woes as corollary to a sudden systemic credit drought, the recent losses suffered by the US markets had been imputed to corporation earnings deterioration apparently reflecting the worsening state of the US economy.

The distinction is that THEN Global central banks were quick to respond to the credit seizure with an admixture of policy adjustments to provide for band-aid treatments which apparently succeeded, as measured by the performance of the equity markets.

Today the problem seems different, while the credit woes implied monetary tightening; the aftereffect could now be seen in surfacing in corporate earnings as shown by the S & P chart in Figure 6.

Figure 6: Stockcharts.com: S&P, Phisix, Gold and US 10 year Treasuries

The sharp decline in S & P 500 has been accompanied by a considerable volume buildup as shown by the blue circle in the main window. This could suggest for further downside action.

Recently we have pointed out that the Philippine Phisix (above window) has been increasingly correlated with the movements of the US dollar index than to the US markets since the recovery run last August. However, it should be noted too that the former’s connection with the US markets remains significant as shown by the blue vertical lines where volatilities or inflection points have been almost in lockstep.

This has also been mostly true with gold…until February. But apparently, the latest activities in gold prices have considerably shown a MARKED DIVERGENCE; it was least affected during the July credit squeeze and has grown strongly despite the recent weakening in the US equity markets (green circle).

Nonetheless, the collapse of 10 year Treasury yields (red circle in the lowest pane) in the light of probable foreign selling depicts overarching concerns over the vitality of the US economy.

As we have repeatedly said, despite the record high oil and gold prices, Chairman Bernanke and the US Federal Reserve, who realizes of the sensitivity of its financial driven economy to the degree of leverage embedded within its system, aside from protecting the primary conduits of the Fiat Paper Currency standard, will risk to err on the side of inflation, where its monetary policies will adjust depending on the performance of its equity markets in lieu of the accelerating decline in the housing industry.

The US treasury’s plan to convene banks and financial institutions to create “a single master liquidity enhancement conduit, or M-LEC” is simply one of these measures to shelter banks from further losses.

To put bluntly, if the US equity markets continue to drop and hit our 10% strike price (Dow Industrials 12,780 or S&P 1,410), we should expect the FED to cut by another 50 basis points, where the sharper the drop, the bigger or the more frequent those cuts will be.

Otherwise if the US market recovers and continues its upside move then it could defer its action until the market reveals signs of distress.

With Friday’s move, we can expect the market to test the downside.

Across the Pacific, at the current clip we expect the Phisix and Asia to trail the US markets until those gamut of rate cuts would shear the “umbilical cord” that joins the US and the Asia.

In other words, volatilities prompted NOT by Glorietta 2 but by the actions in the US dollar and the US markets are likely to sway the Phisix over the interim.

But, we expect buoyant gold and oil prices to support or cushion emerging markets as well as the “strongest link” embodied in the Asian region.

In effect, we should expect to see the deepening of such divergences as the foreign central banks and private institutions reallocate more of their funds away from US dollar assets, where the incentives to own and support these appear to have greatly waned by:

1. Rising Asian and OPEC inflation rates which could lead to the depegging of currency links (Gulf countries) or should translate to further domestic currency appreciation requiring less to recycle surplus funds into US dollar denominated assets.

2. Losses could prompt Central Banks to cut positions as the declining US dollar reinforces the loss in the price values of their portfolios.

3. The prospects of an economic wide spillover from the accelerating deterioration in the US housing industry should translate to declining returns or yields.

4. A rapidly slowing US economic outlook would prompt for expectations on policy actions that would narrow the currency yield spreads and reduce the advantages of holding US dollar assets.

5. Through Sovereign Wealth Funds (SWF), global central banks have now been shifting to non-US dollar assets to increase returns via purchases in mostly global equities.

Even the IMF recently says that the US dollar remains overvalued.

The US dollar may bounce due to being technically oversold. But if the August trends reveals of a sustained outflow from its foreign principals then the US dollar will likely head lower and should mark an all important inflection point. And asset allocations would ultimately adjust to such developments.