Long-term perspective on currencies and central bank policies

I was doing some house cleaning, tagging old entries and came across something I wrote in 2005 on central bank policies:

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

This referred to the US dollar but the underlying logic still applies to this week's scare regarding China turning seller of Euro assets.  China has deep pockets and very little interest in adding to currency instability.  The status quo (Yuan pegged at sub-market rates to stimulate Chinese exports) has done well by them and while it can't go on forever now would be a shockingly poor time for a drastic change.  Why would they do this in the midst of speculative fervor to short the Euro and a general panic regarding European assets?

My 2005 self went on to make the following predictions:

There will be some sort of market event with the most likely candidates being housing and interest rates.

This market event will ultimately require international cooperation (G7, G10). It may take a series of trials (maybe a series of crises) by various CBs and governments but eventually they will need to coordinate policy. The world will need to decide how to handle the issue of the weakening dollar as its main reserve currency.

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

Unemployment seems like the best indicator of how hard or soft the landing is in the real economy. Below the June '03 high of 6.3% seems like a good definition of a soft landing for the U.S.[The main question being discussed was whether the US was whether the Fed hiking cycle was leading up to a soft landing.]

The U.S. current account deficit will get worked off through the growth of emerging market consumption rather than U.S. economic contraction. These emerging economies are the logical target for the world's investment dollars so once the market regains control of capital distribution they should see some benefits.

While this was a useful high level map, in the end it mostly helped me to avoid risks.  The policy coordination I expected has yet to materialise and instead it is a dog eat dog world of competitive currency devaluations.  This makes a fertile (read volatility swings) ground for trading, especially in currencies.  I expect this will continue until central bank coordination occurs enabling debt-heavy importing countries to start paying off their creditors.

Dollar Remains Unimpressed by U.S. Payroll report

From Briefing.com:

09:25 ET 10-Yr: -01+/32..4.487%.. GNMAs: +01/32.. USD/JPY: 115.0500.. EUR/USD: 1.3339

The Rally That Wasn't: The buck was given a strong boost over & through recent resistance zones on the majors following the data but that boost fizzled quickly. The brief rally was aggresively sold into sending the dollar well lower. The euro went from 1.3276 to 1.3237 to 1.3344 in the span of about 20 minutes. The dollar index, for all its 47 point range post-data is now sitting around where it closed yesterday at 82.72 (-0.04). Negative sentiment on the dollar was clearly unaffected by the jobs report.

Nothing about that report looked bad for the dollar as the initial bond reaction showed. Not sure how else to interpret the action other than sellers using the liquidity around the news to get out of more dollars.

In other dollar watching news Brad Setser points out ICBC's interest to repatriate $16 bn generated by its IPO. Guess the PBoC will just step up and buy them but I wonder if their will be some political chatter about the request.

Update 3:50 PM:

From the FT:

“The market was looking for the next trigger to sell the dollar, rather than buy it,” said Tania Kotsos, strategist at RBC Capital Markets.

Currency Story Continued

From Reuters:

MORE TO COME?
The Singapore dollar, widely used with the yen to bet on a yuan move, shot higher to a two-month high of 1.6503 per U.S. dollar, up 2 percent on the day compared with 1.6843 on Wednesday, before dealers reported the intervention.
Singapore said it will maintain its policy of gradual and modest strengthening of the Singapre dollar and said fundamentals of the city-state's economy had not changed.
Hong Kong said it would not consider changing its currency peg to the dollar even if the yuan keep appreciating and said the Hong Kong dollar will remain very stable.
The Indian rupee rose to a six-year peak against the dollar around 43.20, up more than half a percent.
"The move is clearly positive for Asian currencies first, and to some extent the euro. It is pretty clear that the basket will involve a reasonable chunk of Asian currencies," said Emanuele Ravano, European strategist at PIMCO in London.
The Korean won's non-deliverable forward prices, used by offshore investors to trade the won, showed investors are factoring in a 2.2 percent rise in the won/dollar rate in one-month's time.
...

Following the yen's rise of more than two percent, Japan's top financial diplomat Hiroshi Watanabe said he is watching the market carefully and would take action if needed.
Japan has been urging China to reform the rigid FX regime but it had repeatedly said the yuan revaluation doesn't mean a higher yen and it has hinted it would intervene if necessar

Update 2:51 PM: This quote from Nouriel Roubini sums up what I am watching for:

And this could really be the beginning of the end of the Bretton Woods 2 regime of fixed pegs to the U.S. dollar in Asia. Malaysia already decided today to drop its peg relative to the U.S. dollar. This China move may also force Hong Kong to phase out its long term currency board and U.S. dollar peg. And other Asian currencies will soon sharply appreciate, following the yen's lead today. Even currencies at the periphery of this Bretton Woods regime (such as those in Latin America) may sharply appreciate. The systemic consequences of this currency realignment throughout Asia and the world could be radical and have significant impacts on U.S. long-term interest rates, on U.S. financial markets and on the U.S housing bubble.

Yen Strength

From Bloomberg:

The yen rose the most in seven weeks against the dollar and appreciated against all major currencies on speculation China is closer to a decision to allow its currency to trade more freely.
The rise in the yen followed an announcement that U.S. Treasury Secretary John Snow and Federal Reserve Chairman Alan Greenspan will testify to Congress on June 23 about U.S.-Chinese economic relations. Both men have called for China to let the yuan float, freeing it to appreciate against the dollar. A stronger yuan boosts the yen by improving Japan's export competitiveness against China.
``The revaluation news spread like wildfire,'' said Enrico Caruso, chief trader at currency hedge fund Tempest Asset Management in Newport, California. ``That's the biggest driver of the dollar-yen right now.''
...
The latest round of speculation that the yuan would be revalued was tied to the announcement earlier today that Chinese President Hu Jintao will attend the Group of Eight industrialized countries' annual summit in the U.K. on July 7, according to Patrick Brodie, chief currency dealer in New York at Sumitomo Mitsui Banking Corp.

I am pretty sure this is a case of trying to fit the news to the market. Not that I disagree with the move but I don't think the G8 attendence in itself means anything. I mentioned last week that sentiment had swung about as far as I thought possible from the "its coming tonight" view of two months back.

Summing Up the Week

We end the week weighing the auto downgrades and steepening yield curve (new 30-yr) against an unexpectedly positive jobs report and Kerkorian's bold bottom fishing maneuver in General Motors (GM).

On the auto downgrades it seems very likely that the bond market had already anticipated the downgrade. Its arrival shifts the focus off of the auto bonds and towards the wider bond market. I would not be surprised if GM and F bonds bottom here or shortly while junk spreads continue to widen. A best case would be junk widening while investment grade tightens but I would guess such a trend would be short lived. I am not really sure where Kerkorian's bid fits into this picture other than to muddy the waters. It is not clear what his motivations are and I am not sure that GM's equity is the best risk / reward trade in here.

I said any investment grade tightening might be short lived because the jobs report and new 30-yr created a lot of uncertainty in the long end of the yield curve. On Tuesday I thought the market would start to anticipate an end to the hiking cycle but this jobs report brings us back to considering 50 bp hikes. Easy to see why it was important for the Fed to reinsert a benign long-term inflation outlook. Anyway, the jobs report is just one data point and it needs confirmation in the rest of the data this month as well as next month's report. People were all about the "soft patch" at the beginning of the week so this report should cause a serious reexamination.

At some point between now and August the market will probably have serious doubts as to whether the 30-yr actually comes back. There are also supply constraints until the new bond is a sure thing so if the shorts get too heavy while it is only an idea that could set up quite a squeeze. A decision in August seems to put the new 30's issuance in Nov or Feb.

All this U.S. news has managed to crowd the yuan revaluation out of the news. Asian currencies are still trading strong though. Even though China does not want to reward speculators, the pressure internally are only going to get worse until they revalue. I thought they were coming to grips with that but maybe it takes another couple of months. They would need some help from Japan or Korea to scare the speculators at this point and I don't see much of a cause for that. The dollar also rallied nicely on the back of the jobs data but the theme to me is still European weakness. Gold and silver are focused on USD/EUR rather than JPY/USD. I am not sure why that is.

My Two Cents on the Currency Debate

This week's econoblog has breathed some new life into the currency debate. David Altig and Kash are exploring what actually constitutes a hard landing, while Brad Setser takes issue with Andrew Samwick's reliance on the calming effect of central bank actions.

As I said on Monday, I am not so sure that any hard landing scenario will necessarily be kicked off by dollar selling. Based on Kash's sevenfold path through a hard landing, maybe we are already at step 4. If we do see market weakness in stocks, real estate, or credit spreads (i'm adding that one), it should shake up monetary and fiscal policies. Once that happens we get to watch the policy decisions to see if market weakness will translate into real economic weakness.

I have some general beliefs about what might happen but guessing my way through the possible scenarios is a bit beyond me.

• There will be some sort of market event with the most likely candidates being housing and interest rates.
  
  
• This market event will ultimately require international cooperation (G7, G10). It may take a series of trials (maybe a series of crises) by various CBs and governments but eventually they will need to coordinate policy. The world will need to decide how to handle the issue of the weakening dollar as its main reserve currency.
  
  
• On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.
  
  
• Unemployment seems like the best indicator of how hard or soft the landing is in the real economy. Below the June '03 high of 6.3% seems like a good definition of a soft landing for the U.S.
  
  
• The U.S. current account deficit will get worked off through the growth of emerging market consumption rather than U.S. economic contraction. These emerging economies are the logical target for the world's investment dollars so once the market regains control of capital distribution they should see some benefits.
  

Signs of a Hard Landing?

I just finished reading econoblog at the WSJ featuring Nouriel Roubini and David Altig. It was a thorough debate on the USD / foreign borrowing dilemma but it did not really cover much new ground. Probably just seemed that way to me because they have both been talking about the topic for quite a while on their respective blogs.

Their discussion was whittled down at the end to whether a fall in the dollar due to a lack of foreign central bank demand would necessarily lead to a hard landing. I was left with a feeling of irony because right here the world seems to be tilting towards a hard landing (or at least the sudden fear of a hard landing) but it is not because of the dollar. Instead it stems from new found inflation fears, higher interest rates, and some credit issues at GM (maybe AIG, FNM, C...). If these trends continue the next big risk I see in the pipeline is clearly the housing market. The housing market has gained increased importance in this economic cycle because of the impact of refinancings on consumption. Interest rates may become range bound for a little while but even so it seems like the demand for housing is going to pull back and perhaps be overwhelmed by supply. Charts of the housing stocks show a lot of room before next support.

For the stock market, I tend to agree with Barry Ritholtz that we are seeing the sort of deterioration in internals associated with at least medium-term weakness. Check out the McClellan summation and notice how much weaker it appears than the market. I also like to watch the percentage of NYSE stocks above their 200 DMA which is currently hitting levels not seen since last May (59%). I am still long some post FOMC purchases but am shortening my original horizon of 2-3 weeks to be flat by the end of this week. A pullback tomorrow does seem likely but if stocks can stay above Thursday's lows maybe we can get a better rally into the end of the week. The rally may go longer but I want to position myself to be net short and not be trapped long if the rally fails abruptly.

Circling back to currencies the dollar is going to challenge its downtrend line very shortly with its 200 day MA sitting just above that. It might try to shake things up by getting through those levels for a short time (and maybe DXY 85.45 as well) but within the next 3 weeks I imagine it will again be headed lower. Commodities are taking a well deserved rest / pullback while some related commodity stocks look pretty ugly for the short term. Maybe a buying opportunity but like the dollar I would act over weeks rather than days.

Japan has Diversification Plans Too

Bloomberg:

The dollar fell to a nine-week low against the euro after Japanese Prime Minister Junichiro Koizumi said today his country ``in general'' needs to consider diversifying its foreign currency reserves, the world's largest.
Koizumi said in response to a question at parliament ``it's necessary to diversify the investment destinations'' of reserves while ``considering what's profitable and what's stable.'' The dollar pared losses after a finance ministry official said Japan has no plan to shift its $820.5 billion of reserves, comments later echoed by Finance Minister Sadakazu Tanigaki.
``The market will believe Koizumi,'' said Steve Barrow, a currency strategist in London at Bear Stearns Cos. ``This is an issue that's not going to go away'' in the foreign-exchange market. ``That's going to undermine the dollar.''

Yen is still 104.2 but that statement is big news. The Euro hit 134.56 after the news.

The FT adds this:

Elsewhere is Asia, the South Korean won jumped Won13 against the dollar to a seven-year high of Won989.2 as Korea's consumer expectations index surged to its highest level since September 2002. This prompted Seoul to spend an estimated $2bn on intervening to buy dollar and send the won spinning back to Won1,000.2.
The New Zealand dollar rallied to a fresh 22-year high of $0.7449 against the greenback as the Reserve Bank hiked New Zealand interest rates by 25 basis points to 6.75 per cent, surprising the 50 per cent of the market that had been expecting rates to be held.

South Korea spooks the Currency Markets

A while back, I referred to South Korea as the weakest member of the dollar managing cartel in a comment on Brad Setser's site. If you are wondering why South Korea's hint at a policy change may be a big deal I highly recommend reading his entire post. He and Nouriel Roubini have written some great stuff describing the gamesmanship involved in trying to fix currency levels.

In a nutshell we have been watching for 6 months as smaller counties diversify away from the dollar while China and Japan try to maintain the status quo. As of Q4 S. Korea was also trying to keep its currency static to the dollar. If the comments today are not retracted and are followed by action then S. Korea becomes the biggest small country to abandon the dollar. That could conceivably speed up the selling or increase the share of the U.S. borrowing needs that must be funded by Japan and China.

It is best to think about what is going on in terms of game theory with China and Japan sitting in separate rooms and deciding if they can still support the dollar while doing so means increasing the risk of loss.

What the Job report means

Here is a solid summary of November's unemployment report and this article summarizes the implications for the bond market.

I am still pretty sure the bond market has been getting hurt because investors are beginning to look at real returns rather than nominal returns. With the dollar making new lows on the jobs report I think that the trend towards higher yields will reassert itself shortly. The Fed may begin facing political pressures to stop hiking but they need to keep ahead of the currency market which means hiking until positive U.S. economic data gets reflected by dollar strength.

It was interesting that virtually everyone in the market seemed to be expecting a strong jobs report and my best guess for the reason is simply rationalizing the stock market's advance. As I said in my morning post yesterday, the stock market wanted to go up and whatever the numbers were it was going to do so. That sort of rationalization is a sign of euphoria. It is throwing your hands in the air, saying you don't understand the market's strength, and trusting other participants to be better informed about the future of the economy. That mindset will work just as well to justify lower prices.

Fed Impact

I read the FOMC statement as saying we will get another 25 bp hike in December which is what the market has been anticipating since last Friday. This should be bullish for the dollar simply because its carry against other currencies has improved on margin since last week Thursday.

I would call it bullish for the long end of the treasury curve too as the Fed seems to be taking proper precautions against inflation.

All in all the report was what the market was expecting so the net effect should simply lend more confidence to the markets.

Wrong and Wronger

The dollar continues down the rabbit hole. My confidence in a long-side trade is ebbing. I will give it one more day and then lean towards shorting the next bounce, perhaps around the former 85 support. There was some strong economic data out of Britain that caused some of the weakness but it is hard to not see it as associated with the election.

I expect equities to linger around the same levels today, maybe trading slightly up. I continue looking through volume scans to find stocks that have momentum and will try to add positions slowly. The last few days have been quite strong and I don't think very many people participated in the rally. The indices probably need a pullback and you are seeing a bit of that with the selling in the nets and semis but it remains to be seen if the market at large comes back. Remember two Mondays (a week and a half) ago when the insurance scandal was going to collapse the market? There will probably be more obvious buying opportunities ahead.

Launchpad

The dollar is seeing some good strength today and I like that pattern much better for a post election rally. It had a small bounce off the 85 level Tuesday, pulled back and retested it, and is now sitting on a launchpad if there is a quick resolution.

I would add to that foreigners may be less familiar with Bush and Kerry and may avoid election uncertainty as a matter of course. That might lead to a more tradable reaction in the currency.

Follow the bouncing ball

As the USD bounces this morning, I am thinking a bit about just how crowded that short is. I am not sure I have ever seen a trade in 10 years that is so widely believed in. Even I believe in it. Because it is crowded though I will watch carefully as the DXY (Dollar Index) approaches that 87 level. I will also consider other shorts against Asia (like GBP/JPY) before getting into dollar positions.

Also, the Reserve Bank of Australia, ECB, and Bank of England all have meetings this week. The election is distracting a lot of people but these meetings are significant because both Australia and Britain nearing the end of their rate hikes. At the turning points the markets will focus on nuances to see what to expect next. And of course the FOMC meets next week for what should be its last rate hike for a while.

Mostly I am looking through the election because it is ungamable. The candidates will only make subtle differences to the markets and even a tied election will eventually get resolved. Life will go on pretty much the same as it is today.

Weekly Game plan

This week I expect some generic weakness on Monday and Tuesday and a bounce when the election reaches resolution. The DXY (Dollar Index) is near multiyear lows which should hold the first test and bounce 2 points from 85 to 87. This rally, if it materializes, will bring with it some metal weakness. I believe that oil has topped so next week we will see general commodity weakness. I would stay away from oil for a few months but there could be some good purchases in the metals.

For the stock market it feels like the semiconductors and NASDAQ are a bit overheated and may underperform. The cyclicals maybe a good place to look for the outperformance. Near the end the week it could be a good time to start putting out shorts in the financials. I think it makes sense to leg into a long term trade buying semis and cyclicals on weakness against finance sector shorts. FNM (Fannie Mae) in particular should begin a multimonth downtrend as it adjusts its business to new capital requirements and new legislation circulates in congress.

I see interest rates as a bit low in here but it I am not sure they are topping out yet. The commodity weakness could be perceived as a sign of the economy slowing or falling oil prices could be interpreted as stimulus.

Vols will probably take a sharp dip on Tuesday as the fears of terrorism pass.

Synchronicity

I can almost here frat boys chanting "Frank the tank! Frank the tank" as I watch HAL (Haliburton) trade today. Clearly, my morning thoughts were a bit out of synch with the market.

The oddest thing here is that while the dollar has been willing to give up its gains from Tuesday, stocks have been well bid. Not sure I get it with the overhead resistance, sharp nature of the move, and of course looming election. Why buy vols but hold your stocks? Mine is not to question why I suppose.

I am still looking for a dollar rally and some metal weakness post election. Should stocks be down substantially on Monday I will make some selective purchases.

Dollar Index (DXY) in the Hotseat!!

DXY staying below the downtrend and breaking below nearterm support.