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Thursday December 18, 2008 - 20:36:54 GMT
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Forex Blog - Market Failures Yield Distorted Price Signals

Market Failures Yield Distorted Price Signals


It has been nothing short of amusing (read frustrating) to hear the rubbish being peddled over why this currency did this or that asset did that.  And perhaps no more aggravating than in the blovosphere of currency trading in the last week in the face of the unprecedented decline in the USD (manifested mainly versus the euro).


I have no doubt that the Fed taking rates to zero (effectively) and explicitly outlining quantitative easing in the FOMC statement was a shock for markets and is behind dollar weakness and bond strength.  But I find it hard to swallow when we are told the dollar is weakening because the Fed is printing money and when central banks print money they devalue their currency and drive investors out of their government’s debt securities.  All this is true, but to think it happens the day of the start of monetization or the running of the printing presses is simply wildly off mark.  If the weak dollar was representative of capital flight (US economy depends on foreign capital to finance domestic spending and investment) we would see bonds weaken simultaneously.  The 30-yr bond is yielding a record low, the 10-yr note is yielding the lowest rate in nearly 55 years and the dollar is not weakening uniformly – yes it is down vs GBP, CAD, AUD, NZD and JPY, but not nearly to the extent it is down vs the EUR. 


Markets have a reason to respond to a zero rate policy.  But the move does not automatically make the USD the new ZWD (Zimbabwe dollar).  Indeed a glance at Japan’s experience with ZIRP/QE shows the yen did not weaken until near the end of the policy mix…my only point is ZIRP/QE is not an immediate (necessary and sufficient) condition for a run on a currency.


Moreover, if official interest rate differentials are what matters now, then why aren’t the AUD and NZD outracing the EUR vs USD?  Aussie banks are not nearly as levered as European banks, China has a massive checking account to pay for growth (benefits Aus more than EZ) and the ECB has a far greater chance of reaching a zero interest rate before the RBA. 


So what is up (or down) with the dollar?  I frankly think it is more technical in nature – a very compressed (time) correction to a very overbought USD rally that was nearly as impressive to the upside as the last week has been to the downside. 


But I think there is some basis for skepticism over a major shift in the dollar narrative on ZIRP/QE by the Fed when BOE admittedly is at risk of doing the same, BOJ could get there (or very close) Friday, SNB is nearly there, BOC will get there by end Q1 and in due course the ECB will be there by next summer at the latest (sorry JC…your goose is cooked).  


My other observation (untested) is that when markets fail as efficient allocators of credit, capital and risk (pricing) as has happened with the abject failure of the banking system necessitating an ever larger role for government involvement in these functions, than prices determined in capital markets are ever more distorted.  There is reason to question an 18 cent move up in euro/dollar in under two weeks…markets are impaired and market signals are compromised. 


Make no mistake about the significance of the Fed’s all-in on Tuesday.  It was an acknowledgement that the banking system is so badly broken and so impaired as a credit creation machine that the Fed is circumventing the banks and using the securitization market to get credit in the hands of households and firms…and through the healthier regional banks.  But short of the Fed going into the major banks and directly allocating credit to borrowers, the hole left by the major national and multinational banks may be too big for the Fed to fill using likes of credit card firms, student loan firms, GSEs and healthy regional banks.  If banks are still in lock down by the middle of next year and efforts to circumvent the main banks fails to halt the slide in home prices, consumption and employment, then it is conceivable that equity stakes will rise and agents of the Fed and US Treasury will be running lending operations and risk taking at the banks.


So what should a rational investor or a speculator to do in an irrational world facing growing government attempts to impose rationalization?  Do as the Fed does before the Fed does.  Buy Treasuries ahead of the Fed.  Buy agency debt ahead of the Fed.  Buy bank debt with FDIC explicit guarantees (in a reach for yield).  Buy Gilts before BOE buys Gilts.  Buy short sterling before BOE cuts to zero.  Buy JGBs before the BOJ buys JGBs.  And a bit further down the road, buy munis before the Fed buys munis.  And buy mortgage backed securities before the US Treasury and Fed go off on massive spending and asset purchases to support the housing market in Q1.


I think before this is all over it might be possible to buy equities before central banks buy equities, but not yet and not unless the world is really close to ending…not my forecast or black swan finale. 


But being long euro/dlr on the idea that a run on a dollar is imminent in light of the Fed running a printing press, then you are at risk of taking junk in and junk out – distorted market signals from a failed capital market.  I like this trade when the Fed comes around to actually creating inflation not just underwriting asset prices and cauterizing real economy wounds.   


And looking for a massive USD decline versus the euro to continue indefinitely comes in a period when every country needs a weak currency, particularly export-driven economies like most of the currencies that are currently rallying versus the USD.  Long gold could be the antidote to competitive devaluations ahead…there may be no obvious sanctuary currencies until markets start working again and there is no telling when that will happen…I doubt before 2010.


David Gilmore



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