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Wednesday February 23, 2005 - 11:22:40 GMT
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Dollar manipulation, or something else?


This very fact that crowds possess in common ordinary qualities explains why they can never accomplish acts demanding a high degree of intelligence. The decisions affecting matters of general interest come to by an assembly of men of distinction, but specialists in different walks of life, are not sensibly superior to the decisions that would be adopted by a gathering of imbeciles. The truth is, they can only bring to bear in common on the work in hand those mediocre qualities which are the birthright of every average individual. In crowds it is stupidity and not mother-wit that is accumulated.

Gustave Le Bon

FX Trading

“In Seoul, a senior South Korean official said the latest fluctuations in the dollar and won were excessive. ‘We've been diversifying our foreign-exchange assets since many years ago,’ said Choi Joong-Kyung, director-general of the Ministry of Finance and Economy's international finance bureau. ‘It shouldn't suddenly make news and the market's reaction shows how irrational the sentiment is,’ he said,” The Wall Street Journal reported today.

There are two possible reasons for the dollar move yesterday:

1) Outright manipulation!, or
2) Something changed in the macro environment!

As I was watching market’s very odd price action yesterday, I had no plausible answer to these two nagging questions:

1) If there is some concerted effort by global central banks to dump dollars, why haven’t US Treasury bond prices plummeted?

2) And, if the price action is based on a change in the global macro fundamentals i.e. inflation and liquidity, why are the commodity currencies, Australian and Canadian dollar lagging the rest of the pack on the move?

But how can the currency market be manipulated—it’s by far the largest market in the world, you might ask? Well, Mr. Choi Joong-Kyung gave you the answer: irrational sentiment!

The variables that impact daily upon the currency markets are vast and diverse—it is extremely difficult to get a handle on so-called cause and effect from day to day. And even when you do know the fundamentals, the price action relative to said fundamentals often appears perverse. It’s precisely this dynamic that leads many players to trade in extremely short-term time frames; thus reacting to every scrap of news thrown onto the market by any two-bit media pundit and their cadre of industry “sources” who also, by the way, have positions in the market. Objective journalism it is not.

These “scraps of news” are then perpetuated and given weight by a crowd of so-called traders who chat with each other all day long—each proving their point because they have a Holy Grail technical analysis package on their desk top to pinpoint, you guessed it, cause and effect. “And gee, the story came from a ‘reputable’ news organization, so it has to be true. And look, prices are surging, it must be true”…and on and on it goes…

This is a crowd that is RIPE FOR MANIPULATION!!!

And because the currency markets are so damn leveraged, when the news-bit driven groupies act, the rest of us either have to play along or get out the way.

That is my summary of why manipulation could have been responsible for yesterday’s news. I thank one of my most astute readers, Dave, for forcing me to focus on scenario number one. Here is an excerpt from an email he sent to me this morning:

“…At the time, I'm scanning the charts and see the USD/ZAR moving real quick...strange I say to myself, this pair doesn't make such moves so early in the trading day. Well, right in time, lo and behold, Reuters releases a story right before the Japanese open on Tuesday in Asia.

Focus of the story: Bank of Korea to adjust their foreign reserves. Since they have the 4/5th highest amount of USD reserves, something to take note of as obviously everybody did. Also mentioned in the story is a survey of reserve bankers stating they plan to make adjustments and the story even digs up a banker in Bahrain chatting about how the EUR is gaining. The story has a real sense of urgency to it. BUT, WAIT A MINUTE, the Bank of Korea mentioned this idea last December! The reserve bankers' story was out in January! And when is the last time anybody heard from or paid attention to a Bahrain banking official. Never mind that all of these points were old news and that nothing of any economic substance had changed in the last two weeks. THE MARKET WIZARDS HAD DECLARED THAT THE EURO MUST RISE AND, BY GOD, OR BY REUTERS, SO IT SHALL THEY SAID TO THEMSELVES.

And, the really funny thing about this story is that if the BoK was actually going to switch out of dollars, then they had just lost over 2% of the value of their current reserves and made any other pairs they wanted to buy 2% more expensive. Now, come on, they are definitely not that stupid. As it now turns out, today we read that they never intended to suggest they were dumping the dollar but simply that they would be adding other countries currencies but not at the expense of the dollar.”

The second scenario is that something changed in the macro environment yesterday—or at least it was crystallized.

This is an excerpt of a note I sent to clients last night:

• It is oxymoronic to think of rising liquidity and an aggressive Fed. But that is what we are seeing. Notice that M2 continues to soar despite the fact the Fed began hiking rates back in June.

In effect, we have the “reflation” trade back in vogue if the liquidity dynamic is the driver. Asset bubbles rock on!

Reflation trade:
• Sell dollars
• Buy commodities (usually including metals and energy, but the move today included the grains, as wheat an soybeans surged)
• Buy bonds
• Buy stocks

But, what was interesting today was that US stocks were punished—they were former beneficiaries of the reflation trade. Maybe hedge funds and others believe European stocks are looking more promising…boosted by abundant liquidity across the zone. Here is a chart of the German Dax Index vs. the S&P 500 index prices in euros:

Seeing these two charts in isolation, where would you be putting your money? This, in effect, has the potential to provide background support for the euro.

It is an odd dynamic indeed:

• Fed tightening short rates
• Excess market liquidity, especially in Europe
• Rising inflationary expectations
• Possible coordinated moves away from the dollar

This odd combination could lead to vicious circle for the dollar that we need to consider:

a) Fund managers prefer euro stocks to US equities on valuation and the currency dynamic. Besides the macro dynamic of the potential for a portfolio gains boosted by a rising euro, there is an underlying fundamental at work. Germany—the key driver of European growth is in better shape than many believe, according to the Economist magazine this week:

“A study by Deutsche Bank suggests that Germany's productivity growth has been just as fast as America's since 1995 if both are measured on the same basis. Wages in Germany, however, have grown more slowly, so unit labour costs have fallen. Partly thanks to such pruning, Germany's real trade-weighted exchange rate with the rest of the world (based on relative labour costs) has risen by only 4% since early 2002 despite the surge in the euro against the dollar (see article).

“German business is supposedly too flabby to compete in world markets. Yet over the past five years German exports have grown more than three times faster than America's, pushing Germany ahead of America as the world's biggest exporter.”

b) Euro bonds, despite a lower equivalent yield than comparable US Treasuries, maybe expected to outperform. Euro inflation appears tame relative to the US, and the European Central Bank isn’t expected to move on rates at least until some time in the Q3 of this year, at the earliest.

c) A liquid global economy provides support to China, which in turn sustains real demand for commodities. As more liquidity flows back into China, further pumping up their respective financial bubble, it moves away from the buck.

d) To the degree US inflation rates rise faster than Europe, it reduces the benefit of the rising yield differential for the dollar i.e. the real rate differential (nominal interest rates minus inflation) is what counts.

There are many loose ends when trying to define a change in the macro environment. The interrelationships are often tenuous at best. It’s one of the reasons I am leaning toward scenario number one--manipulation. It’s easier to define and a lot more interesting.

Jack Crooks


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