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Monday April 18, 2005 - 11:55:37 GMT
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Dollar and liquidation...


“There is nothing good or bad, only thinking makes it so.”

William Shakespeare

FX Trading

US economic growth will disappoint going forward; that is the dominant market perception, solidified with release of worse than expected news for US manufacturing on Friday. Is that a surprise? Not really. But it’s also no surprise that growth is slowing almost everywhere else. So, in the game of relativity, nothing changes on that front for the dollar. The US is still growing relatively faster than its competitors.

But what does change is the belief the Fed will balk. That seems to be the message being sent by the bond market. But what if the bond market is sending another message, or an additional message—a prelude so to speak of something in our midst. And what might that something be: a flight to quality thanks to global leverage liquidation. In other words, it could be hedge funds running for the exits. If so, it could eventually result in a major prop for the dollar.

The major leverage players hold both commodities, tied to Chinese growth, and emerging market bonds in their stretch for yield. Their bet being US rates would stay low, the dollar would remain weak, and China would continue to grow uninterrupted as far as the eye can see. But this game is changing. Maybe we have seen a similar scene play out before that we can use as a guide to the future.

Asia was the darling of world growth in the late 1980’s. Remember the Asian Tigers? Remember how everyone loved investing in Asia. Traders and investment gurus were “printing money.”

It seems safe to say that nobody anticipated anything like the current crisis in Asia. True, there were some Asia skeptics - including myself - who regarded the claims of an Asian economic miracle as overstated, and argued that Asia was bound to run into diminishing returns eventually. And some people - again including myself - raised warning flags a year or two before the Thai crisis, noting that the current account deficits of Southeast Asian countries were as high as or higher than those of Latin America in 1994, and arguing that Asian economies had no special immunity to financial crises. But even pessimists expected something along the lines of a conventional currency crisis followed by at most a modest downturn, and we expected the longer-term slowdown in growth to emerge only gradually. What we have actually seen is something both more complex and more drastic: collapses in domestic asset markets, widespread bank failures, bankruptcies on the part of many firms, and what looks likely to be a much more severe real downturn than even the most negative-minded anticipated.

Paul Krugman, 16 January 1998

Part and parcel to the Asia meltdown and contagion, it triggered a major hedge fund failure, Long Term Capital Management (LTCM) in September 1998—LTCM was a fund run by the elite of quantitative market wizardry at the time. Boy, did those guys know how to model. Rocket science was an understatement when describing them. The problem is financial models don’t consider black swan events. Russia deciding to default on its bonds and devalue its currency wasn’t part of the algorithm for LTCM. In others words, when bids on bonds simply disappear, instead of just falling, it’s a little tough for the system to react. No, that stuff wasn’t in the game plan.

Take a look at the chart on the next page. The Asian crisis was in full-swing during 1998 and continued into 1999. Two things that stand out:

1) First US bonds rallied on safe haven…then tanked.
2) The dollar (blue line) benefited mightily

Chart: bonds/dollar 1998-2000

Is a replay in store for us? When we get our 20-20 hindsight vision, we should know.

Jack Crooks


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