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Wednesday June 1, 2005 - 11:26:18 GMT
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A $troll down memory lane


“The myth that ‘science is objective’ may tend to be fostered in most cultures today in an attempt to preserve whatever status quo exists by giving it scientific blessing.”

Robert Ornstein, The Psychology of Consciousness

FX Trading – A stroll down memory lane

Rumors that German officials are discussing the viability of the European Monetary Union are seeping onto the news wires.

Ah! Sentiment! It is a wondrous and curious thing indeed. Currency trading—a fickle game played by a fickle crowd; it boils down to “everyone loves a winner.”

As many of you may recall, the powers that be in the financial punditry and just about everyone else on earth was expecting the US dollar to fade away into oblivion earlier this year. “It’s the deficits.” “It’s the Administration.” “It’s Iraq.” “It’s China.” “It’s central banks reallocating reserves.” “The elite at Davos don’t like the dollar.” Blah, blah, blah, on and on into infinitum…

Black Swan received some nasty emails from some players in this market when we dared to challenge the intelligentsia view on the dollar; we turned dollar bullish very early in the year, in the face of a lot of “slam dunk dollar bears.” To paraphrase some mail we received: “You guys are whistling passed the grave yard on the dollar,” read one such email. “The dollar will soon lose its world reserve status and you’re clueless if you think the dollar will rebound,” was the gist of another.

That’s all it took for us to realize we WERE definitely on the right track with our early call that the dollar bottomed in late December. Whenever you see that type of extreme one-way bet in financial markets, and even if you know almost nothing else, it’s usually a pretty good indication that some type of turning point has either been or is about to be reached.

You all know our reasons for dollar bullishness then—and they haven’t changed now. These were the reasons given early in January and articulated in Currency Currents on January 24th:

1) Yield differential improving for the buck
2) Relative US economic growth
3) A crystallized sentiment extreme against the dollar
4) The possibility of the Bush Administration putting action behind “strong dollar policy” words
5) An emerging view that a falling dollar won’t solve the current account problem

Along the way we added an additional theme: A hard, or harder than expected, landing in China means offshore money rushes back into the buck. And now, we must add one more—the viability of the euro as a real currency is being tested.

And in light of the bond rally and dollar rally, here is an excerpt from Currency Currents on January 19th 2005. It is the incredible prescient forecast by Hoisington (institutional fixed income managers):

…Early in ’04 they were bullish on long bonds, when the consensus was not. And we know the rest of the story. Again this year the consensus (I plead guilty) expects long bonds to get clobbered as the Fed hikes interest rates. But Hoisington says “the potential will again lie in the long end of the market.” Slower economic growth and lower than expected inflation are why.

I believe much of Hoisington’s forecast has implications for the dollar, for example:

1) On the falling dollar’s inability to stimulate export growth: “Most forecasters expect U.S. exports to improve this year because of the two year decline in the dollar, but this view may be too optimistic…We believe that global excess capacity and a fear of losing U.S. market share caused these importers to hold the line on prices despite the falling dollar.” [In addition, the impact of tighter monetary policy and higher energy prices means the major economies will be stagnant in ’05.]

2) Why we should see increased savings and less spending this year:
a. “Household debt levels imply that the financial condition of the typical American household is stretched. Household debt was a record 115.3% of disposable personal income in the third quarter, an all time high for the series… Repairing the consumer's extended balance sheets will serve to stunt spending.
b. Oil shock: Each of the preceding oil shocks were associated with recessions [the current shock is the third largest of five since 1970]…Historically, the first response of consumers is to reduce saving to pay for higher interest expenses and energy bills, and only later do they decrease their purchases for discretionary spending.

3) Why inflation will surprise on the low end: “When the Fed says that it wants low inflation, and that it is willing to further tighten monetary conditions, the record suggests that it should be taken at its word…Thus, the macro economy will be characterized by too many goods chasing too little money, the condition that produces disinflation.”

“In the past twelve months the CPI increased 3.5%. This advance reflected a 56% surge in oil prices from the end of 2003 to the close of last year, as well as large increases in some key commodity price indexes to all time highs. In the present situation, such events are contractionary, not inflationary, even if they temporarily lift the core inflation rate. They are only permanent if the Fed monetizes them by accelerating monetary growth. The rate of increase in M3 like that of M2 dropped to a nine year low in 2004, effectively isolating the higher oil and other commodity prices. The CPI should reverse sharply to the downside this year, and the multi-year low in the core inflation rate lies ahead.”

Though Hoisington believes the Fed will continue to hike short-term rates, the sharp reduction in inflation due to slower growth, more consumer savings, falling commodities prices, and a stagnant global economy will push inflation rates sharply lower in 2005. The Fed achieves what it wants: higher real interest rates and slower monetary growth. And according to Hoisington, long bond investors get what they want: “…a safe and very rewarding investment.”

This economic scenario supports the view that a weak dollar does little to help reduce the US current account deficit. Yet it provides the backdrop for increased US savings (reducing the need for foreign funding of US deficits at the margin) and rising real interest rates. Both would be good news for the buck.
We finish with one more excerpt from Currency Currents on January 6th 2004:

…I think as “traders” or “speculators” we need to drive a stake through the heart of the notion one can determine the direction of the dollar based on the current account. Long-term, I am not denying it MAY not be healthy. But, when it comes to any conceivable time-frame in which we base our dollar trading decisions THE CURRENT ACCOUNT IS AN UNRELIABLE INDICATOR. And if it is unreliable it is useless.

In hindsight, once the “strategist” capitulate to the new dollar trend, we will probable be subject to their new enlightenment, which will be nothing new at all. I think it was Jesse Livermore who said “There is nothing new in Wall Street.” We should extend that to say, “There is nothing new in the currency world.”

The new enlightenment will probably be what your already know or should know—underlying conditions. Back to Mr. Livermore (as chronicled in Reminiscences of a Stock Operator) for help here:

“I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing its initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends on underlying conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine.”


So as we watch the “new enlightenment” among the intelligentsia unfold, be aware that a bullish extreme in the dollar will be achieved. We will see this extreme in fractal time frames. But over the intermediate- to long-term, we are still a long way from that.

After all, our favorite long-term dollar bear has not yet spoken.

Jack Crooks
Black Swan Capital


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