Wednesday July 13, 2005 - 11:24:22 GMT
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Black Swan Capital - www.blackswantrading.com
“There are few things more unbalanced to the mind than the act of suddenly winning or losing large sums of money.”
Henry Howard Harper, The Psychology of Speculation
A two-day correction in the dollar—is it over? We think not. But when it is over, we believe the euro is in real trouble. And it comes back to interest rates.
There is a debate now about the viability of European Central Bank (ECB) monetary policy. Many are calling for swift action and emergency rate cuts. The ECB is standing firm—in effect communicating that monetary policy stimulus may not matter anyway. And in that sense, one gets the feeling they are afraid of lurching into the same quagmire that has trapped the Bank of Japan (BOJ)—out of bullets and demand still hasn’t responded.
After the BOJ pushed interest rates to zero, attempting to flood the market with yen in order to stimulate demand, the Japanese economy still didn’t respond. The Bank of Japan became stuck with its zero interest rate policy and there was no place left to go. Deflation engulfed the economy and continues to be a problem some 15+ years after the Nikkei peaked.
That’s the monetary policy backdrop. We think sooner than later the ECB will be forced to act. And when it does, and if the euro-zone economy does not respond, we think the euro will take on a new role and take a big dive against the buck. That role: carry-trade currency.
A carry-trade currency is loosely defined as that which is borrowed, then exchanged (sold) in order to buy something else. That something else can be other higher yielding currencies, bonds, stocks, real estate—the list goes on and on…the key being that this borrowing and exchanging of the carry-trade currency leads to a self-reinforcing process that pushes it lower.
For now, based purely on market sentiment, the dollar correction has more room to run. There is plenty of dollar bullishness out there that this market probably needs to shake off. But the path of least resistance is clearly down for the euro against the dollar.
If the euro take on the role we suspect—we may get a glimpse of just how ugly a self-reinforcing vicious cycle in a currency can be.
Black Swan Capital
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