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Thursday September 8, 2005 - 11:39:26 GMT
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Dollar Tug-o-War


“We all know that art is not truth. Art is a lie that makes us realize truth.”

Pablo Picasso

FX Trading

The dollar is trading in the midst of a tug-a-war it seems! Dampening effects of Katrina vs. risk premiums! Is the dollar about to lose two of its major props: growth and yield appeal?

Chart: Dollar vs. Eurodollars

From Pimco’s Bill Gross, September Investment Outlook : [Our emphasis]

Oh, I know I’m paid and paid well to shroud the Outlook with pessimism whereas equity, hedge fund, and these days private equity managers are paid and paid well to cast a perpetual glow of hope on tomorrow’s dawning. But in determining whether or not the sun is rising or beginning to set on our economy and its markets, perhaps it is best to return to the maestro himself for a hint on the timing of this affair. ‘Any onset of increased investor caution,’ he wrote at Jackson Hole, ‘elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.’ The secret for successful future strategies, therefore, may be to decipher what precipitates that increased investor caution and when.

From The Wall Street Journal today:

But for some Fed officials, Katrina merely has amplified concerns they already had that higher energy prices were working their way into underlying inflation. While higher oil prices might reduce growth, ‘there is also a risk on the inflation front, and the risk is higher now than it was a year ago,’ Federal Reserve Bank of Chicago President Michael Moskow said yesterday. With the economy running close to capacity, businesses are more likely to pass higher energy costs on to other goods and services, he told the Futures Industry Association in Chicago yesterday. If inflation accelerates, it could become embedded in workers' and companies' wage-and-price behavior, he said. ‘The Fed would need to respond accordingly in order to restore price stability.’

Back to the future! The Fed is in a damned if it does and damned if it doesn’t raise rates scenario. Risk a runaway asset bubble by proving moral hazard is only a talking point if the Fed pauses. Risk a tanking of the housing market if it raises rates. I guess that’s why they get paid the big bucks.

Mr. Gross and others seem to expect Mr. Greenspan and Co. will raise rates to the 4% level—then stop.

Chart: Fed Funds

Source: The Wall Street Journal

“The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market.”

Ludwig von Mises.

And if we see what Mr. Gross expects—deflating home prices…

“If the home asset bubble stops expanding, deflates, or pops any time soon (and I suspect we are only a few short months from at least the first of these three) then the potential for Greenspan’s ‘debt liquidation’ follow-on is something that investors must begin to prepare for. Debt liquidation, as opposed to loan growth, slows an economy or sinks it into recession, generating the higher risk premiums that the Chairman warns us lie ahead,” writes Mr. Gross.

…then we see a major hit to collateral values, which raises systematic risk and touches off a race to the short-end of the Treasury curve, as Mr. Gross expects.

None of this would be good for the dollar—because it would lead to the expectation the Fed will turn and cut rates. Right? Well, maybe!

Any time we look at stuff like this, there should be a warning label attached. Because, number one, we can’t forecast interest rates. And number two, if we could, we need to remember that not all things remain equal as we are told in economic 101. For if everyone is racing to the short-end of the Treasury curve, by definition it means they are running from something else. That something else could be emerging market bonds, Asian investments, or commodity currencies also predicated on growth and yield.

“It ain’t over till it’s over.” Once again, Yogi cuts right to the chase.

Jack Crooks
Black Swan Capital


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