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Tuesday February 13, 2007 - 10:28:28 GMT
Black Swan Capital -

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It's all linked

Key News
• German economic growth unexpectedly accelerated in the fourth quarter. (Bloomberg)
• UK core CPI was less than expected for November; 1.6% vs. 1.8% in Dec.
• Key Reports Due (WSJ):
7:45a.m. ICSC Store Sales Index. Previous: +1.3%.
8:30a.m. Dec Trade Deficit. Expected: $59.5B. Previous: $58.23B.
8:55a.m. Redbook Retail Sales Index. Previous: +1.7%.
5:00p.m. ABC/Wash Post Consumer Conf. Previous: -1.


”Irrationality as a real economic attribute is not only the pith of behavioral finance; it is the next frontier for all market research.”

Woody Dorsey

FX Trading – It’s all linked

Maybe it’s going to be drip-drip instead of big bang! I’m speaking of the yen, of course:

“Today, several oddities appear related to the misalignment of the yen. For example, even though earnings of Japanese companies have not clearly improved since the end of last year, the stock market has risen considerably. Most investors attribute this rise to the weakness of the yen. Second, the low long-term yields in the US may be related. After all, the increase of MoF holdings of US Treasuries in 2003-04, funded by cheap borrowing from the Bank of Japan, could well constitute the Godzilla of all carry trades. Even the debate about triangle mergers in Japan — which Keidanren, the main business organization, is trying to block — has been distorted by the exchange rate. If the yen were at a more reasonable level, foreign firms would find acquisitions in Japan more expensive, and the incentive for business to beg for management protectionism would abate.

“At some point, a misaligned exchange rate is bound to correct. When it does, large misalignments in other markets are likely to end as well. Correcting misalignments is good, but preventing them is better. This is where the G7 comes in,” wrote Morgan Stanley’s Robert Feldman on January 29th.

But to believe it will be drip-drip means the G-7 will be able effectively manage the yen higher. That would make herding cats look like child’s play. So, we remain open to fireworks. Because when the fuse is finally lit on the yen—that puppy is going to light up the sky exposing a vast web of interlocking relationships that will drain liquidity much faster than initially created.

The chart below shows the not too surprising relationship between rising EURJPY cross (moniker for a weakening yen) vs. S&P 500 Stock Index vs. Emerging Markets Stock Index. We’re sure corporate earnings are doing just fine, as we are told. But we can’t help remembering something about cheap money being the mother’s milk of stock prices…


And though we know the number is large, we always get a nice little chill down the spine when we see it quoted:

“Take, for example, the rise of hedge funds and the explosive growth in structured financial instruments. The outstanding notional amount of exchange-traded and over-the-counter derivatives contracts snowballed from US$77.3 trillion (or 245% of global GDP) in 2000 to more than US$400 trillion (or 840%) last year. Likewise, in search of higher yields, private capital flows to emerging economies soared from US$50 billion a year in the 1980s to US$675 billion last year. It may be ‘so far so good’, but the wave of liquidity that has boosted global GDP growth beyond its trend rate and depressed term premiums could easily become a source of financial volatility, as we have witnessed several times in recent years,” writes Serhan Cevik of Morgan Stanley.

Granted, this revolution in finance has enriched many. And hopefully it will continue to do so. But we can’t help thinking there is a Black Swan event lingering out there. Something by definition way beyond the scope of portfolio “stress testing.” Does anyone remember Russian bond prices vanishing from the trading screens back when derivatives were still “manageable”?

Jack Crooks


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