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Friday March 9, 2007 - 10:06:39 GMT
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Carry-Trade Players Say: "Don't Worry Be Happy" But We Know Better

Key News

• The net worth of U.S. households climbed to a record high in the final quarter of last year, boosted mostly by gains on stocks, the Federal Reserve reported Thursday. (AP)
• In the clearest sign yet of how rapidly funding is vanishing for the risky loans that helped fuel the housing boom, nervous creditors forced New Century Financial Corp., the nation's second-largest subprime mortgage lender, to stop making new loans. (WSJ)
• Key Reports (WSJ):
8:30a.m. Jan Trade Gap. Expected: $59.0B. Previous: $61.18B.
8:30a.m. Feb Nonfarm Payrolls. Expected: +90K. Previous: +111K.
8:30a.m. Feb Unemployment.Expected: Unch. Previous: 4.5%.
9:40a.m. Feb ECRI Inflation Gauge. Previous: 119.5.
10:00a.m. Jan Wholesale Inventories. Previous: -0.5%.


“It is a Wall Street truism that the stock market is a ‘voting machine’ wherein investors vote on the true value of a stock. But sometimes, investors are actually not making any reasoned independent judgment at all. They may simply decide that it is unnecessary or counterproductive to excessively examine their own behavior. How else do we account for the myriad fads and fashions of consumers? Why does the market undergo so many unpredictable twists and turns? Why do certain business books become enormous bestsellers even though they are simpleminded and poorly written? Why do certain people emerge as market gurus when all they do is mouth platitudes uttered hundreds of times before? Perhaps the answer lies in that confounding and sometimes unknowable aspect of human crowd behavior, and in the intrinsic limitations of human information processing.”

F.J. Chu

FX Trading – Carry-Trade Players Say: "Don't Worry Be Happy" But We Know Better

This article appeared yesterday in the Sovereign Society’s A-Letter:

George Soros once said:

"I came to a strange conclusion. The cycle got stuck in 1982...We now live in a system where we continue to go to the brink and then recoil when we see the abyss opening at our feet. The cohesion we manage to muster in the sight of a disaster tends to disintegrate as soon as the danger recedes, and the process then repeats itself in different forms."

Has the global macro scene changed much since then? No, not much. The linchpin holding all the pieces together is still the same-credit. As a trader, you come to recognize that a world awash in money can hide a lot of warts. But when the veil of credit is lifted, markets can turn ugly in a hurry revealing warts and all.

We got a sneak-peek of this recently, when traders from major institutions raced to pay back credit, when stocks, risky bonds, commodities, and selected currencies tumbled. It was ugly. The markets weren't at the brink, but it's possible we may get there in the near future.

"The longer the world endures mounting imbalances without suffering any serious consequences, the more the financial-market consensus believes this disequilibrium is sustainable," writes Morgan Stanley economist Stephen Roach.

In other words, if it ain't broke, don't fix it. Let a sleeping dog lie. If a correction is out of sight, then it's out of mind. And then there's my favorite, "don't worry, be happy!" It's this underlying belief in sustainability that keeps the boom alive.

Beliefs hang on to a person like a pit bull. They are hard to shake. Already we're witnessing pundits and investors boldly announce that the "correction" is over. Risk-taking is back in vogue after a brief holiday. Time to borrow more money from Japan and the Fed, and plunge back into all the good stuff: risky bonds, stocks, high yield currencies, you name it - anything risky - even if there's only a tiny-fraction of extra yield to be get the picture. Credit holds this game together and credit sustains it.

But sooner or later even creditors wake to the reality that their belief in this perpetual bull market boom has put their assets in harm's way. It usually takes at least one scary surprise to shake off the pit bull of complacency.

For example, a 9% drop in the Chinese stock market might help investors shake off their complacency. Or a complete meltdown in sub-prime mortgages that's rippling across the globe like Godzilla trampling victims in its path might do it. Oh, that's right, we've already seen that. And surprise, surprise, financial institutions are rushing to tighten lending standards. Hmmm....

Tighter lending standards equals tighter credit. Increases in central bank policy rates, as we've seen from New Zealand and European Central Banks, equals tighter credit. They're trying to convince investors these tighter rates are nothing major, even expected. But, no matter how you slice it, credit is slowly draining from the system.

And in the background we see several factors that don't necessarily bode well for financial asset appreciation, such as: brewing protectionism, the U.S. housing slump (again), and wage cost increases (which threaten inflation). All this going on while ex-Fed Chairman Alan Greenspan is spouting about the "probability of recession." Mr. Bernanke must be so pleased to be receiving such support for his Goldilocks view of things.

The point is, there is a lot of risk out there in the markets, much of it not yet fully recognized or appreciated.

A Mixed Bag in Currencies, But There May Be Some Logic to Apply

From a currency perspective, it is a mixed bag. On the economic fundamentals, it suggests the U.S. dollar could be in for serious trouble. But, let us not underestimate the power of the buck's luster as a safe haven. In other words, there are hundreds of billions of dollars held offshore by major U.S.-based investment fund managers. If that money, now held in yen, yuan, Singapore dollars, euro, Australian dollars, etc. races back to its home base, the dollar will certainly "catch a bid."

But generally speaking, in a world of rising risk - high-yielding currencies and fundamentally overvalued currencies should be avoided at all cost. Undervalued and low-yielding currencies make the most sense for this environment. Why low yielding currencies? It's because low-yielding, or funding, currencies are the ones under selling pressure as they are used to create the credit that created the risk. But if risk unwinds, I would expect these funding currencies to bounce back with a vengeance.

By the way, shortly after Mr. Soros expressed concerns back in the 1980s that sounded eerily similar to today, the 1987 stock market crash taught us a painful lesson about financial risk taking. Now THAT'S what I mean by ugliness in financial markets!

Jack Crooks


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