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Friday June 29, 2007 - 10:41:39 GMT
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Risk Cometh! Will Liquidity Goeth?

Key News
• Japanese core consumer prices fell slightly for a fourth straight month in May. (Reuters)
• Japan is not considering setting up a new investment body to more actively manage the nation's huge pool of reserves. (Reuters)
• Key Reports (WSJ):
8:30a.m. May Personal Income. Expected: +0.6%. Previous: -0.1%.
8:30a.m. May Personal Spending. Expected: +0.7%. Previous: +0.5%.
9:45a.m. June Chicago PMI. Expected: 57.5. Previous: 61.7.
10:00a.m. End-June Reuters/U Of Mich Sentiment Index. Expected: 84.0. Previous: 83.7.
10:00a.m. May Construction Spending. Expected: +0.2%. Previous: +0.1%.


Life means learning to abhor
The false, and love the truth

Robert Browning

FX Trading - Risk Cometh! Will Liquidity Goeth?

We recently mentioned the reflexive relationship between the act of lending and the underlying collateral that supports lending i.e. the same underlying collateral that supports a loan is bid up in price by the act of lending itself, as described by Mr. Soros. This relationship helps explain why liquidity, seeming so abundant during asset price booms, can “inexplicably” dry up so fast. The players come to the realization that castle built to the sky rest on a very thin foundation. Okay…nothing new here but the history of busts we don’t know (apologies to Mr. Truman).

What is new during this massive gorge of credit we have witnessed, a la hundreds of trillions worth of derivatives, is the notion/idea/belief/hallucination/dream that because these derivatives have been parceled out into smaller baskets and spread across a greater number of investors, that risk is therefore reduced.

Financial theory holds that if you spread risk you tend to reduce your relative risk, a la modern portfolio theory. I guess we can’t argue about that, but we will. For try as we might to feel good about risk spreading on the scale we’ve witnessed in this cycle, we can’t.

Maybe it’s because we know modern portfolio theory is itself flawed. The assumptions of the rational man and the assumption of the Gaussian Bell Curve, are fantasies (theoretical constructs to be more precise) in order for the Capital Asset Pricing Model and the elegant curve of the efficient frontier to materialize magically before our eyes. However, have been battered around a time or two ourselves, we’ve come to the conclusion that in the real world one can properly quantify risk only after the fact. At critical stages in the cycle, men are far from rational and the shape of the curve isn’t always a bell and those pesky outliers that should rear their ugly heads only once in a million or so years, according to the theory, have way of showing up much more frequently.

Our point, if we are making one, is that at some stage the system must reach risk saturation no matter how many little “safe” parcels are created. My pool holds about 16,537.5 gallons of water where it’s in the ground or 16,538 old gallon milk jugs. So we ask: Is there a qualitative and/or quantitative difference if a whole bunch of smaller investors—which are closer to the ground of the real economy—go belly up instead of one or two big ones?

Adding fuel to our burning question was this from the front page of the Financial Times yesterday [we have emphasized the good part]. Commenting on the global bond deals being pulled from the market because of the problems in the US subprime sector, HSBC Chairman Stephen Green said he was “’worried by the degree of leverage in some big-ticket transactions nowadays’ and felt ‘something is going to end in tears.’”

“He also warned that losses could be higher because the parceling out of risk to so many parties across the financial system could make it more difficult to arrange a rescue – a comment that highlighted widespread and growing unease among senior banking executives.”

The fact of the matter is that once again none of the concerns about risk, assuming there are any, seem to matter to currency investors as we close out the week. We say that because of the price of Comdols (commodity dollars representing high yielding currencies) going higher and the yen (the world’s key funding currency) going lower.

Below is chart of the US dollar index. We continue to believe that if any of this risk stuff starts to matter—the lowly buck will catch a bid on safe haven flow from US fund managers rushing to salvage some collateral. Stay tuned.

Jack Crooks


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