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Friday July 13, 2007 - 10:44:20 GMT
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Enjoy, but one-way bets deserve care

Key News
• The U.S. trade gap widened in May due to higher oil prices. But the deficit for other goods was nearly flat, reflecting foreign demand and a weaker dollar. (WSJ)
• After cooling for three straight months, [China’s] broad money M2 growth rebounded to 17.1% YoY, from 16.7% in May, still above the central bank’s target (16%) for the year. (Morgan Stanley)
• Key Reports:
8:30a.m. June Import Prices. Expected: +0.7%. Previous: +0.9%.
8:30a.m. June Retail & Food Sales. Expected: +0.1%. Previous: +1.4%.
8:30a.m. June Retail & Food Sales, Ex-Autos. Expected: +0.3%. Previous: +1.3%.
10:00a.m. Mid-July Reuters/U Of Mich Sentiment Index. Expected: 86.0. Previous: 85.3.
10:00a.m. May Business Inventories: Expected: +0.3%. Previous: +0.4%.

“Derivatives are constructed on the basis of the theory of efficient markets. The fact that they have become so widely used would seem to imply that the theory of efficient markets is valid…Beta, gamma, delta are, for the most part, just Greek letters to me.”

George Soros

FX Trading – Enjoy, but one-way bets deserve care

Is the market efficient? If it is, why play? And if it isn’t efficient and if Mr. Soros’ contention that derivatives are based on the theory of efficient markets—otherwise the math wouldn’t ever make sense—why do so many people trust derivatives?

We would suggest the answer is lies once again in human nature (not mathematics): Greed validated by price action leads to more money being thrown onto the price trend. And because currencies “free-float,” based on supply and demand that can flow from extremely subjective views, the degree of potential instability in the currency market is “cumulative” as these self-reinforcing trend followers grow over time.

A scenario that could invalidate the consensus might go something like this: We all hate the dollar. We all keep selling the dollar. And in its place, we all keep buying the key dollar alternative, the euro. But sooner or later we witness some type of debacle on the derivatives front. And in this scenario, this debacle leads to much lower global growth, maybe even recession. And in this environment it becomes painfully apparent that European finance, thanks to the still live and well welfare state, comes unglued as a common currency they have, but synchronized fiscal policies they have not.

And more to that point, a point made by GaveKal Research—the money being recycled from Asia into the US is to a much larger degree being funneled into consumer spending, whereas that from Asian sent to Europe goes more toward government spending.

Two points here: One, consumer spending no matter how seemingly “drunken sailor-like” will always provide greater overall efficiencies to an economy than anything the government does over time. And two, even though the US is accused continually of losing control of its fiscal policy (I plead guilty to leveling said charge and it may be true), the relative size of its debt as a percentage of GDP has remained fairly stable since 1990. The same cannot be said of European governments. They have all increased, and some dramatically.

So, if a derivatives debacle were to slow global growth, which is now not in the cards, and Asia started using its excess reserves to bolster its domestic market in the face of declining Western demand, maybe the US does better on a relative basis. I this sounds very counterintuitive given that Asia is holding so many US bonds. But maybe Mr. US Consumer will have a greater wherewithal to save than the experts expect, making up for the lost Asian flows. After all, Mr. US Consumer continually confounds the experts on their ability to spend.

Europe on the other hand already has relatively high savings rates, at least compared to the US. But European governments have no place to hide in the face of declining money flow which supports spending to support the welfare state. New entrants to the EU will want their fair share, and in this environment, out of control spending countries such as Italy, who have mooched off the excellent EU credit rating, may be in store for real trouble. Things have a way of coming out in the wash over time.

So, we can all feel good if we’ve been riding the dollar down, smug in our assessment that all things financial in the US are going south—Europe is the place to be. It’s a heady one-way bet that may prove true. But, we’ve noticed over the years that markets have a way of fooling those making smug one-way bets.

It’s something to ponder, as you enjoy your weekend.

DXC Chart Weekly

John Ross and I want to thank you for being a reader of Currency Currents. Take care.

Jack Crooks


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