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Tuesday July 17, 2007 - 11:25:55 GMT
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Overshoot and “overvalued” are rear view mirror terms

Key News
• U.K. inflation slowed less than economists forecast in June. (Bloomberg)
• German investor confidence fell in July more than economists predicted. (Bloomberg)
• More than two-thirds of economists surveyed expect the Bank of Japan to raise interest rates in August, a government-affiliated association said on Tuesday. (Reuters)
• The payroll survey has missed up to 139,000 construction layoffs, a new analysis of underlying payroll data has concluded. (WSJ)
• "A revaluation of the yuan which reduces the growth of China's exports may also reduce the exports of its neighbors, such as Korea and Japan, depressing rather than boosting their own GDP (gross domestic product) growth rates and creating pressure for currency depreciation rather than appreciation," the BOE working paper said. (WSJ)
• Key Reports:
7:45a.m. ICSC Chain Store Sales. Previous: +0.1%.
8:30a.m. June PPI, Ex-Food & Energy. Expected: +0.2%. Previous: +0.2%.
8:30a.m. June Producer Price Index. Expected: +0.1%. Previous: +0.9%.
8:55a.m. Redbook Retail Sales Index. Previous: -1.3%.
9:00a.m. May Treasury International Capital Flows. Previous: $111.8B.
9:15a.m. June Capacity Utilization. Expected: 81.6%. Previous: 81.3%.
9:15a.m. June Industrial Production. Expected: +0.4%. Previous: Unch.
1:00p.m. July NAHB Housing Index. Previous: 28.
5:00p.m. ABC/Wash Post Consumer Confidence: Previous: -9.

LET things be—not seem, …
Do, and nowise dream.

Robert Browing

FX Trading – Overshoot and “overvalued” are rear view mirror terms
Morgan Stanley currency economist Stephen Jen believes the dollar will surprise in its strength during the second-half of the year once the dust settles in the subprime market and the US economy reasserts itself. But he also believes the euro and pound are in overshoot territory and could go higher. About 1.40 for the euro and 2.07 for the pound, make sense to him.

The problem with forecasting on the fundamentals, once we lurch into overshoot zone, is that the fundamentals tend not to matter as much as they did early on. It is the nature of overshoot. And it usually lasts longer than we expect.

Overshoot occurs in all markets, but we contend it’s seen more often in currencies because the variables that drive currencies are relatively more confusing than they are in other markets. Is it interest rates, geopolitics, central bank reallocation, oil priced in euro, derivatives, deficits, inflation, on and on into infinitum. It could be a combination of all, a few, or none. The only thing that matters is the players’ belief in a rationale, their reward from adding speculative capital to the trend, and this validation further enforcing the rationale. In short, as speculation becomes the predominant driver, other factors lose their importance. And as long as everyone is happy, and currency speculators are very happy to have capital sitting in relative high yield paper with an appreciating currency to boot, the trend can and usually will be sustained.

So, I think Mr. Jen is right about the euro and pound being in overshoot territory. But if the currency crowd continues to be rewarded, why should anything change? That answer, like many others, we don’t have.

We do have scenarios, but only hindsight gifts bring answers. It’s why all analysts appear so smart after the fact. But at some point the dynamics will change, they always do. And speculative capital flow will start flowing back in the other direction. In fact, it was the background interest rate divergence that changed the dynamics the last time we saw the dollar heading toward new all-time lows, back in December 2004 (it rallied for 11-months of 2005). The type of divergence that appeared in the Fed Funds Futures (inverted) vs. US $ Index chart as displayed here yesterday (and below today) is similar:

CHART Fed Funds vs $...

Or it could be a black swan event of some kind that rocks the risk-taking mindset globally and changes the dynamics. We still cling to a background theme (one of many held in our aching heads) that says there is a lot more money in the hands of US-based fund managers who have invested overseas (estimated at around $4 trillion-pus) than is held by Asian and Middle-Easterners in their collective reserve coffers. And should the black swan spread its wings, much of that $4 trillion could wash back on shore very fast in search of a hiding place in short-term US treasuries and that would be very dollar bullish.

But investing doesn’t run on unsubstantiated background themes. It runs on what is happening in the real world. Risk taking is alive and well. Liquidity is still massive. Derivatives seem to be holding up just fine, validating the view that the nominal value of issuance now standing near $415 trillion will not cause systemic problems (jury still out on that in our humble opinion; but it’s the market’s opinion that matters).

It all suggests that overshoot is best evaluated in the rear view mirror. One day in the future, whether it be 2-weeks or 6-months from now, after the trend breaks, analysts will be out in force on CNBC and Bloomberg to tell us exactly why the euro and pound became extremely “overvalued” and the dollar is now “rallying.” It is the way it is. And the way it has to be.

Jack Crooks


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