Are the Rosicrucians at it again? For the second straight session, a ropy-looking US equity market was buoyed at roughly 2 pm NY time to rally strongly and close within a few S&P 500 points of unchanged. The tin foil hat brigade is no doubt having a field day. Strong Microsoft earnings (man, when was the last time they were relevant?) after the close could set the stage for upside today.
The real story, however, is the continued shellacking of the US dollar. Enthusiasm for any positive action in US equities or other American assets has got to be tempered by the knowledge that the dollar appears to be falling in value against virtually everything in the known universe. Well, everything except a large number of coastal houses, that is.
Oil, for example, has ascended on wings of eagles and is now up more than $30 on the year. Remember when $30 was thought of as the long-term equilibirum price for crude? Now it's just 10 months' worth of price action. Of course, product prices have yet to follow suit; if they do, then Macro Man's constructive US equity outlook will require a rapid re-assessment. In any event, the superspike to $100 isn't looking so slow-motion any more.
Gold is following a similar pattern, as is of of course the euro. One of Macro Man's preferred indicators has reached a critical threshold this week. The interest rate differential between the US and Europe, as priced by the third (i.e., June 2008) eurodollar/euribor contract has swung to a premium for Europe for the first time in several years.
A truly daunting prospect is that if strip pricing is realized, the dollar will have the third-lowest interest rate in the G10 by the middle of next year. And that will mean that the greenback will end up as a funding currency in the tens of billions of dollars worth of passive carry strategies that have had such an influence on currency markets. A situation wherein investors do not receive interest rate compensation for financing the US current account deficit should spell doom for the dollar.
And yet....the dollar isn't the whole side of the story. True, in the scenario described above, the US will rely on foreign central banks as the primary conduit of deficit financing. Yet Macro Man remains troubled by this analysis, as it implies a definite knowledge that the deficit comes first, and thus requires financing.
But the Eurozone, for example, with only a modest current account deficit, is still the recipient of €150 billion or more a year in central bank financing inflows. For Europe, it seems quite clear that the financing has come before the deficit (which is now widening, particularly if we look at the EU as a whole.) Macro Man continues to believe that the US deficit/financing issue is more complex than most currently assume, and that sans unwanted financing, the deficit would be lower (and market rates higher) than is currently the case.
In any event, the current market dynamic is clearly being driven by factors described above: US reflation and declining rate premia. And from that perspective, dollar weakness is justified. Yet in conversations with other market risk-takers, Macro Man has detected a distinct lack of enthusiasm to buy euros. Valuation is apparently finally taking its toll on private-sector demand for euros, so traders and fund managers are less enthused about betting the mortgage on EUR/USD than they were in, say, Q4 2004.
It is the case that the euro's trade-weighted index is at its highest level in more than a decade- and the chart below (the Bank of England TWI) doesn't even include China, so it almost certainly understates the true degree of euro strength. Ultimately, this is likely to have a material impact on European growth, though currency hedging will likely mitigate the impact compared with 15 years ago. Nevertheless, it is unlikely that the EUR/USD rate will go up forever, and at 1.50 we should probably all be prepared for Europe to start digging its heels in more forcefully.
Results from the S&P poll are mixed so far...if you haven't voted yet, by all means please do so.
The real story, however, is the continued shellacking of the US dollar. Enthusiasm for any positive action in US equities or other American assets has got to be tempered by the knowledge that the dollar appears to be falling in value against virtually everything in the known universe. Well, everything except a large number of coastal houses, that is.
Oil, for example, has ascended on wings of eagles and is now up more than $30 on the year. Remember when $30 was thought of as the long-term equilibirum price for crude? Now it's just 10 months' worth of price action. Of course, product prices have yet to follow suit; if they do, then Macro Man's constructive US equity outlook will require a rapid re-assessment. In any event, the superspike to $100 isn't looking so slow-motion any more.
Gold is following a similar pattern, as is of of course the euro. One of Macro Man's preferred indicators has reached a critical threshold this week. The interest rate differential between the US and Europe, as priced by the third (i.e., June 2008) eurodollar/euribor contract has swung to a premium for Europe for the first time in several years. 
A truly daunting prospect is that if strip pricing is realized, the dollar will have the third-lowest interest rate in the G10 by the middle of next year. And that will mean that the greenback will end up as a funding currency in the tens of billions of dollars worth of passive carry strategies that have had such an influence on currency markets. A situation wherein investors do not receive interest rate compensation for financing the US current account deficit should spell doom for the dollar.And yet....the dollar isn't the whole side of the story. True, in the scenario described above, the US will rely on foreign central banks as the primary conduit of deficit financing. Yet Macro Man remains troubled by this analysis, as it implies a definite knowledge that the deficit comes first, and thus requires financing.
But the Eurozone, for example, with only a modest current account deficit, is still the recipient of €150 billion or more a year in central bank financing inflows. For Europe, it seems quite clear that the financing has come before the deficit (which is now widening, particularly if we look at the EU as a whole.) Macro Man continues to believe that the US deficit/financing issue is more complex than most currently assume, and that sans unwanted financing, the deficit would be lower (and market rates higher) than is currently the case.
In any event, the current market dynamic is clearly being driven by factors described above: US reflation and declining rate premia. And from that perspective, dollar weakness is justified. Yet in conversations with other market risk-takers, Macro Man has detected a distinct lack of enthusiasm to buy euros. Valuation is apparently finally taking its toll on private-sector demand for euros, so traders and fund managers are less enthused about betting the mortgage on EUR/USD than they were in, say, Q4 2004.
It is the case that the euro's trade-weighted index is at its highest level in more than a decade- and the chart below (the Bank of England TWI) doesn't even include China, so it almost certainly understates the true degree of euro strength. Ultimately, this is likely to have a material impact on European growth, though currency hedging will likely mitigate the impact compared with 15 years ago. Nevertheless, it is unlikely that the EUR/USD rate will go up forever, and at 1.50 we should probably all be prepared for Europe to start digging its heels in more forcefully.
Results from the S&P poll are mixed so far...if you haven't voted yet, by all means please do so.
12 comments
Click here for commentsuniform distribution of poll results imply better take chips off and spend quality time worrying about something else :)
ReplyMM, you are right that EUR/USD cannot go up forever, but often currencies seem to move much farther than anyone believes possible. Your comment that some people are becoming wary makes me think that the move probably has more upside. Wait until everyone throws in the towel.
ReplyOn the US CAD, I agree that the situation is much more complex than most people make it out to be. Capital inflows and a current account deficit are two sides of the same coin -- you cannot have one without the other, and to say that one side is driving the other is an oversimplification. Lower US rates will reduce the attractiveness of USD assets, but relatively slower US economic growth should also cause a reduction of the CAD.
Anonymous, thre's a slight skew towards bearishness in the poll, but yes, it's less pronounced than I might have hoped.
ReplyCDN, the lack of market enthusiasm for euros is one of the reasons I have a fair amount of short dollar risk there!
On the few markets that I follow in any detail, upside is being provided by a very few components, raising the possibility of being bearish or neutral on stocks and voting for over 1550 on the index - and being right on both counts. It's an ugly situation for shorts who have reason, and maybe facts, on their side, but are getting sideswiped by magnitudes.
ReplyIndeed, and it's not dissimilar to the aftermath of 1998, wherein there were plenty of stocks that did not participate in the 1999 rally.
ReplyThe problem is that lack of breadth can continue for longer than you think if the enthusiasm for the heavyweights driving index rallies remains unperturbed.
The possibility of the $ becoming a funding-currency will have a perverse effect on other markets as money flows out of the US to other markets and in turn causes huge bubbles to form in real-estate and equity markets ... the ensuing crashes will be global and remiscent of 1997-1998
ReplyI have taken a short euro position vs. USD equal to 2/3 of my long yen position vs. USD just now. There is a 2-day bearish set-up in gold if it breaks $756.80 by next Thursday (known as an inside false break-out pattern), which targets $725-$698 (Dec). Commercial traders are record short gold. I am flat gold since $760 area and am surprised to see it break $780, but not in lieu of the crude move I guess.
ReplyI have also started selling US equity futures again (RUT Dec). Risk exposures are flashing major warning signals based on my modeling - I also have working weekly technical bearish signals in the S&P 500 and RUT, with the S&P targeting 1450-1384 and RUT targeting 750-699. Both are valid unless S&P breaks 1586.50 and RUT 853.20 (both Dec) on the upside.
Regarding the Euro, it is sitting at record highs vs. USD, is overbought on almost every technical measure and commercial traders are very short (not extreme though). Fair value is about 1.15-1.20 based on my analysis, and is probably the reason currency speculators are not as enthused to be long it.
That's my take and I'm not buying today's hype!
Got a Fed call Corey?
ReplyRJ
RJ,
ReplyI think the general feeling is "since they have to" (cut that is) it will only be 25bps. 50bps seems too much in lieu of record everything, 0 not enough in lieu of doing 50 last time!
If you are talking about having a call option on the Fed per se (to hedge my euro/rut short), then no, I'm letting my shorts speak to the rate cut being fully priced in at this exact moment ;)
But let's say my euro short has a tight stop!
Thanks Corey, though I'm not sure 'too much' is in this Fed's nomenclature, as near record's last time were of no concern to them, especially since the house market is about as close to crashing as a house market can get.
ReplyRJ
Hi Macro Man,
Reply1.50 for the EUR/USD is wishful(?) thinking I think. Much will be decided come next Fed meeting. If Bernanke lowers then I am willing to bet all my funny money that the ECB will have to lower too.
And of course the BOJ is stuck in hold too.
Claus
Claus, bear in mind that 1.50 is only 6 cents away, and we were 6 cents below the current spot rate..er..a day or so before the last Fed meeting!
ReplyWhile the ECB may well be forced to change monetary tack with the euro at 1.50 (and so they should!), current rhetoric has been decidedly on the hawkish side. Axel Weber, for example, doesn't sound anywhere close to wishing to cut rates.
Of course, the rhetoric is likely replacing actual monetary tightening (at least via the interest rate channel), but at this point it's difficult to see a pre-emptive easing (hell, there might not be enough time to pre-emptively ease bnefore 1.50, conceivably.)
It's probably safe to assume, though, that if the Fed eases and the dollar tanks, that Trichet will switch verbal gears on the 1st if the dollar goes down the swannee on Halloween.