Old Men Playing with Fire
The euphoria was short lived last week. The markets rose for the first part until the Federal Reserve delivered the rude awakening that it might not yet be ready to cease and desist from fighting against inflation. After cruising through a week, catalyzed by the hopes of a Fed pause, the Dow Industrials rose to a 6-year high and was poised to break above its all time high in the week ended May 5th, while the S&P; 500 index, which has a broader base, scaled a 5-year high. However, the good things came to an end in the recent week, as the Fed felt that inflation is still a concern despite somewhat slower economic growth. The crucial sentence was: "The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information." An inflation scare followed that sent stocks, bonds and the dollar skidding at the end of last week and certain analysts (some would call them "Perma-Bears") say more declines are possible as it dawns on investors that further increases in borrowing costs could be in store.
Meanwhile, the dollar index continued to tumble right along. We had commented on the G7 meeting two weeks ago and since then, the sellers continued to dominate the daily tape action. From the looks of it, there is some serious liquidation going on. The left chart above shows that in the short run we are already somewhat oversold, speculators should take note. However this reflects just some short term extreme in sentiment. Longer term it becomes more and more obvious that the dollar index has entered a new bear market phase. Marc Chandler, chief exchange strategist at Brown Brothers Harriman, was quite upset about this development. He started his latest article on TheStreet.com with the following salvo: "Old men should know that playing with fire is dangerous. Yet that is precisely what the old men in the G7 and IMF are doing with regards to the U.S. trade deficit. Many have argued, for some time, that the large U.S. external imbalance was a major risk to the world economy. The previous solution was for the U.S. to boost domestic savings, for Europe and Japan to make structural reforms to boost domestic demand and for Asia to adopt more flexible capital markets. But the current leaders' lack of political will to implement the strategy led to the more expedient course of signaling that the currency market should bear a greater burden of the adjustment. That in turn has sparked a near freefall in the U.S. dollar."
US interest rates are rising sharply, the "old men" of the G7 and IMF have admitted that they are weak and that speculators can safely assume that the path of least resistance is a declining dollar. Many had predicted this outcome for many years. They had said that the only way the U.S. is going to be able to "normalize its balance sheet" is through dramatic devaluation of its currency. The dollar bears said this so often and for so long that now, that it is actually happening, it feels almost like a letdown. Anticlimactic or not, the dollar has indeed dropped dramatically, but in the past 5 years this took place mostly against the Euro and the Canadian dollar. Asian central banks, on the other hand, had long ago decided to buy dollars. It became a competitive currency devaluation, as each Asian country bought US dollars in order to keep its own currency from rising against the countries with which they felt they were competing. Japan against Korea, Philippines against Indonesia and everybody was competing against China. They all thought they needed competitive currencies to export into the USA.
The two pictures above tell the story. Since November of last year, the Euro and the Yen have gained almost the same percentage against the dollar. The end of Zero Interest Rate Policy in Japan started the yen-buying by speculators. They knew that the Yen-Carry trade was still going on around the world and that all those loans, taken out in yen by big institutions and hedge funds at almost no interest rate cost, had to be repaid eventually. What the borrowers did not have to pay in interest rates they now lose by having to buy a more expensive currency when they repay their loans.
The Japanese have long sought to prevent drastic appreciation of the yen against the dollar, and as we saw from mid-2003 through early 2005, were willing to purchase vast amounts of U.S. bonds to execute this policy. They have similar concerns with China: As Japan is a much costlier place to do business than China, they are working toward a weak yen-yuan cross-rate. If the yen per yuan rate rises -- the yen weakens against the yuan -- Japan feels no great urge to buy U.S. bonds to suppress the yen. And since the yen-yuan cross-rate has been stable since the February announcement, U.S. 10-year note rates have jumped. The reasons for higher US interest rates have many reasons - true, but diminished Japanese buying certainly played a part in it. The stronger yen is a sign that money is flowing back into Japan at the expense of the dollar and at the expense of domestic borrowers in the US.