Wednesday, July 12, 2006

The Best Case Scenario

EUR/USD 1.2703 / 06 Hi 1.2780 Low 1.2684
USD/JPY 115.37 / 41 Hi 115.54 Low 114.16
EUR/JPY 146.56 / 60 Hi 146.72 Low 145.76

The Bush Administration managed to get itself some positive headlines recently by bellowing about a 30 percent reduction in the projected Federal Government Deficit. The bottom line is that the deficit in 2006 will be USD 296 billion on current projections compared to USD 318 billion last year, hardly a breathtaking result. The old trick of following up ugly forecasts (USD 423 billion) with surprise improvements seems to be working. This tired tactic has been used over and over with regard to the Federal Government Deficit. And it works every time. Short attention spans on financial markets and in the media can be useful. No-one with a frontal lobe which is still operative should take the slightest notice.

The Bush Administration still faces a lot of hurdles and careful management of financial market expectations will be required. Henry Paulson will need all his market savvy. The U.S. currently has to deal with a massive external funding requirement, an over-indebted Consumer Sector, rising rates, a very green Federal Reserve Bank Governor and a hostile wider world. In this environment a lot needs to be achieved.

The Best Case Scenario would be if a gradual, steady USD devaluation could be managed. This would allow the U.S. to correct its external deficit over time. In essence U.S. imports would fall and U.S. exports rise as the USD devalues. At the same time the U.S. could wean itself off its long running dependence on the foreign capital inflows needed to finance current consumption. In this benign scenario the relentless rise in the FED FUNDS rate would come to an end sooner rather than later, as inflationary threats would be contained. A gradual USD devaluation would ensure that the impact of imported inflation on domestic CPI would be modest.

Today's U.S. Trade numbers show the necessary USD devaluation is nowhere near over.

The adjustment process could also turn out to be rather painful. The Worst Case Scenario would centre around a sharp fall in the USD together with a run on U.S. assets as foreign investors rush for the door. This would force the FED to either hike rates aggressively as an emergency measure (not quite like Iceland or Turkey - but you get the idea) and to hold rates higher for longer, regardless of the (negative) impact on domestic economic activity. Treasury yields, which are to a great extent dependent on offshore investment inflows, would rise sharply and, with rates rising across the curve, the impact on economic activity could be devastating.

Either way the U.S. (and by extension the world) needs a lower USD. The question is can this be managed without causing massive dislocation in financial markets? It's a fine balancing act.

What we do know is that interest rates may be close to topping in Anglo-Saxon countries and the Euro-zone and the Japanese Central Banks have only just moved into hiking mode. Yesterday's decision in Canada to keep rates steady, and the CAD selling that followed, highlighted the potential risks for the USD in this environment.

OIL 74.44
GOLD 647.30

World leaders were hoping the G8 meeting scheduled this weekend would take place on a positive note, or at least with some sign of an opening in negotiations from Iran. That now looks unlikely. Indeed Geopolitics are back in the spotlight and there is no improvement in sight. Bombs in India and the Iranian refusal to respond to the EU's July 11 deadline saw GOLD spike higher, but everything else was eerily unmoved. Note there was little in the way of safe haven USD buying.

With the crisis in Gaza looking uglier every day and no sign of progress in Iraq, this Summer is unlikely to provide the kind of calm the Goldilocks team needs. Any kind of weakness in the putative World Reserve Currency (the USD) will see the shift into GOLD continue. Buy GOLD on every dip (provided you have deep pockets and a long term investment horizon) and sell the USD on every rally. And remember the keywords for today's markets: volatility, volatility, volatility. This is not a market for the faint hearted or tight stops, unless you like seeing them triggered.

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