Thursday, October 05, 2006

Leverage versus the Real World

EUR/USD 1.2713 Hi 1.2722 Low 1.2692
USD/JPY 117.64 Hi 117.95 Low 117.52
AUD/USD 0.7470 Hi 0.7480 Low 0.7448
EUR/JPY 149.57 Hi 149.96 Low 149.27

Once upon a time there was civilisation, good government and the rule of law. Then the barbarians took over. Guess what? The barbarians are back. You can tell because they have two principal exports: mindless violence and little green bits of paper. The Americans are doing just great exporting both to the rest of the world. Everyone wants to own these little bits of green paper because they give you more little bits of green paper at the rate of around 5.25% a year. In addition, with these little green bits of paper you could, potentially, buy your own capacity for mindless violence and then the world would be a much better place. At least for the war mongers and the arms dealers.

Anyway right now there is a fight going on. That fight is about reality. Or rather perceptions of reality. In the make believe world the U.S.A. is bringing democracy to the Middle East, Condoleezza Rice is in the Middle East right now working towards that aim. In the make believe world repealing laws which previously protected against unlawful arrest and inhumane treatment of prisoners will make Americans safer. In the make believe world the very heart of all the conflicts out there is the clash between radical Islam and progressive America. Or if you like between Islamo-Fascism and American values, however they may be defined. As Joseph Heller would say: we are fighting for "Mom's apple pie". Pity no-one in America reads the classics anymore. Except the Bible. Which is a classic too and everyone in progressive America, including George W., supposedly reads it. Except for the bit about "Do not kill" and "Let your 'Yes' mean 'Yes,' and your 'No' mean 'No'.

But then they seem to have a problem with definitions in America. You know you're in trouble when even really little words like "is" can't be defined precisely. What does torture mean? What does the Geneva Convention mean? Isn't it just a legal document which we can redefine with the help of crafty lawyers? What does anything mean anyway? It's all relative and EVERYTHING can be spun. Just watch.

Don't bring them on, just bring back the Middle Ages. Mission accomplished.

And while all that is happening U.S. markets have caught onto the idea that the economic slow down in America is now OVER and the next cyclical economic upturn is about to begin, with a little help from the FED. So the Stock Market is making headlines. Good headlines, headlines which may distract the American public from the fact that the value of their real estate is falling through the floor, with more to come.

In this make believe world real trends don't matter. What matters is leverage. With enough leverage, and a little bit of spin, trends can be created. So it doesn't matter that the U.S. hasn't run a trade surplus since the beginning of time. It doesn't matter that the U.S. is dependent on the flow of foreign savings to finance growth. After all, the U.S. is using these capital inflows to build infrastructure, to educate and train their workforce, to build productive capacity. In this way the money borrowed will provide a return which will be one hundred times more than the cost of funding. Er, no actually that doesn't appear to be the case. Over the past decade or so the U.S. has used the money to inflate assets such as Housing and Technology Stocks, and to wage war on Iraq and Afghanistan. None of these "investments" will see a positive return. Indeed, the deflation of some inflated assets is already under way. And even Bernanke doesn't believe that that particular trend is over yet. FED PAUSE? You betcha.

And the wars, while good for some, will ultimately just bleed the U.S. Treasury. This sounds more like Osama's plan than Karl Rove's. But then Osama probably has a bit more of a long term horizon than say the next U.S. election.

So much for the real world. In the make believe world of leverage and spin real-world trends don't matter. What matters is that the USD currently provides a better rate of return, if you consider short term interest rates, than any other major currency. So, provided that there is not a major depreciation in the USD, you are better off holding USD than say JPY or EUR. Of course a 2% depreciation of the USD versus the Euro will wipe out that extra return. A 5% depreciation of the USD versus the JPY over a year will do the same. We are not talking huge margins here. But for now the market is happy with that. When the market turns, as surely it must in this leveraged world, the results will be ugly.

U.S. fundamentals remain USD negative. The Carry Trade Crowd is testing the top of the USD range right now. A failure to sustain a break above recent USD highs will lead to a bail out. And bail outs in this highly leveraged, short-term trading market can be brutal.

OIL 59.40
GOLD 571.00

OIL is holding as the market digests OPEC's intention of reducing output. This seems to be a not particularly nice thing for U.S. allies to do at a time like this. But then the Bush Administration needs to go back and review "How to win friends and influence people". The chances that the U.S. "friends" in OPEC will take into consideration U.S. needs right now are, well, quite small.

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