Wednesday, October 24, 2007

Are we there yet?

EUR/USD 1.4240 Hi 1.4266 Low 1.4189
USD/JPY 114.05 Hi 114.95 Low 114.06
AUD/USD 0.8990 Hi 0.9047 Low 0.8993
EUR/JPY 162.41 Hi 163.89 Low 162.18

The official narrative is one of cautious optimism. (Well that is what they are paid for.) But the discussion has shifted focus. Now pretty much everyone expects the USD to devalue, with the exception of Jim O'Neill at Goldmans who is peddling the quaint idea that the small fall in the U.S. Trade Deficit will see USD buyers come rushing back. Why slightly reduced SELLING pressure associated with the slightly less negative trade performance of the United States should translate into actual USD buying is not clear. However, that was his story, at least up to a few weeks ago.

In the real world it's hard to identify much buying interest in the USD coming from anywhere. No-one wants to own USDs and it seems that lots of people are interested in getting rid of the USD assets they already own. So the big question now is: can the USD devaluation be managed in an ORDERLY fashion or not? As if that makes a big difference. Do you want the short, sharp blow to the head or would you prefer a lingering death?

The idea being that the "lingering death" option, while fatal for the U.S. economy as a whole, would allow U.S. Assets (read the Stock Market and U.S. Treasuries) to continue performing positively. Especially if the FED waves its magic wand at the end of the month, cuts rates and injects 'liquidity' back into the system. Liquidity being the buzz word. No-one knows what it is or what it means but everyone is pretty sure that if there is enough liquidity then the whole financial market house of cards can hold up even while households hit the wall all over the United States.

Of course, everyone also knows that cutting rates is risky because it could undermine offshore support for the USD. Which is why no-one is talking about the U.S. Current Account Deficit, which is big and scary, or the sad fact that Foreign Capital has started to head for the exits.

In July Net Foreign Capital Inflows were negligible and in August, well, Net Foreign Capital Inflows would have been more properly named Net Foreign Capital OUTFLOWS. Because that's what happened to the tune of USD 69.3 billion. So the U.S. in August 2007 failed to attract the foreign cash it needs to keep the USD stable and the show on the road by about, oh, around USD 140 billion. (The USD needs to attract around USD 70 billion in new money every month and it lost that amount instead.) This is not good news for the USD. In fact this is very bad news.

USD targets keep being adjusted to the downside with the only question being: orderly or complete panic? And in that friendly international market environment Ben Bernanke, the brave, must decide whether or not another rate cut can be delivered, seen as how the U.S. economy is starting to look like it needs life support.

The U.S. is dependent on foreign capital inflows and foreign capital inflows are hard to maintain if it becomes clear that the USDs you buy today are going to be worth quite a lot less tomorrow. Rate cuts make it harder still (to keep those flows coming) because they reduce the yield premium which is supposed to partially compensate for risk.

Well maybe Bernanke's up for the risk. And maybe asset markets will cheer him on but the USD sure won't and it hasn't exactly been looking perky lately. Another rate cut and the USD takes another hit and the question is: what will asset markets do then?

So far the scramble to reduce risk has seen U.S. Treasuries perform relatively well, particularly considering the, er, less than prudent fiscal management of George W. and company. Although the positive performance of U.S. Treasuries is only exciting if you are natural-born USD holder. If you live somewhere else, like say Japan or the EuroZone, the performance of U.S. Treasuries is unlikely to have set your hair on fire, once you factor in currency fluctuations or, if you prefer, USD depreciation.

OIL 85.35
GOLD 762.10

It is interesting to note that there are three world leaders who have an interest in getting the price of OIL as high as it can go: Putin, Ahmadinejad, and George W. Bush (who has well documented ties to the OIL industry). Funnily enough, these three leaders have been instrumental in escalating tensions in the Middle East. There have been veiled threats, talk of WWIII and so on and so forth. And guess what? The price of OIL has risen even in the face of less than spectacular outlook for global economic growth. Good job boys. Mission accomplished.

And a higher OIL price might keep shaky regimes in place and feather nests here and there, but it's going to do precious little to improve the general economic outlook. What the world saw in the 1970s and the 1980s were called OIL SHOCKS for a reason. Some people, though, got very rich and the same is happening today.

So where were we? Oh yeah, an imploding household sector in the U.S., capital flight from the USD, higher OIL prices (which certain people are quite happy to see remain high) and lots of dead bodies associated with the recent Sub-Prime Mortgage market fiasco. Only no-one knows where the bodies are buried. Risk aversion is going to remain on the agenda for quite some time, Ben Bernanke or no Ben Bernanke, and that's not good for asset markets.

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