September 26, 2010

A Race To The Bottom

At the end this week’s FOMC meeting, the Fed made an implicit announcement of QE2.  No, not the Queen of England nor its name-sake ocean liner.  The Fed was hinting at a new round of Quantitative Easing (QE2.0 for our readers under 35) if economic growth were to approach sub-par values.  The prospect of possibly another trillion dollars of new money to be injected into the financial markets had no benign effects. 

Silver shot above $21, the highest in 30 years and Gold was at $1,300 an ounce (by the way, we lost count as to how many new all-time records occurred in the past two years).  The effect in other markets was not insignificant either.  The 2-year Treasury yield fell to an all-time low of 0.42%, the 5-year yield fell to 1.33% just a few ticks away from the all-time low of 1.26% during the darkest days of the financial crisis.  Clearly, the market is more afraid of deflation than inflation at the present moment.

At the same time, the 2008/09 default response in terms seeking safety in the US Dollar has now turned into a flight out of the US Dollar and back to other safe havens such as assets that may provide somewhat of a hedge against the obvious dilution in real Dollar terms; hence, the new all-time high in Gold.

While deflation is the obvious concern at the moment, one cannot ignore the fact that there is a notion of inflation risk on the investor horizon.  How far that horizon may be is difficult to assess but it is out there and it may hit US denominated investors sooner than they expect, particularly when valued in real US Dollar purchasing power compared to other currencies (Bond investors may want to re-assess the risk of holding longer dated bonds too).  Let us look at some of the symptoms of this new flight to safety.

The US yield curve is still quite steep and there is an almost 4% difference between the very short and long-term rates.  Compared to Japan, which did indeed experience two decades of de-facto deflation, Japan’s yield spread between short to long-term bonds is below 2%.

US Yield Curve

Japan Yield Curve

YC-US YC-Japan

In terms of equities, they can also provide a hedge against inflation.  When returns on cash and yields on short-term bonds are near zero, capital has to look elsewhere for yield.  Much of the emphasis in terms of assessing stock market performance is typically towards the economy.  If the outlook on the economy is positive, investors usually anticipate better returns for companies and stocks are the default pre-emptive strategy to benefit from the prospects of higher company earnings and higher stock prices.  Hence the notion that the stock market is a leading indicator of the real economy. 

There is however another argument.  What if investors were not anticipating a growing “US” economy but they were simply concerned about the possibility of another trillion dollars of easy money flooding the markets?  Concerns about the real value of the US Dollar may then explain why stocks have been holding up so well, despite the fact that the outlook for the US economy has not improved nearly as much as some expected.  There is a way to measure this trend by examining how the US Dollar correlates to the Stock market.  US Stocks and the Dollar had an alarmingly consistent negative correlation of about –0.50 since the beginning of 2009.  In plain English, each time the Stock market moved up by 1 point, the Dollar would move down by 1/2 point and vice versa.  That would explain at least in part why Equities in the US have been holding up and where a good portion of capital has been flowing to in search of yield which is apparently non-existent in short to medium-term fixed income instruments.


The concerns about a loss of purchasing power also had the obvious impact in currency markets.  The US Dollar lost ground against most of the major currencies in recent weeks.  The Australian Dollar has gained back nearly all the losses from the financial crisis and is back to its pre-crisis level.  The strength of the currency has been in part due to the rise of Gold and other commodities but it is also a result of the roughly 4% yield differential between the Aussie and the Greenback.

US$ versus Australian Dollar

But the fall in the US Dollar has not been primarily caused by the yield differentials from the currency pairs.  This has been evident in rise of numerous other currencies with equally low short-term yields.  The Dollar caved in against the The Swiss Franc (now below parity) and it even reached a new all-time low against the Singapore Dollar.

US$ versus Swiss Franc US$ versus Singapore Dollar

More significantly, the US$ fell to a 15-year low against the Japanese Yen. Despite last week’s central bank intervention, the US Dollar has retreated again, making the Japanese currency more valuable.  

US$ versus Japanese Yen US$ versus Japanese Yen (Monthly)

There is a common theme in all this: A race to the bottom. 

Currently, the US Dollar is clearly leading this race in terms of being closest to the bottom.  Considering the current landscape of interest rates however, the Japanese have been scraping the bottom for two decades now and that may provide some insights into the dilemma of some of the G20 nations.  Japan, which had near zero rates for an extended period of time and yet, their currency has been at a 15 year high against the Dollar.  Clearly, the strong Yen is a problem for the export-driven Japanese economy.  With rates at the bottom, there is limited room to maneuver  in terms of stopping the rise of the Yen any further.  The recent intervention of Japan is point in case as it did little to change the market trend. 

The US administration officially wants a strong US Dollar but that would obviously undermine a number of stated goals i.e. reducing the trade balance (increasing exports rather than imports), reducing the deficit and reducing the effective cost of interest on its debt.  Instead, as long as the world can be lulled into the perception of no or minimal inflation while the values of other non-cash assets are appreciating, the government is effectively reducing its true debt burden. 

Other countries have a currency problem from another perspective.  Take Australia, which is an exporter of many raw materials including minerals and precious metals, all of which have been on the rise recently.  Combine the increase in commodity prices with a rising Australian Dollar and the country is approaching levels that negatively impact their exports to countries like China.  China which in turn pegged its currency to the US Dollar and is by many still perceived as 30-40% undervalued, has to swallow the cost of the combined price increases of raw materials with the additional net price increase from say the Australian Dollar when valued in Chinese Yuan.  From Australia’s perspective, concerns about a further increase then are real as well.

A similar case applies to Brazil, which has been trying to stem the rise of its currency for some time now.  While their economic success in the past few years must be largely attributed to the increased demand of commodities and the resulting rise in their prices, they too are now approaching values (commodity price combined with higher exchange rate versus USD or Chinese Yuan) that may pose problems for their exports.  The US$ versus Brazilian Real has been approaching lows of pre-crisis levels in recent months.

US$ versus Brazilian Real

And where is the Euro in all this?  Earlier this year, in the midst of the Greek sovereign debt crisis (which isn’t over by the way), the Euro has been plastered as “toast” all over the financial news media.  The fall of the Euro however, showed some very positive effects particularly with regard to export-driven economies like Germany.  Germany’s economic recovery this year may not necessarily be the effect of superior policy by their administration but rather a lucky windfall from the ~20% fall of the Euro versus the two currencies that also happened to be major target markets for their exports, namely the USD and CNY.

Euro versus US$

Going back to our theme of today, a panacea for a sluggish domestic economy may indeed be the de-facto devaluation of a currency versus other major currencies.  For command economies like China, this can easily be done with a simple administrative declaration.  Other countries like Switzerland and Japan have been trying to stem the rise of their currency with a combination of market intervention and policy moves, both can be costly for their central bank and treasury.  Other export-driven countries like Brazil have been using taxes and duties to slow down the inflow of capital which made its currency so strong.  Australia may also find itself at a point where currency appreciation must be slowed down or stopped.  While each country has to weigh their methods of managing currency risk, there are no easy and unilateral choices.  None of these choices are without repercussions.  The benefits of some short-term relief i.e. a brief period of a boost in exports from the windfall of lower currencies must be balanced with the long-term caveats of the loss of purchasing power.  The theme of today suggests another concern, perhaps most evident by the rise in the value of Gold.  It is the growing mistrust of governments and their (mis)handling of public finances which makes the notion of a stable currency a problematic one. 

The race to the bottom is on.  In currency terms, there are a few favorites right now but the prospect of diminishing returns from too strong a currency is a concern. Some administrations will be toying with the “D” word.  “D” may be best known for deflation but it may play out more significantly as a Devaluation or Dilution them with respect to the major currencies.  Buckle up, we’re already in the midst of the race...

Good luck and good investing!

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