Market Correlations Weaken; A New Normal
09/15/2009 12:01 am EST
Running the risk of beating a dead horse, the more the global economy normalizes, and the more the distribution of economic outcomes normalizes, the less markets will blindly trade risk on/risk off. So having days where many in the market are casually assigning causality to the move in gold above $1000 and the decline in the USD index to a 12-month low as the start of a debt/currency crisis are signs of normalization, even if grossly off the mark. Just look at US Treasuries and equities—the day a crisis in confidence in US economic policy starts, the dollar decline will not happen independently of Treasuries and equities—sell all. For the gold bugs, where reality is an inconvenience, as long as China targets its currency to the USD to support a massive bilateral trade surplus, by definition, it will accumulate more dollars than it can sell—hedging for this monster is at the margins. China can pressure the USD lower, but China will not unleash a run on the USD. Asia generally is a net USD accumulator in periods of USD weakness for the very reason it manages exchange rates, and Korea, Taiwan, and Thailand are all buying USD in this decline. Look at the US Treasury’s $70 billion auction this week—demand from indirect bidders (mainly foreign central banks) was solid.
Equally significant is the tired state of affairs of the risk on/risk off narrative for (explaining) pricing of assets and FX. The dollar is down on reduced risk aversion, say many analysts. Just look at the rally in commodities, equities, EM FX, and any major currency with a nominal yield advantage—risk trade is on. But the yen is up versus the USD and EUR. Wasn't the JPY the risk-off currency of the last 18 months? And the yen and A-shares perfect inverse correlation has vanished too.
At market inflection points, competing narratives, hackneyed narratives, and the emergence of fringe views in the mainstream are part of the process of transitioning to a new normal. This applies to currencies, equities, and fixed income. The dollar has broken key levels and there is some momentum building, which suggests good downside ahead for USD index, upside in EUR/USD, and downside in USD/JPY. But NZD/USD and AUD/USD are vastly overbought (unless you think the price of milk and lamb products are forever going higher). AUD has a robust China recovery priced, higher rates from the RBA priced, and maybe even an elevated risk of a run on the USD priced. Just buying AUD and NZD because they are going up is not a wise approach in the new normal. I suspect the RBA is an active USD buyer now, and despite the RBNZ's Bollard telling a local radio show that he does not think there is much that the Bank can do to check the rise in the NZD, we don't have to go back too far in time to see open currency intervention from this central bank. I am not suggesting an AUD and NZD downtrend lies ahead—just decent correction is due—and making the point that a new normal requires a more thoughtful approach to trading.
What is the new normal? One where traders and investors have to do their homework. One can't buy anything not nailed down. And one should not assume that the new normal is just like the old normal. Government's visible hand is in the mix of capital markets and has a front row seat in the real economy, which has serious implications for asset prices, risk, leverage, bubbles, and moral hazard. If I had to ascribe this implication in one word it would be volatility. Despite its best intention of reducing volatility, the presence of government in markets and the real economy will make for more—not less—volatility in asset prices, commodities, and FX.
I also get the sense that many in the market failed to get the G20 central bank memo last weekend. Markets are well ahead of central banks on when the latter will start exiting unconventional (and conventional) monetary policy accommodation. This applies to the RBA as well, though it has been most fiercely emphasized by the Fed and ECB (even Fed inflation hawks or district presidents are on board this message).
Which leads me to another sign of a new normal unfolding: The inflation debate. This one I find most amusing. Gold bugs on TV seem to have found their stride. All this monetary accommodation means prices are heading up. Look at commodities, and look at gold especially. Why is this not a deflation trade? Is gold not a hedge against deflation as well as inflation? Does anyone think debt monetization by the Fed or BOE is a guarantee for higher inflation when banks are not creating credit, not lending, and when households and firms are paying down debt? Beware of demagogues. Beware of economic dogma and especially political economic dogma. And the bid in commodity prices seems to be a function of China buying natural resources and building gold reserves from a miniscule share of overall reserves—it will always be miniscule when FX reserves are $2 trillion and growing.
Finally let's not casually attribute causality to the decline in the USD. This is not the beginning of the end of the USD as the world's reserve currency, not unless you are 50 miles up and the view is the next 100 years. There is momentum in a lower dollar and it is worth playing from the short side in the next few weeks, but some FX longs like CAD and GBP seem more appropriate than tired AUD and NZD longs.
And if the new normal is emerging, markets should also prepare for the day when stronger US fundamentals, even if questionable beyond a few quarters, should start providing a reason to check the selling of dollars and perhaps start providing a reason to buy dollars. If Fed balance sheet expansion ends at the end of October as planned, we could be due for a mighty bounce in USD this fall. That said, with the Fed underwriting the mortgage market (securitization), it is reasonable to ask if this role can end in another six weeks.
By David Solin, foreign exchange analytics, www.fxa.com