Fear of risk rained on the currency investors’ parade as an equity market sell-off fueled a US dollar and Japanese yen (JPY) rally. At times it looks as if we will break this pattern of markets up dollar down/markets down dollar up, but it seems investors continue to return to the US dollar and Japanese yen as soon as they become worried about equity market returns.
Many of the callers into the trade desk wonder how anyone would be buying the Japanese yen and US Dollar as ‘safe haven’ currencies. I think a lot of this buying of yen and dollars isn’t necessarily due to investors believing they are safer in US dollar and Japanese yen, but rather a result of the reversal of carry trades. The dollar and yen are the two major funding currencies of the carry trade. Investors borrow yen and dollars and then invest the proceeds into higher yielding assets including equities. This is what is called the carry trade, and it works best when an investor can use high leverage to increase the return. Since these trades are highly leveraged, they are closely monitored and reversed at the first sign of a possible fall in the value of the higher yielding assets. So while the popular press will talk about the ‘perceived safety’ of the yen and US dollars, I believe much of the dollar and yen buying is due instead to a reversal of the carry trade. Investors aren’t buying these currencies because they think the Japanese and US economies are stronger and therefore safer than others, but are simply deleveraging to take risk off the table, and are buying yen and US dollars in the course of this deleveraging.
So what caused investors to worry about their investments in the equity markets? Chuck sent me this note before heading out the door last night:
“I saw currencies jump around again on Wednesday… But here’s something that makes me scratch my bald head, and should make you wonder too… If you’re confused with this, then don’t feel alone… Fed Head Bullard was speaking yesterday and at one point he said… ‘FED MAY NOT START TO RAISE RATES UNTIL EARLY 2012.’ That really got the currencies going… But later in the same speech, he said, ‘MEMORY OF HOUSING BUBBLE MAY PUSH FED TO START RATE HIKES MORE QUICKLY THAN AFTER PAST RECESSIONS.’ WHAT? He said that the Fed may not start raising rates until 2012, but then says that the Fed may push to start rate hikes more quickly than before? In my best Andy Rooney voice… Do you ever wonder how these Fed Heads get in the door? Oh well… The second statement didn’t change the currencies, but it did change stocks… And for the first time in quite a while… US stocks sold off, and non-dollar currencies rallied.”
As Chuck points out, the St. Louis Fed Head Bullard seemed to be speaking out of both sides of his mouth, but his second statement that the Fed may push to start rate hikes more quickly than before scared equity investors. He stated that in the debate to tighten policy, “the idea that you might be creating asset bubbles by keeping rates too low for too long will be an important argument.” This is what scared the markets.
The economic data released yesterday certainly didn’t help investors’ confidence in the global recovery, as US housing starts unexpectedly dropped 11% in October compared to the month before. The pace of construction was the lowest since April’s record low, and illustrates housing’s reliance on government support. Obama has extended both the first time homebuyer’s tax credit and instituted a new (and I believe stupid) program to give existing homebuyers a tax credit to go out and buy a new one. These programs will probably give a bit of life support to the housing market in November, but many question just how long the government can continue them.
Another piece of data released showed that the cost of living in the US rose more than forecast in October as the price of gas pushed CPI up 0.3% following a 0.2% rise in September. Today we will get the weekly jobs data along with the leading indicators for the month of October. Last month’s leading indicators surprised the market with a 1% increase, but this month the expected rise is just 0.4%. This would be the seventh consecutive month of increased indicators begging the question: Just how LEADING are these indicators??? They have posted positive gains for seven months, but the economy sure doesn’t feel like it is picking up steam. Housing and unemployment continue to be drags on the US economy and, according to Chairman Ben S. Bernanke, economic ‘headwinds’ will limit the recovery for an ‘extended period’.
Speaking of our esteemed fed head, Bernanke’s clout among US lawmakers will be tested today as the House Financial Services committee will consider how much to expand audits of the US central bank. Panel members will be voting on a Democratic proposal to retain a ban on audits of the Fed interest-rate decisions. This would be a big blow to Ron Paul and his bill to allow audits of the Fed. Unfortunately I believe the Democratic ban on audits will pass, and Ron Paul will have to figure another way to try and hold the Fed accountable.
The worst performing of the currencies versus the US dollar over the past 24 hours is the New Zealand dollar (NZD), which fell by over 2%. The kiwi dropped as the nation’s main opposition party said it would no longer accept the central bank’s primary policy of targeting inflation. The head of the central bank’s salary is actually tied to keeping inflation rates at an acceptable level. This is one of the main reasons interest rates in New Zealand have been among the highest of industrialized nations. But in the opinion of the nation’s main opposition party, these high rates have been at the cost of slower growth and weaker exports. In my opinion, having a central bank focus on keeping inflation within a targeted range is absolutely required; and tying the main policy makers’ incomes directly to this objective is smart.
The Australian dollar (AUD) also dropped for a second day on interest rate speculation. As Chuck has written, the markets have expected the Reserve Bank to raise rates again at their December meeting, but the minutes of their November 3 meeting caused some concern that they will not raise rates again until 2010. The minutes, released yesterday, said the pace of interest rate increases is an ‘open question’ as policy makers balance the risk of inflation against an economy that could slow as government stimulus ends. But I am still firmly in Chuck’s camp, and believe the RBA will raise rates in December, and that interest rate differentials will continue to rally the Aussie dollar versus the US dollar.
Minutes of the Bank of England’s November meeting were also released yesterday, and showed that the policy makers were split on whether to extend the ‘quantitative easing’ program or possibly cut rates further. The pound sterling (GBP) lost ground against both the euro and US dollar as investors worried about the lack of direction. The minutes show there are three different camps at the BOE, one that favors expanding the program of pumping money into the system with bond purchases, another that favored no change, and a third that wants to use another interest rate increase to stimulate the economy. The lack of a clear plan by the central bank policy makers strikes fear into investors who want to see more of an agreement on the direction of policy.
While we don’t trade the Russian ruble, it is part of our BRIC MarketSafe CD (for which time is running out!). Chuck pointed out to me yesterday that the Russian ruble has been the best performing currency of the BRIC, which was surprising. A story overnight said that Russia’s central bank would have to accept a stronger ruble next year as rising commodity prices move the currency higher. Strong commodity markets have pushed capital into the Russian markets, pushing the ruble higher. Policy makers had indicated they would try to cap the ruble’s gains, but the IMF warned recently that these efforts to fight the ruble’s advance would prove ‘unproductive’ and that ‘underlying factors’ justify the ruble’s strength. This is good news for holders of the BRIC MarketSafe. If you haven’t purchased this latest MarketSafe CD, the cut-off is approaching – you only have until December 3, and then your opportunity is lost.
OK, to recap… The dollar rallied on carry trade reversals… The ‘audit the Fed’ bill is in jeopardy… Aussie and New Zealand dollars fell… And the BOE is split on the future of monetary policy in England.
By Chris Gaffney