September Strength Should Continue

Those of you familiar with the game of ice hockey will understand what I mean when I write, “it’s time to check the goalposts”. A good netminder will, with his stick, periodically bang the goalposts behind him in an effort to make sure all the angles are covered. Well, the same theory applies to those seeking to invest successfully. The markets have experienced a nice run in the 1st half of September and it’s now time to check the proverbial goalposts.

The market equivalent for a piece of iron painted red to which I refer can best be described as the relationship between the carry trade (expressed by the AUD/JPY), the NYSE Composite and the credit markets. We used these three factors to check angles back in April with our successful ‘Stalking the Bear’ series. And then again in July with our correct ‘change in trend may be in the offing’ comment. So, without further delay let’s check the posts….

Post 1: Below you will see a weekly chart of the NYSE Composite. This is an update to the chart that first appeared on this blog in the post ‘Stock Market Strategy: Irresistible Force Meets Immovable Object’. Please note that the red ‘immovable object’ of a downtrend has been breached and the black ‘irresistible force’ of an uptrend remains intact. So, for the moment, intervention and liquidity creation trumps economic reality. Score one for the bullish camp and look for a continuation of the September strength…..

click to enlarge images

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China Backpedals on the Yuan

Last week we drew attention to the strange behaviour of Chinese officials, who pushed the yuan downward against the dollar while their trading partners were calling for the Chinese currency's appreciation. This shift occurs as China is clearly trying to diversify its investments, as exemplified by the hike in its allocation in government debt from the zone: Y1.7 trillion in Japan in the first seven months of 2010, up from just Y255.7bn for all of 2005, and $2.11bn in South Korea. At the same time, China has reduced its investments in US debt by $8.95bn to $844bn. (La Chine diversifie ses réserves de change; The Real Drivers of Diversification in China’s FX Reserves). This also surely explains a big part of the yen's strength vis-à-vis the dollar and the euro. On the basis of the latest statistics published in the China Securities Journal, this is the current breakdown of currency reserves: dollar 65%, euro 26%, pound sterling 5%, yen 3%. The main reason (in their eyes) for these changes in currency reserve allocations is the fear, as expressed on numerous occasions since 2008, but more and more clearly in recent weeks, that the dollar will lose its status as the world's reserve currency (too much of the Fed's QE?), leading to a significant decline in its value. PBOC governor, Ms Hu Xiaolian, has made the latest pronouncement in this vein: “My view is that the Yuan doesn’t have a key role to play in rebalancing bilateral trade between the U.S. and China. I don’t think excessive argument and criticism on this issue will help”. (WSJ 1 Sep 2010) "Once a reserve currency's value becomes unstable, there will be quite large depreciation risks for assets. A diversified international currency system will be more conducive to international economic and financial stability.” (China Finance, 6 Sep 2010). In reality, you can already read the same views in Ms Xialian's speech of 15 July before the PBOC: “Three Characteristics of the Managed Floating Exchange Rate Regime.” However, the yuan's recent depreciation vis-à-vis the dollar hardly went unnoticed in the United States where it sparked an immediate reaction from Robert Hormats, under secretary of State for economic, energy and agricultural affairs: ‘U.S. Official Warns of Backlash Against China’. “A lack of action by the Chinese to address U.S. concerns about currency issues and intellectual-property protections could encourage a more protectionist agenda on Capitol Hill.” "We're likely to see some legislation offered that would be adverse to Chinese interests if more steps aren't taken.” All this in an already tense context, as Larry Summers (Director of the National Economic Council) and Thomas Donilan (Deputy National Security Advisor) travel to China to discuss all these highly sensitive issues. They will not only talk about the yuan, but also about China's anger at US involvement in the South China Sea and US concerns about Iran. ‘Bumpy months ahead for U.S. and China’ So surprise, the yuan's controlled depreciation last week has abruptly moved upward, just in time for Mr Summers' visit. Here is an updated graph comparing the yen and the dollar. Yuan and yen vs the US dollar China back-pedals a bit…

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European Woes Continue

Coming back from the Labor Day holiday, US investors have been caught a bit off guard by the reversal of sentiment toward Europe. The euro had rallied in the immediate aftermath of the stronger than expected US jobs data ostensibly on a greater appetite for risk. There was some follow through early yesterday and then only lower.Anecdotal stories include empty shops in Greece and concerns over the lack of government's in Belgium and the Netherlands. French unions are on strike today in Paris. Irish bank solvency has re-emerged as a key issue. Today a European bank took 60 mln dollars from the ECB's Fed swap line. The ECB noted that last one one bank--perhaps the same one as this week--took 40 mln dollars from the swap line at a rate as much as 4-times greater than LIBOR.

The euro high in the North American session has been $1.2772. Chart-based resistance looks to be in the $1.2800-20 area, the high from the European session. Hourly RSI's are over-extended and that leaves the euro caught between poor fundamentals/sentiment and near-term supportive technicals. Range trading is the most likely result near-term.

Disclosure: No positions

About the author: Marc Chandler

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Tuesday FX Interest Rate Monitor

Risk aversion took a step forward following analysis by Wall Street Journal staffers, claiming flaws in the methodology of the July stress-testing process across 91 European banks. The contention is that banks have understated the value of government paper they are holding, which underestimates maximum potential losses in the event that a government defaults. The story unleashed yesterday also claims that certain banks failed to include paper issued by specific nations, which might help explain why so many Eurozone analysts missed the mark at the time. Yields across the globe have claimed back much of last week’s losses as data warmed up especially in the world’s largest economy.

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EUR's Recent Run Lacked Clear Catalysts: Was That Really the Starting Gun?

Nothing that has come out over the last couple of days on Europe is exactly new; it has been festering all summer. However, the speed and ferocity of the renewed EUR splurge, without a really good catalyst, has caught us by surprise. The WSJ article, I mentioned yesterday, is irrelevant, but the market has been fiercely rummaging through their June notes to recycle the obvious.

In euros' defence, the Eurocrats have wheeled out the Clown-in-Chief at the European Central Bank (ECB) - “ECB's Quaden sees no double dip in Europe." Sounds great, but this is from the guy that didn’t even see the single dip coming.

Just after Northern Rock (NHRKF.PK) collapsed, and in the midst of the unfolding blow up in the credit markets, he said (see full speech here):

The latest news from Europe is not bad. 2006 was an excellent year and prospects for this year and next year remain positive.

He followed this speech in October 2007, saying:

As regards the short – and medium - term outlook, I would make a distinction between the main scenario, which is the most likely outcome, and the risk assessment. The most likely scenario remains favourable with growth still close to our potential but it is now surrounded by much more uncertainty than usual. And that applies to other regions of the world.

'Nuff said.

But the worrisome thing is, is that Mangler has spoken. And we know the correlation between Mangler speak and euro fortunes, and they are not positive. The market has grabbed ahold of this story, "Germany won't back Euro rescue fund for ever: Merkel," and is using it as new ammo.

"Forever," of course, is a very long time, but in the short run, Germany doesn't really have much choice unless they want to speed up the introduction of the NeuMark. But the main concern that Team Macro Man has is that she has broken ranks from the STFU policy and spoken out.

So where does this leave us? It still all seems too fast and too soon for euro collapse Part Deux. Also, the 40 point round trip in German 10-year yields over the past week perhaps indicates that the market isn’t quite sure of itself either.

And though we are fully believers of the macro concerns, re Europe, we feel that the timing is wrong. As for Switzerland, unless they manage to rent more space to park all the money flowing their way, they are in danger of doing a Mr Creosote. "One more wafer thiiiin swieees franc, sir?"

Was that really the starting gun to the race we have been in training for all summer? We are hoping we haven't been left behind and it's a false start, and the runners will have to return for a restart in a couple of weeks' time.

Disclosure: No positions

About the author: Macro Man

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Wednesday FX Interest Rate Monitor

Bonds have come back off the boil as investors try to figure out whether or not the European banking system might weigh any further on the global recovery following a recent poke at its methodology. Yields slumped on the news that Europe’s bankers might not have fully reported government debt on its books but as the shock wears off it seems that investors might be willing to return to business as usual. The lack of transparency in the reporting, even if were true, fails to answer the obvious question of whether or not the latest news increases the likelihood of a government default. It is hard to say at this point, however, that markets have brushed aside the report. However, firm action from the Bank of Canada quickly soured sentiment mid-morning reminding bond traders that recovery is out there – somewhere.

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What's Happening in Europe? Watch the Currencies

The value of a currency is “the single most important price in a nation’s economy.” So claims Paul Volcker.

If this is the case then the eurozone continues to have problems.

As information has filtered out that European banks may have more problems than originally thought given recent “stress tests”, the euro has shown continued weakness, almost across the board.

“The euro suffered and haven demand sent the yen and the Swiss franc to record highs amid renewed concerns over the health of the eurozone financial system.

Analysts said nervousness was heightened by news from the German Banking Association, which said the country’s 10 biggest lenders might need another €105bn of additional capital. Hans Redeker, of BNP Paribas, said the outcome of the European bank stress tests were being put in doubt.

He added that there were increasing signs that countries on the periphery of the eurozone, such as Greece and Portugal, were showing a frightening decline of growth momentum with the risk that these economies were moving into a debt spiral.” (See details here.)

This news seemingly resulted in declines in the euro against the dollar (down 1.4%); against the pound (down 1.2%); against the yen (down 1.8%) and to a record low against the Swiss franc (down 1.6%).

With all the weakness the United States dollar has experienced in recent months against other major currencies, the value of the dollar has shown substantial strength against the euro since the problems in the eurozone were exposed earlier this year. The euro reached a near-term high against the dollar in early December 2009, but then fell about 21percent against the dollar into early June 2010 as European nations rallied to stem their joint fiscal crisis. The euro recovered some after a “combined solution” was reached, but its value has declined once again and still rests around 16 percent below the December high.

Furthermore, there still seem to be unknown unknowns surrounding some of the nations in the eurozone (see “EU Probes Hidden Greek Deals as 400% Yield Gap Shows Doubt”) and some of the banks (see “German banking weaknesses come to light”).

Financial markets don’t like surprises.

It appears as if there are still some surprises to surface within the eurozone.

These revelations will continue to apply pressure to the leaders in Europe. It is so hard to form a common union where people want to maintain all the privileges of independence (fiscal and otherwise) yet hope to produce a common good (greater economic strength and unity).

Like any marriage, the partners have to give up some of the things that they cherished as individuals. Furthermore, openness and transparency is a “must” for any such relationship. The road to “unity” may be quite bumpy at times, but the partners must work through these periods and establish common understandings and good habits.

In the case of nations, there is an information market in which people can “bet” on whether or not the marriage will succeed. This market is the foreign exchange market. Right now, the market value of the euro is declining, indicating that the investors are concerned about how the eurozone marriage is working out. This weakness in the euro will continue until the fear of surprises disappears.

Disclosure: None

About the author: John M. Mason

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