Category: currencies

Is gold the canary in the carry trade coal mine?

According to a recent article in Bloomberg, various asset classes have been 90% correlated to the upside over the past 8 month rally, the highest such correlation of the past 50 years. In other words, the global carry trade is back with a vengeance. Only this time the primary funding currency is the U.S. dollar (i.e., the speculators are short the buck).

These tight correlations blew apart on Friday as the dollar and stocks rallied on a better-than-expected employment report while gold tanked $60/oz. and bonds sold off. Will “good” economic news unwittingly prick the carry trade bubble and provide the gravitation pull that pancakes these assets in concert? We suspect so. We also suspect that gold will at least hold up better than equities.

Three months ago the Gold/S&P 500 ratio bottomed at 0.93. By last Thursday this ratio had rallied to 1.10. Today it stands at 1.03 (1143.50 per oz. gold/1108 on the S&P). This ratio peaked at nearly 6x during the gold bubble of early 1980 and troughed at 0.20 in 2000-2001. With the monetary authorities hell bent on destroying the economy and ultimately the currency, a ratio of 2, 3, or 4x is not outside of the realm of possibilities.

Even supermodels are bearish on the dollar

Although Dennis Gartman makes us wince at times with a lack of humility, we were impressed by this observation about the dollar on Bloomberg Video last Thursday:

Everybody, everywhere is short the dollar in any sort of manifestation they can get their hands on… In 35 years of watching markets, I cannot recall a single trade that has been this one-sided. And when the public gets that one-sided, it usually ends in tears.

Sure enough, today Bloomberg revealed supermodel Gisele Bundchen has joined the chorus of dollar bears:

Bundchen wants to remain the world’s richest model and is insisting that she be paid in almost any currency but the U.S. dollar.

Like billionaire investors Warren Buffett and Bill Gross, the Brazilian supermodel, who Forbes magazine says earns more than anyone in her industry, is at the top of a growing list of rich people who have concluded that the currency can only depreciate because Americans led by President George W. Bush are living beyond their means.

The article quoted Bill Gross…

We’ve told all of our clients that if you only had one idea, one investment, it would be to buy an investment in a non- dollar currency. That should be on top of the list.

… and Warren Buffett:

We still are negative on the dollar relative to most major currencies, so we bought stocks in companies that earn their money in other currencies.

We will admit to being particularly partial to the dollar’s prospects againt Gisele’s currency of choice, the euro. After all, the Bullish Consensus on the euro is 93%. According to The Economist’s Big Mac Index, the euro is roughly 29% overvalued vs. the dollar on a purchasing power parity basis. The ECB grew its balance sheet around 12% in the past 12 months vs. about 3% for the Fed. Credit problems are clearly not isolated to the U.S. And now supermodels are dispensing with investment advice on Bloomberg that amounts to jumping on a bandwagon that’s been rolling along for 6 years.

More kind words for the U.S. dollar

We feel too many people are leaning the wrong way with the dollar. Mr. Market is set up to drive the most people crazy. If so, the scenario that drives the most people into a padded cell is inflation in the things they buy and deflation in the things they own on margin (although goods inflation and asset deflation could be relative). A credit crunch would bring this about and the knee-jerk reaction would be to get liquid, i.e. raise dollars.

Year-to-date, the vast majority of mutual fund flows are going into global funds, the Bullish Consensus on the dollar index is at 19%, Canadians are coming over the border to buy cheap American goods, and dollar bears like Peter Schiff are strutting around like peacocks. Though there is plenty of froth in the U.S. equity market, the real froth is in emerging markets (especially China). We think the idea that global markets escape the U.S. storm for the first time in modern history is pure fantasy, particularly with their best customer – the U.S. consumer – going into a coma. A good old fashioned contagion would squeeze out these excesses, returning the dollar to its original safe haven status, at least for awhile. Finally, the latest Grant’s shows Federal Reserve Bank credit growing at a 2.3% annual rate in the last 3 months and 3.6% in the past year. Meanwhile, European Central Bank assets grew at a 21.0% rate in the last 3 months and 12.3% in the past year. Why the ECB’s rapidly inflating fiat currency is head and shoulders above the American brand is beyond us, yet the vast majority of investors remain convinced.

The exception to being bearish on foreign currencies is clearly the Japanese yen (Bullish Consensus = 49%). 2-year government paper in Japan yields a miniscule 1.32%, not exactly a haven for investors. In fact, by some estimates, speculators have borrowed upwards of $1 trillion in the yield-challenged yen to lever up into higher yielding currencies like the Euro (93% BC), British pound (89%), Canadian dollar (93%), Aussie dollar, and New Zealand dollar. If, in fact, the great unwind is underway, this massive carry trade will largely liquidate itself to the yen’s advantage. Bank of Japan assets have actually contracted 4.5% over the past 12 months, although the BoJ has exanded its balance sheet at a 36.0% annual clip the last 3 months.

Over the weekend, the G-7 meeting failed to produce any political support for the dollar. Yet, after an initial drop, the dollar is rallying – perhaps a sign that the dollar pessimists have largely exhausted themselves.

The case for the U.S. dollar

A good friend and astute observer of the financial scene posted “The Case for the U.S. Dollar” on Prudent Bear’s message board last Friday:

The case against the US dollar is well documented and explains why gold has been so strong. Gold may also do well in a period of sustained dollar strength and credit deflation as the “currency of last resort”, but this latter thesis is untested and vulnerable and thus the first investor reaction to a strong dollar is likely to be to sell gold.

The case FOR a strong dollar against other fiat is simply that the alternatives suck worse:

Japan: The BOJ is screwing its culturally-predisposed saving-society with close to 0% interest rates; Japanese housewives are speculating in the difficult currency markets in a desperate attempt to offset dwindling investment income. China: Interest rates below US rates for an emerging market with high and rising inflation, an opaque banking system, corruption, and corporate earnings juiced by corporate treasury stock speculation.

United Kingdom: The UK is the US Financial System on Speed. Real estate bubble, sub-prime mortgage debacle, current account deficit and interest rates too high to support it all. Oh, and a central banker who warns about moral hazard a day before deploying it. What a joke.

Euro: This is an untested currency. Let’s see how the Greeks and Italians (with budget deficits much bigger than the US, by the way) handle “cohesion” when their economies go down the drain. They’ll want a much weaker currency or they’ll want out. But more relevant to the present, the US may have created all the “exotic” mortgage crap, but the naïve German banks bought the stuff. Germany is pissed at what they perceive as US rating agency fraud; they will unlikely be willing to accept a strong currency and weak exports for a fraud perpetrated against them. Oh, I almost forgot. Spain is about to financially implode.

Central Europe: Let’s see, Hungary and Poland are funding their mortgages in Euros. Smart move until it blows up. Latvia has a bigger real estate bubble than US. Czech Republic has lower interest rates than US.

Russia: Check out the money supply. Don’t ever complain about US M3 growth unless you are willing to complain doubly about monetary growth in Russia. The Ruble is obviously very dependent on high oil.

Well, you can always buy the Thai Baht but it’s now a negative carry trade!!

The difference between US dollar bad news, and non-US dollar bad news, is that the latter is NOT priced in.

Predictably, our friend’s contrarian take was not well received. In fact, the dollar is routinely despised, particularly among the bear community.

We must profess a small, but growing, place in our hearts for the lowly dollar. In five of the past six years, it has lost ground versus the currencies of its trading partners. Last Friday, the Bullish Consensus on 5 major currencies (yen, euro, pound, Canadian dollar and Swiss franc) averaged 80%, one of the most exuberant readings ever. The U.S. Dollar Index weighed in with just 20% bulls. The loonie is so strong, Canadian students are reportedly throwing parity parties and shoppers are crossing the border in droves in search of bargains.

Our dollar-warming friend makes an intriguing point: the dollar may be trash, but is it really any worse than other fiat currencies the world over? After all, the European Central Bank grew its balance sheet 9.7% over the past year versus just 3.5% for Bennie and the Fed. The official government-doctored inflation rate in the U.S. clocked in at 2.0% in August, while China’s statisticians admitted to a 6.5% annual CPI rate. And let’s not forget, the U.S. was not the only country fomenting a mortgage finance bubble – just look at the housing-related messes in the UK and Spain.

So the dollar does have some redeeming qualities – it is undervalued (on a purchasing power parity basis) and enjoys plenty of competition in the monetary mismanagement department. But perhaps its strongest appeal right now is that it is nearly friendless.

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