Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?
As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.
Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.
Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.
Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.
We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.
Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.
To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.
M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)
Figure 1 M2
Source: Board of Governors of Federal Reserve
The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.
Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)
Figure 2 Fed’s 5y-5y forward break-even inflation rate
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.
This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.
Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.
(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline
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