Boiling Point: Currency Wars Take Center Stage

It's been over three years since the market stopped functioning smoothly, and central banks haven't yet wound down their efforts at stimulating growth. Instead, they're accelerating them, causing important correlations between currencies and stocks and bonds to break down, thus highlighting the need to own gold and stay liquid.

All this "quantitative easing"-QE as it's called-that involves central banks buying their sovereign bonds with borrowed money, is devolving into a game of "whack-a-mole" or, worse yet, currency wars. As one central bank prints money, it puts more pressure on the next to print in order to offset the negative effects a strong currency has on exports.

Whatever the IMF decides, I see two possible scenarios playing out that I'll outline below. But where it all ends is anyone's guess, which is why I think staying liquid and raising cash is important right now.

Shifting Correlations

The Bank of Japan's (BoJ) problems with yen appreciation stand out especially. Since mid-2007, the Rydex CurrencyShares Japanese Yen ETF (NYSEArca:FXY) has rallied over 40 percent as the yen has surpassed its previous high in 1995 despite the BoJ's recent intervention.

The chart below, showing the relationship between U.S. 10-year Treasury yields and the yen, tells the story. Notice how benchmark yields began moving opposite the yen starting in spring of 2007. While there have been brief periods like this before, it's never been more pronounced than since 2007.

(For a larger view, please click on the image above.)

One of reasons for this move is the overall deleveraging going on as everyone from individuals to corporations look to lighten their debt burdens. Another could be the simple fact that borrowing in yen to invest in Treasurys to capture the yield differential is no longer attractive. Some have even speculated that the dollar has replaced the yen as the currency of choice for the carry trade.

But what's significant and clear is that whatever the cause, the forces causing this divergence in U.S. yields and yen strength is still in full force today.

To make matters worse, the historical correlation between the S&P 500 and the euro/yen cross has gone by the wayside since the fall of 2009, as the chart below shows.

(For a larger view, please click on the image above.)

Both the BoJ and European Central Bank have expressed discontent with the current valuations in their currencies. Japanese officials have mentioned the 82 level for dollar/yen, while the European Central Bank would like to keep the euro below the 1.40 level. It will be interesting to see who has more success.

Assuming this correlation between U.S. stocks and the euro/yen cross still matters, and the yen weakens against the euro, it would appear that the cross will have to play catch-up, appreciating from here. Reverse that scenario-assume the yen stays flat or appreciates against the euro-and stocks will probably correct to the downside.

(For a larger view, please click on the image above.)

With all these cross-currents going on, I see one of the two following scenarios playing out in the near term.

First Scenario

The BoJ succeeds in weakening the yen and the ECB gets it way and the euro weakens from current levels. If this were to happen, the dollar would be in for quite a rally.

Looking at the the dollar's performance against a trade-weighted basket of currencies in the chart above, yen and euro weakness would mean the lows the dollar makes would over time become steadily higher than the 2008 bottom, as the trend line below the prices shows. In technical terms, that would imply a possible long-term bottom.

Should this play out, the currently crowded inflation trade-shorting the dollar and going long commodities-could be in for a vicious unwinding. It's not likely to unwind to the extent that we saw in 2008 when the market crashed.

But given the current skepticism on the effectiveness of the Federal Reserve's QE2 plans, and assuming the correction in asset prices becomes substantial-say oil drops down to near $60 a barrel-it wouldn't be outrageous to conclude that Fed policy will have become totally ineffective and that the central bank would be almost irrelevant.

This is the reason to stay flexible by maintain a cash position in the most liquid currency in the world, the U.S. dollar.

Second Scenario

On the one hand, the yen continues to strengthen despite more BoJ intervention, threatening the Japanese Central Bank's credibility and the Japanese economy; and on the other, U.S. yields continue to move to record lows as the Fed prints more money, and the euro moves back to 1.50-1.60 area.

Germany and Japan wouldn't be too thrilled with that outcome. Germany is one of the bright spots in the eurozone, so taking Germany out the equation, Europe as a whole would look a lot weaker. And Japan would most likely slip back into recession-not that it ever truly escaped since its own real estate bubble burst 20 years ago-and be horrified that the financing of its 200-plus percent debt-to-GDP ratio just got more expensive.

The good news for both the BoJ and the eurozone is that Treasurys are reaching what most feel are overbought levels despite the Fed's oversized bid in the bond market.

My hunch all along has been that the Fed is well aware of the "spillover effects" of its policies, and will not travel down this road to the extent it threatens its own objectives. How far the U.S. Central Bank actually pushes with QE2 is anyone's guess. Based on what's flying around the Street, the market is already positioned for bond purchases under QE2 to be anywhere from $500 billion to $1 trillion.

What I do know is that stocks rallying nominal terms and not real terms doesn't create equity or help anyone. The whole point of investing is to create wealth in real terms and it's hard to believe that the Fed is not aware of this, although its current actions designed to create inflation might suggest otherwise.

The cost benefit to the Fed certainly doesn't work at the expense of pushing the Japanese economy over the edge and throwing Europe back into a tailspin. Like I said, a lot is up in the air these days, so keep your inflation hedges and stay liquid.

Chadd Bennett is a trader and former financial adviser specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

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Copyright ® 2010 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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