The Dollar Walked by Pavlov's Dog While Marching to Malthus Theory
Douglas Borthwick submits:
The USD has staged a comeback over the past week, as commodity market pullbacks led by aggressive margin adjustments have caused profit taking across the short USD spectrum. Our view of further USD weakness going forward continues, and we shall highlight the reasoning below.
We all remember the story of Pavlov and his dogs. He would ring a bell and the dog would drool, expecting to be fed. The market trades in a similar manner. When peripheral weakness is highlighted by the market, the automatic response is to sell the EUR and buy the USD. When news comes out that China is raising rates, or raising the reserve requirement, the market automatically sells the AUD and buys the USD. Is this the correct reaction, or is it an instinctual reaction? In both cases we would argue instinctual rather than correct.
Peripheral weakness has been noted before; in November 2010, the EUR/USD dropped from 1.4250 to 1.2986. At the same time the 2-year basis swap between the EUR and the USD widened from -22 to -52. The EUR/USD dropped while banks increased their perception of counterparty risk with European banks. This time around is different. The EUR/USD has dropped from 1.4940 down to 1.4170, yet the 2-year Basis Swap remains around -18. This is telling us that although peripheral concerns have sparked a pullback in the EUR/USD, the counterparty risk perception shrugs off the data.
Despite rating downgrades and media headlines of European insolvency, the forwards market is shrugging off the headlines. This can be somewhat explained by the rise in the interest rate differential between the US and Europe. In November, the differential was around 108 bps in Europe's favor, dropping to 80 bps. The most recent pullback in the EUR/USD has seen the interest rate differential drop from 168 bps to 151 bps in Europe's favor. The last time we saw the EUR/USD at this 1.41/1.42 area, the basis swap was at -22, and the interest rate differential at 108 bps. Now we have the basis swap at -18 and the interest rate differential at 151bps in Europe's favor. Both risk perception and interest rate differentials are telling us the the credit and interest rate markets do not agree with the anxiety shown in the currency market.
As for raising rates in China and the AUD/USD; China has raised rates consistently over the past 6 months and yet the AUD/USD has consistently strengthened. This is true from June 2010 until now, and was also observed from 2005-2008, when China was last in 'flexibility' mode. Market expectation does not fit market reality. China raising rates is not AUD/USD destructive, but rather AUD/USD constructive.
Pavlov's dog is running this show.
In the simplest of terms, Malthus believed that the world's population was limited by the world's food supply. However, the world has seen a dramatic shift over the past decade that challenges this view. As China and India have opened their doors and created domestic demand, the world's food supply has seen a significant rise in demand from a population that was already present, just not involved. Stimulating internal demand and growing economies at a near double-digit pace has created a tremendous number of consumers that weren't there a decade ago; amid fears of regime change, nations have to provide their populace with the products they demand.
Whereas someone may have eaten only vegetables, now they demand chicken. Those that used to eat chicken now demand pork, the pork eater moves up to beef, and so on. When a rural worker moves from a state of subsistence to working in a factory, he gains currency that turns him into a consumer. The consumer may demand an air conditioner, a better diet, perhaps even jewelry. This newfound demand for commodities with an expectation for delivery causes the present commodity boom driving prices higher. Price rises can be managed against 'speculators' via continued raising of margin requirements in the futures markets. However, while this works in the short-term, as seen spectacularly in the Silver market over the past few weeks, over the longer term, it will have no effect. As Asia demands delivery of commodity products, the prices have to rise.
The significant, almost instantaneous growth in the global consumer pool has fueled the growth in commodity asset purchases by China, India and South Korea from the 'Grocery Store' countries of the world, notably Australia, Argentina, Brazil, Colombia and Chile. If Asia cant have the commodity delivered through the futures market, it will gain delivery at the source by purchasing the underlying as it grows in the ground or lies beneath it.
China and the US:
This week saw a meeting between the US and China that was telling in many ways. The 'Grand Bargain' remains on track. China continued with its pledge to increase domestic demand and further strengthen the CNY, while the US pledged it would deal with its growing fiscal deterioration. We have discussed the US administration's pledge to double US exports over the next 5 years, and this has been duly noted by both the Fed and the US Commerce Secretary Gary Locke in recent days, with Locke noting the 'US is on target to meet doubling exports in 5 years.' This is the bright spot in the US is the growth in exports, and comes on the back of a weaker USD. With no rebound in sight for housing, indeed a double dip in the works, only through exports can the US create real growth.
The Fed cannot afford higher interest rates given the fragility of the US housing sector. Worries about inflation are tempered by consistent raising of margin requirements in the commodity markets. This is a short-term fix for a longer term problem.
A higher CNY will result in a weaker USD. Recent moves in the EUR/USD and the USD/Index are transitory in nature (to take a misguided quote from the Fed regarding inflation). Higher commodity prices will persist as the USD sells off going forward. It is time the market stops reacting to the peripheral Pavlovian bell and instead focuses on Malthus and the 'Grand Bargain'.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
See also Income Without the Dividend: A Strategy for Generating Income in a Down Market on seekingalpha.com
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