Submitted by Nic Lenoir of ICAP
We have complained over the past few months that there is simply way too much liquidity in the system, and that this is creating asset bubbles all around the globe. While this is quite obvious looking at the performance of the S&P 500, no matter what you may hear on CNBC or from your mutual fund manager about fundamentals supporting this move, the phenomenon has been exacerbated in emerging markets. It makes sense after all. Given that the crisis was rooted in the US and many issues haven't been seriously dealt with other than putting a little bit of lipstick on the occasional pig, a lot of money has been going abroad with the USD weakening, and emerging or commodity currencies screaming higher.
I pointed out Brazil on several occasions. While a lot of money has been funneled into Chinese markets via ETFs, after a 100% rally the Shanghai composite has been struggling to go higher since August and has corrected modestly, especially compared to the magnitude of the advance preceding the correction. The Bovespa has been rallying furiously too, up 125% since last October as of last night and showing no signs of slowing down. And this is when something unbelievable in modern economic policy happened: the Brazilian government imposed a tax on foreign investments to stem the ramp up of the Real. This is not only surprising, as demonstrated by the 4.5% sell-off today in Brazilian equities, but it is more importantly a great step.
I am not arguing whether taxing investments was the right solution to the problem, there are many people that will debate theoretical considerations over and over in a much more literate way than I could. The point is that for once someone said loudly enough to the Federal Reserve and other accommodative central banks: "your liquidity is no longer welcome". There are many people who have argued that the policies currently experimented in the U.S. will have very nefarious consequences in the future, but the best form of protest has been to buy gold, which in itself is a carry trade and is permitted and encouraged by those same policies of excess liquidity... The dog is biting its tail a bit with this strategy, especially since if the government did what the investors criticize it for not doing, then the trade would lose massively. Not very satisfactory morally, and it correlates to pretty much every other risky asset but with less beta so it underperformed quite massively a lot of the other carry trades.
This is why this move by Brazilian authorities is such a good thing. With more actions like this one maybe we will not have to chose between carry risky assets against a low yielding currency as the only trading strategy with a viable horizon beyond 24 hours. It is also interesting to note that this comes hardly two weeks after the Chinese government raised the ceiling of allowed investment in domestic shares by foreign institutions, basically the exact opposite measure. And many other governments who have been complaining about the excess liquidity of dollars flooding all markets showed no better common sense than borrowing in USD by issuing USD-denominated bonds, thereby proving they don't believe or understand the message they are trying to convey in their official speeches, and they have learned absolutely nothing from last year's funding crisis. So for having the courage of its aspirations, we salute Brazil!
In terms of markets it is hard to tell whether this is the beginning of a sizable correction or not. We have no dented enough into the profts of the carry positions to really have some stumbling around the exit doors just yet. If we could take out the 50-dma in EURUSD and USDJPY it would be a start. Testing the 50-dma in AUDUSD would alost be a victory in itself, as sad as it is to say. But this move by the Brazilian authorities could be the first of several by other governments. A friend pointed out to me last week on a couple occasions that New Zealand is very uncomfortable with the NZD where it is, and that rates expectations there are grossly overstated. Apparently he was citing some discussions with central bank staffers there, and his arguments were very convincing. Maybe this kind of news will embolden them to take matters into their own hands.
In the meantime I will be watching carefully trend following indicators to assess the level of pain of carry traders. After all we are only overdue for some payback! As per our trade update yesterday and this morning it seemed the Dollar Index was due for some short-term strength and equities for a retracement. We haven't even breached the intermediary support at 1,082 in S&P futures, and the DXY is a touch short of our short-term target of 75.80. Our short-term entry was good, but there is little reason to get too excited just yet. So let's take a few minutes to thank Brazil and remain vigilant.
Good luck trading,