The Global Frown
August 12, 2010
By John R. Taylor, Jr.
Chief Investment Officer
Everything was fine last week. Even the ugly US employment numbers that were released on Friday morning were greeted with enthusiasm by the global marketplace as both the bond market and the equity market rallied. What could be better? The numbers weren’t that bad and there was always next month when they could improve. Why not hope for the better outcome in the future as the government authorities and the news reports wanted you to believe? Basically numbers like the ones last Friday are ‘Goldilocks’ numbers, not too hot and not too cold. They allow everyone to think that things are not great, but the authorities can, and will, make them better. Poor employment numbers imply the Fed will lower rates, which would make equities more attractive in the future (using the dividend discount model or something similar). At the same time bonds rally as a result of the projected lower rates, and finally the dollar declines which helps commodities and carry trades, also making it easier to repay outstanding dollar-denominated debts. Winners all around. “Sweet!”, as they say in the lottery ads here in New York.
From the foreign exchange point of view, the market calls this the “dollar smile”. If the dollar’s economic numbers are weak, but not terrible, then the dollar will decline while all other markets rally – this is the dip in the middle of the smile. If the numbers are good, then the dollar will rally – twisting the right end higher. But if the US numbers are truly terrible, then the dollar will rally as well. The rationale seems complex but the forces moving the dollar are very powerful. If the US economy is perceived as heading into recession, then banks and other financial actors take risk off the table, cutting back their balance sheets, which sets off a scramble for dollars. In the modern marketplace, recessions make the dollar go higher. The very aggressive dollar rally in the fall of 2008 is a powerful example of what happens to the left end of the dollar smile. From the US point of view, this is clearly a dollar smile, but when the same thing is seen from the rest of the world, it becomes a global frown. If the US is either strong or weak, the global markets suffer. Profits are made only when the US economy is struggling along, and losses multiply when the US either goes on a positive tear or gets into serious trouble.
Things changed dramatically between Friday, when the weak employment numbers were released, and Tuesday afternoon when the Fed announced it was edging back toward Quantitative Easing by taking the roughly $180 million it received from interest and pay-downs in its MBS portfolio and reinvesting that cash in the Treasury market. This move told the world the Fed saw the US economy headed into a recession. Although both Friday and Tuesday signaled a weak US economy, the Fed’s position only became clear on Tuesday, and by early Wednesday, the whole world knew the US economy was headed lower. The Fed’s move signaled the situation was not a lukewarm Goldilocks but a cold one on the way to getting colder. At FX Concepts, we have been calling for a recession next year, and as the Fed – and the market players – come to realize this, equity markets, commodity prices and currencies (except the yen) should all decline. At the same time, liquidity should tighten dramatically, credit spreads should widen, and government bond markets should rally strongly. Although the US signaled the beginning of the coming recession, the Eurozone is still naively expecting its €750 billion rescue plan with austerity thrown in to save the day. Our analysis argues that this plan will start crumbling within the next few weeks, sending the euro sharply lower once again and ushering in the deep recession of 2011.
h/t Teddy KGB