Currencies | Dec 14 2009
By Greg Peel
I don’t think many would disagree it’s become a dull and dreary old Australian stock market in December. As we enter the third week thereof, any hopes of a famed “Santa rally” can now be put to bed. Volumes have become thin as interest has waned.
It’s probably a sense of world-weariness as much as anything else. Like 2008 before it, 2009 has been a tumultuous year, causing almost as must angst by featuring a rising stock market as 2008 did with a falling stock market. With Christmas and summer holidays rapidly approaching, investors seem now to be happy just to sit out the final days before hitting the beach.
The story is same in the US, except for the “hitting the beach” part. The US case is simply one of locking in profits and shutting up shop ahead of the year-end close of books (most US companies run a fiscal year as a calendar year) and determination of bonuses. Volume on the NYSE has become so thin as to scare off volume, thus becoming a self-fulfilling ghost town.
A large part of the stock market rally of 2009 can be closely tied to the year’s ongoing weakness in the US dollar. Apart from driving commodity prices ever higher, and ever further away from actual demand levels, a weak dollar has reflected carry trade activity in which US and international investors borrow in US dollars at low historical interest rates and exchange those dollars for risk assets such as local and foreign stocks, commodities, and anything to do with emerging markets. The weaker the dollar, the more this activity is prevalent, the more risk asset prices rise, the more investors are encouraged to join in the fun.
The theme for most of the year has been that if the dollar is down, the stock market is up, and vice versa. This has worked for Australia as well because US investors have used a weak dollar to provide funds for investing in Australian stocks and to pick up on the appreciation of the Aussie dollar as well. Hence there is a risk on both sides of the Pacific that if we were to see a meaningful bounce in the US dollar, we would finally get the meaningful stock market correction many have been expecting all year.
Commonwealth Bank chief currency strategist Richard Grace remains fundamentally bearish on the US dollar, but for the next few weeks sees risks to his thesis. After a few weeks of increasingly disappointing US economic data, last week saw a sudden change in fortune. The US unemployment level suddenly dropped, retail sales surged, and confidence measures spun around from earlier flatness.
These data caused a notable jump in the US dollar index. From late November when the Dubai debt scare surfaced, causing a brief rush back into safe havens from risk assets, to currently, the US dollar index has risen 3%. That’s actually a big move in a short space of time.
Grace also warns we might be in for a more upbeat statement on the US economy when the Fed delivers its “rate decision” on Wednesday night. If the Fed wavers even slightly from its “exceptionally low interest rates for an extended period” mantra, the dollar will go for a run. Already investors are becoming increasingly nervous about a rate rise sooner rather than later in the US, and Grace notes Wednesday night’s US consumer price index result is expected to show the end of a period of deflation.
Deflation is bad for a currency, because real asset yields fall and capital inflows dry up – in this case when the US is trying to fund a massive deficit. Similarly, high inflation is bad (which can be brought about by excessive money printing) because it erodes asset values. That’s why central banks like to target CPI inflation of about 2-3% – it is the healthy middle ground and indicative of a healthy economy.
In the longer term, most economists and strategists – Grace included – expect the US dollar to continue devaluing as the US deficit weighs heavily on the US economy. But no one expects a simple straight line depreciation. There will be bounces in between, and we might be experiencing an ongoing one right now. Grace also points out the market remains very short US dollars.
Don’t get caught out by people telling you this oft-noted position is rubbish because clearly the whole world, and particularly China, Japan and Germany, holds mountains of US dollars. It’s not about central bank holdings, it’s about short term trading positions held by the punters. Currently the Chicago Mercantile Exchange shows non-commercial (ie speculative) positions in US dollars to be very short. Although shorts are not currently at a record, Grace suggests, “Even a ‘small’ reduction in net USD short positions will generate a significant surge in the USD”.
So the risk is that in the next few weeks the US dollar will go for a run. Thus the risk is that the US stock market, and subsequently the Australian stock market, will go for a dive.
Or will they?
On Friday night in the US both the US dollar and US stock market rose on positive data, which is a “normal” response in “normal” times. But 2009 has not been normal. A zero Fed funds rate is not normal and that’s what is generating the US dollar carry trade. So for all of 2009, we’ve had an inverse relationship.
But has the fact the US stock market failed to drop on a dollar rally mean we no longer need to fear a US dollar bounce?
Possibly, or possibly the interest level on Wall Street is so low right now that index movements are entirely unreliable as indicators. The S&P 500 remains near its highs despite the dollar bounce to date but is not really threatening a break-out. Yet if the Fed does soon indicate when it might move its funds rate of the current zero low range, carry traders will see their carry costs jump and their risk trades become less profitable. There should be at least some sort of exodus, from both commodities and stocks.
We may need to wait until 2010 to really find out.
