An Alternative Reserve Currency?

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Includes: IEF, UDN, UUP
by: Jim Delaney

In days of old, when men were bold... err... better not go there; ok, let’s try this.

Trade has been an integral part of man’s existence since the caveman with the pelts gave some to the caveman with the fire so that they could both spend a leisurely evening reading by fireplace while Wilma and Betty went out to gather more wood, sporting the latest in outerwear, of course.

As things progressed and transportation improved to something you rode on and then in the circle of trading, partners grew organically as accessibility increased. For a long time most trade went on with those people and countries that were geographically closest to you. Trade has existed for a very long time but export-led economies are truly a 20th century phenomenon.

With this in mind it was interesting to read some of what went on at the summit held this past weekend in Yekaterinberg, Russia, attended by Brazil, Russia, India and China or the BRIC countries as they are more commonly referred to.

The main result seems to have been the crafting of a statement which included the view that “The emerging and developing economies (especially the four of us) must have a greater voice and representation in international financial institutions. There is a strong need for a stable, predictable and more diversified international monetary system.”

This, for all intent and purposes amounts to a knock on the USD which is interesting because before the meeting the Russian representative, Alexei Kudrin, was quoted as saying that his country had “full confidence” in the USD and that it was “too early to speak of an alternative” reserve currency.

The effect of all of this is that the market, in its own weird and wonderful way, keyed more on what Alexei said than the official statement from the BRIC-a-brac. This gave pause to those who had been buying all things commodity related in hopes of the dollar’s demise. Can you say schadenfreude?... Sure, I knew you could.

Lawrence Eagles, head of commodities research at J.P. Morgan Chase Bank, was a little more sanguine saying, “there has been some profit taking going on,” when describing the recent pull back in commodities.

So, right about now you might be saying: I get all that but how does it relate to credit spreads. I have asked myself that very same question about a million times since Monday rolled around and the market looked, once again, like it was on its way to hell in a hand basket.

I’m not saying this is the answer but my reasoning goes something like this. Credit spreads are a combination of company specific as well as economy wide views on the credit environment. Last week, eons ago I know, inflation was going to make the Weimar Republic look like a walk in Volkspark and interest rates were priced accordingly with the 10-year screeching towards the big 4.0.

When yields on Treasuries rise or fall quickly the instruments priced off of that curve do not react instantaneously. Therefore, spreads will contract some when yields are rising and widen some when they fall. This is not a permanent condition but more of a delayed reaction sort of thing that usually corrects itself within a few days.

In this latest instance this was represented in CDS land as narrowing spreads, which have had a tendency in the past of coinciding with higher stock prices and which seemed to be following that script this time and causing yours truly to increase the number of long positions in the CEC Portfolio.

The subsequent falloff in UST yields, possibly as a result of demand for paper paying 4%, when shorter term paper is trading in basis points or a glimmer of hope for the continued existence of the USD as per Mr. Kudrin, relieved some of the pressure in rates causing a widening in spreads which then resulted in the selling out a good portion of the long positions and increasing the number of short positions in the CEC Portfolio.

It has yet to be determined whether the move afoot is “the move” or as the gentleman from JPM said the result of “profit taking”.

I’ll be trying real hard to figure that out over the next few days and will be sure to let you know what I find.

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