9 Comments on the Global Market

by: David Merkel, CFA

1) In an open economy, you can control your exchange rate or your interest rates, but not both. The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed(October 1987). This article from Morgan Stanley goes over the same idea. Pay attention to the investment implications at the end, though Hong Kong may have already rallied enough.

For a more bearish view, many Asian economies are facing the choice of slowing their economies, or importing inflation from the US. My sense is that we are in an uptrend for inflation globally. Few central banks are truly pursuing sound currencies.

2) Europe is no monolith here. Managing the ECB is some trick, because money is political, and there is monetary union without political union. The Swiss Central Bank continues to tighten, while the Bank of England effectively loosens, because of the recent panic there, involving Northern Rock.

3) One of my favorite observations about technical analysis is that slow moves tend to persist, while fast moves tend to mean-revert. Well, the US dollar is having a grinding, slow adjustment downward. To me, that is just another indicator that the decline will persist.

4) Will the Saudis drop the dollar peg? Maybe. Given the current inflation rate there, I would suspect that they, and other Persian Gulf nations, will move to a currency basket approach that has a high US Dollar weighting. That will allow themselves the flexibility to make further adjustments that allows them to arrest inflation. That will lead to further declines in the dollar against other currencies.

5) What makes a currency attractive? GDP growth and high real (inflation-adjusted) interest rates. The US has neither of those now.

6) An old dear friend of mine, Roy Hallowell, had two merciful rules: a) We all make mistakes. We ALL make mistakes. b) Most of them are like the rest of them. Such is Goldman Sachs Global Alpha. They played too much on the carry trade and got burned, among other bad trades.

7) I am not a bear on emerging markets as a group. There are some running bad monetary and fiscal policies that I would avoid (Latvia, Iceland, Bulgaria, Turkey, and Romania are examples). But in general, many of the emerging markets are not dependent on US conditions to the same degree that they were before. Many are in better shape to face volatility than the US.

8) Given the fall in the implied volatility of the yen, the yen carry trade is coming back. The carry trade works best when implied volatilities are low, because the cost of protection against adverse moves is modest. But, if low interest currencies persist in tightening, the carry trade could be a bad bet. My thought : Japan is not tightening anytime soon, and the carry trade continues there. Switzerland goes the other way.

9) China is different. So what’s happening?

That’s all on this topic for now.