Dollar & Complacency: Mother of all Asset Bubbles?

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Outlook on Dollar, Currencies & Gold by Axel Merk, Merk Investments

Take a quick look at the chart:

When the stock market goes up almost in a straight line hitting record highs and volatility trends downward hitting record lows, it spells complacency. Complacency leads to asset bubbles. Asset bubbles, thus far, have never had a pretty ending.

Complacency: Mother of all Asset Bubbles

Investors have a tendency to ignore the hidden risks in their investments, even if those risks may be hiding in plain sight. You may recall the references to a “goldilocks” economy in the run-up to the 2008 credit crisis. Similarly, in the 1990s, what could possibly go wrong investing in tech stocks? What these episodes have in common is that the downside volatility of asset prices was unusually low. The pessimists warn of pending collapse, yet are ignored.

As an optimist, I agree with the pessimists. Not because I think the world will come to an end, but because the path from euphoric to normal is a rough one. When low asset price volatility lulls investors into believing the markets have become safer than they really are, folks take risks that they are bound to regret. Those that pile into the equity markets on the backdrop of ever shorter corrections, of ever higher asset prices, of historically low volatility, may be running for the exit fast when they realize they had no business being over-exposed to the equity markets in the first place.

Why Currencies?

We like the currency market for a few of reasons, including:

  • Historically, exchange rates exhibit low correlation to equity markets; in fact, if one employs an absolute return (long/short) currency strategy, one can design a portfolio that should exhibit low correlation to equities over time. An example I like to cite is that taking a position in the New Zealand Dollar versus the Australian dollar will almost certainly generate returns that are not correlated to how equity prices behave.
  • Low correlation can provide downside resilience. That may come handy should the quity markets reverse.
  • If deployed without leverage, a long/short currency strategy has a risk profile that – in our assessment – makes it a good candidate to be used instead of a bond allocation. While there are bond strategies that have historically had an even lower risk profile, few alternatives offer as compelling a risk profile as currencies.
  • The currency market provides unique profit opportunities as many market participants are not seeking to maximize their profits: from corporate hedgers to central banks, even tourists spending money abroad.

What follows is our currency outlook for the second half of the year. As all forward looking statements, these opinions are subject to change as we continuously evaluate new information and adjust our outlook accordingly.

The Dollar – Leadership Anyone?

The U.S. dollar has not been acting as a safe haven currency. Part of it may be because of a lack of leadership. We are not referring to Mr. Obama, but Ms. Yellen. And it’s not personal. The Fed has, in our interpretation, communicated that monetary policy shall be increasingly ad hoc. In fact, the best indicator of where rates will go may be whether the convicted felons that the head of the Federal Reserve profiled in her first public speech have a job by now. I wish this were a joke, but I’m rather serious about it: Yellen has indicated she wants to keep rates low as long as necessary to boost employment as long as inflation does not cause too much of a problem.

Curiously, when inflation numbers come out higher than expected, a currency often appreciates versus its peers, as investors anticipate the central bank will do “the right thing” and raise rates. It’s then, over time, that the currency reflects whether the central bank walks the talk. In the case of the Fed, we don’t think the Fed is likely to walk the talk. As such, we continue our overall negative view with regard to the dollar.

Eurozone – Real Rates Matter

Mr. Draghi, the head of the European Central Bank (ECB) has thrown in all but the kitchen sink in an effort to weaken the euro. It’s not working very well. It’s not working very well because negative rates on the deposits at the ECB don’t matter much when there are few deposits. The new initiative, the TLRTO (targeted long-term refinancing operation), while creative and well intended, is unlikely to weaken the euro. What weighs on the euro is that rates are expected to be lower for longer. However, what ultimately matters are real interest rates, not nominal interest rates. And there, we think the U.S. will have lower real interest rates even with the latest efforts of the ECB.

Add to that the overall negative sentiment regarding the euro and we think the euro should appreciate versus the greenback for the remainder of the year.

Sterling – Rates up Sooner?

The UK has had numerous tailwinds in its economy. Recently, Bank of England (BoE) head Mark Carney told us he was just kidding with his forward guidance that rates will stay low for a long time. He didn’t use exactly these words, but made it clear that a rate hike might come sooner than the market anticipates. One of Carney’s concerns is rising home prices; monetary policy can’t do much there, though, as it is cash payers, including Russian oligarchs, looking for safe haven assets – many of these investors are not particularly sensitive to rise in interest rates.

The main thing going against the sterling is that it has already appreciated quite a bit. Still, in our assessment, Carney is likely to walk the talk, providing support to the sterling in the coming months.

Aussie Catching up to Kiwi?

Talk about walking the talk. Rates are on the rise in New Zealand. Again the only negative is that the New Zealand dollar isn’t cheap. Of late, we had gotten a bit cautious about valuations, especially versus the Australian dollar. However, New Zealand has continued to march ahead, bolstered by a hawkish central bank; in contrast, Australia has continued to lag further behind.

We still think that the Australian dollar will ultimately play catch up (at least a little bit) to the New Zealand dollar.

Talking about Australia, the Australian dollar is “proof” that China is not falling apart. We think positive surprises for the Australian dollar may be triggered by good news out of China.

China – Volatility Good?

China is one of the most misunderstood places. The volatility in the yuan earlier this year was intentionally introduced by policy makers to put an end to highly levered arbitrage games between the onshore and offshore versions of China’s currency. The unwinding has been the cause for many headlines, including the fallout in the copper market (copper was used as collateral for speculators; except that some of the collateral appears to have been pledged multiple times); another fallout was that economic indicators were useless, as many financial transactions were disguised as real trade to circumvent capital controls.

As the dust settles, higher volatility will teach businesses to put proper hedging techniques in place, forming the basis for a further liberalization of the market.

We are less concerned about the housing bubble in China, notably because consumers rarely take out a loan; and while banks, municipalities and developers may face challenges, the fallout from a housing crash may be more similar to a stock market crash rather than what we experienced in the US as our housing market crashed.

Finally, China has made it a priority to provide small and medium sized enterprises (SMEs) access to credit. A major entrepreneurial boom could be unleashed as the allocation of credit matures.

In the context of many disliking China these days, we are increasingly optimistic about the outlook of the renminbi.

Japan – #yendoomed?

While we have a long-term price target of infinity for the Japanese yen, i.e. we don’t think the currency will survive, in the short term, Abenomics has taken a breather. In
recent months, we interpreted pricing action in the yen to suggest a failing reform agenda. Of late, however, the yen is failing to rally on occasions where historically it would have. As such, we think the trend of a weaker yen is likely to resume.

Emerging Markets – India Insight

Emerging markets in general have had reprieve from quiet global markets. Don’t count on that to continue. India is a bright star in the space, as capital is likely to flow back into India with the new government and a strong central bank in place. Some of that has already happened, but we think the Indian rupee may continue to outperform.

Norway, Sweden, Canada – Reluctant

Norway should raise rates, but will be reluctant.

Sweden should lower rates, but will be reluctant.

Canada has reached new records in being boring – the currency that is. Various models favor the loonie as a safe haven. Except that I don’t trust the calm: if we get volatility emanating from the U.S., we don’t think the loonie can stay out of the fray.

Gold – Long Term Diverisfier

As many of our readers know, we have increasingly been looking at gold as a long term diversifier as we think real interest rates, i.e. interest rates after inflation, may be negative for a long time. This is why our own long-term asset allocation includes a gold component.

Short-term, when gold starts to rally, as it did last week, people are worried about missing out. So both short-term and long-term we see gold as something to consider.

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