Something of note always happens, either in the financial markets or on the geopolitical stage, or both, when this particular writer leaves for vacation – on this occasion the lower slopes of another major force, Mount Etna on Sicily. In fact, the past couple of weeks have been packed with incident and yet equity markets have proved relatively sanguine. Perhaps everybody is away on holiday, perhaps equity markets are genuinely much more immune to the periodic eruptions of bad news, having become quite used to them over the past twelve months or so. Whatever the reason, equity markets have appeared sanguine in the face of a paroxysm in the currency markets, further gyrations in global commodity prices, the Beijing Olympics and war in South Ossetia (coupled, more recently, with the signing of a military agreement between Poland and the USA). The obvious question is; are all these events linked in some way? If, as we attempt to reveal below, the answer is yes then it would seem prudent to encourage investors to remain wary until this particular tremor subsides.
Over the past week or so attention has focused on the dollar’s surprise recovery on the foreign exchanges. Ostensibly this has everything to do with interest rate differentials and the outlook for base rates on either side of the Atlantic Ocean (we are far from blind to the impact that the dollar’s revival, coupled with weaker base metal and oil prices, is having on the economies and investors elsewhere in the world but this note is back on familiar ground for conspiracy theorists). We have some sympathy with the view that UK and EU base rates will fall once headline inflationary pressure abates. Our expectation is that, in the not-too-distant future, headline inflation will peak and then begin to fall back.
Understandably, central bankers are becoming increasingly exercised by the outlook for growth. In the United States investors seem to be opting for the view that (despite its many pitfalls) headline Real Gross Domestic Product (GDP) will remain in positive territory. An upward revision to initial Q2 2008 output data has reinforced the perception that the next move in US base rates will be up rather than down. We do not agree. Earlier Week in Preview articles have illustrated the risks associated with pinning one’s colours too hard to that particular mast. Even if one were to adopt this folly, our assessment remains that the US economy could easily “double dip” as 2008 progresses into 2009. The positive impact of earlier tax rebates is probably past its zenith, while the positive impact of net exports may be undermined were the dollar’s revival to become entrenched. All that without the grinding inexorability of the credit crunch and its depressing impact on the housing market, consumer confidence and consumption. On balance we still think that the Federal Reserve has the scope to cut rates as activity slows.
In fact we suspect that something else is taking place. Not that long ago we wrote regarding the impact of speculators and the relationship between commodity prices and the dollar. Perhaps surprisingly, no readers criticised the piece, leading us to wonder if, maybe, we were right. Here’s another thing. Throughout August, Fannie Mae and Freddie Mac have been under severe pressure, unemployment in the US is said to be rising sharply, the credit crunch is spreading like a form of bubonic plague, driving foreclosures and creating personal misery everywhere and in the face of all this a series of backward-looking state-organised bail-outs has signally failed to reverse the onslaught. One might have expected markets to wilt and the dollar to buckle. Instead, the reverse has happened. In fact US equities have gained ground and the dollar performed strongly against its competitor currencies. Step from the shadows the, now formally recognised, Plunge Protection Team (formerly best known as the shadowy President’s Working Group on Financial Markets).
The existence of this group, never previously officially conceded, was periodically rumoured to have lain behind occasional bouts of market “manipulation” always on the outer limits of financial market legality. Now the Grouping has official sanction and its role as a market stabiliser enhanced.
More importantly, this Group is not a purely US vehicle. As the campaigning Hillary Clinton stated back in January of this year, the work of the team “has to be coordinated across markets with the regulators here (the USA) and obviously with regulators and central banks around the world”.
Get where we’re coming from? Essentially, the dollar has enjoyed nothing more than a massive global support operation and equities little more than a pronounced period of short-covering in consequence. Fears regarding the outlook for corporate earnings are running high, but fears regarding a possible dollar collapse are running higher still. Think we’re wrong? Here’s the data. According to the Federal Reserve itself, on 16th July it held $2,349bn US Treasury stock on behalf of overseas central banks (The Fed holds debt instruments in custody for global central banks and reports the amount it holds weekly). At the end of last week that figure had risen to $2,401bn, an annualised increase in excess of 38%. This rate of increase is significantly in excess of the rate of dollar take-up associated simply with a walloping trade deficit. This level of take-up smacks of aggressive intervention in the currency markets.
The acid test will be whether this level of intervention can do the job and hold the dollar at prevailing levels. On the basis that intervention is a palliative, not a cure, the pressing issue becomes one of healing the problems associated with the dollar’s malaise in the first place. That won’t be so easy and conditions may actually get worse in the months ahead. Ruth Simon, writing in the Wall St. Journal, has pointed out that c$400bn of adjustable rate mortgages (ARMs) are to, or will have, reset between March and October this year. Assuming that it takes between 3-6 months for debtors to hit the wall, a substantial wave of default is about to break forth from that particular fracture. This would take us to March 2009, just in time for the next round of re-fixing! Ms Simon goes on to explain a nasty little wrinkle known as option ARMs offering the holder the opportunity to pay less even than the monthly interest on the loan, increasing the loan balance until it reaches, typically, 110% – 125% of the original loan balance, at which point it resets significantly higher.
In fact these indications of personal pain to come merely scratch the surface of what is now estimated to be a $1 quadrillion magma chamber which is steadily rising to the surface. Banks, having attempted a partial recapitalisation, are still facing gigantic write-offs and debt refinancing over the next few months (little wonder the LIBOR rate has been rising). Once again the entire US (and perhaps Western) banking system is under severe threat and this is now really focusing the minds of strategists at 1600 Pennsylvania Avenue and beyond.
It has become so hackneyed a phrase that it has almost been forgotten about, however, the old adage that the best way of extricating oneself from trouble is to divert observers’ attention elsewhere, has seldom been more true. Bingo! Just in case the Olympic Games didn’t provide a sufficiently beguiling pretext for looking the other way, the, Pentagon-backed, Georgia launched an attack on the pro-Russian enclave, South Ossetia, on the same day that we were all supposed to be thinking about peace and love to all mankind during the Games’ opening ceremony in Beijing! Well, the timing will certainly have been sufficient to ensure no Chinese participation in events in the Caucuses. The strong Western media angle has been to support Georgia and its Harvard-educated puppet leader against what is equally widely regarded as heavyhanded Russian oppression. Quoted in the Washington Post on 12th August, the former [Soviet] president, Mr Mikhail Gorbachev, suggested that the massively inferior (militarily) Georgia could only have begun attacking Tskhinvali, fully aware of likely repercussions, provided it had had overt support from a “much more powerful force”. Given the region’s strategic importance, both economically and militarily, to both Russia and the USA, it’s not hard to arrive at who that “more powerful force” might be!
For those hoping that a change of incumbent in the White House following November’s Presidential Election might alter US foreign policy, it might be interesting to note that one of the chief “flag planters” in the region is none other than Zbignew Brzezinski (remember him?!). Mr Brzezinski one-time foreign policy adviser to Jimmy Carter, is now, many years later, an adviser to Barrack Obama!
One more thing, what links the dollar’s rise and intervention, to intervention of an entirely different kind in Georgia and South Ossetia? The answer might be that the Fed knew that by encouraging overseas central bankers’ support for the dollar, the heat would be taken off the oil and precious metals prices given the closely inverted nature of the relationship between the two. Could it be, that by driving the price of oil, gold and other precious metal prices down, any collateral concerns regarding the stability of the oil pipeline running through Georgia from the Caspian to the Black Sea might only drive prices of the latter partially higher, rather than to new all-time highs, thus re-igniting concerns regarding the onset of yet higher headline inflation? If that were the outcome the planners’ dream would have failed. With a dreary inevitability, the wheel would have come full circle, bringing attention circling back to the health of the US economy. In conclusion, financial market investors are right to be cautious. In what we suspect will be the not-too-distant future, headline inflation will fall and base rates will be cut, possibly aggressively. Before that, risks of all types remain at elevated levels.
• This article first appeared in Week in Preview, published by
Charles Stanley stockbrokers .