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The Currency Market: Ruled by Rhetoric

 

Is there an easier market to trade right now than the currency market?  There are basically 2 trades going on: risk taking and risk aversion. While this will come as no surprise to anyone who’s in this market, investors in both the stock and commodities markets should also pay attention.

 

Let’s face it, if it were up to the market, stocks would be back to pre-Lehman collapse levels, gold bugs seem to be happy with the price of gold, oil would be extremely cheap, bank interest rates would be higher, yet mortgage rates would be where they are right now, and we’d have a strong dollar. Sounds just peachy, doesn’t it?

 

Of course it does, it’s a complete fantasy. Yet those in government believe they can create situations where they can attempt to achieve these ideal conditions. How do they do this? Through their words.

 

The nice thing about the currency market is that it tends to “trend” more so than other markets. This is good for investors. But bad for policy-makers. Especially if they are firmly rooted in a downtrend. The direction of the trend is established by their decisions, so it follows that they way to change the trend is by changing their decisions.

 

The conflict occurs when they try to achieve the ideal conditions as they are seeking to make the impossible possible.   And in no currency is this truer than the US dollar. After all, in having the world’s reserve currency, US policy makers have a little more juice than their counterparts.  This means that almost all markets are affected by US policy.

 

Again, nothing new here but what it does illustrate is how the markets have essentially become a “tale of two trades”.  The risk taking trade (sell USD &JPY, buy stocks and commodities) and the risk aversion trade (buy USD & JPY, sell stocks and commodities) is not only a bit counter-intuitive, but also a case of “throwing the baby out with the bath water.”

 

A perfect example of this was President Obama’s double-dip recession comments from earlier this week. While the timing of these comments has been debated in the blogosphere, one thing can be certain. Obama was clearly trying to send a message to the Chinese that it is very easy to change the short-term direction of the US dollar without having to change policy. He can do it through his words. 

 

I mean, is the US really in any more jeopardy of falling into the double-dip on Wednesday then it was a week ago? A month ago? A month from now? What this does is slow the pace of the dollar decline, to appease our largest debt-holder. And what we’ve gotten is two days of the risk-aversion trade. 

 

Surprise!

Those comments notwithstanding, what happens if we really do fall back into double-dip recession? 

 

Based on the “tale of two trades” scenario, one would likely assume that investors would dump stocks and commodities and buy US dollars and Japanese yen. However this time I think it might be different.

 

While stocks will surely take a beating, and oil will sell off due to decreased demand, I think I’d still want to hold gold over US dollars, even if it is losing value. There is a reason why guys like David Einhorn and John Paulson are investing heavily in gold, as the flight to safety trade should be to the precious metal and NOT the US scrip.

 

I also wrote recently that regardless of what the risk trade tells me, I want to be long the Australian dollar (AUD). Not only for the interest rate differential via the carry trade, but also because of the Australian economy’s link to gold.

 

So while US policy makers like to get cute with the rhetoric, I’m closing my ears and keeping my eyes open!

 

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