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Who is Going to Blink with Currencies?

By Chris Laird      Printer Friendly Version
Sep 20 2007 2:27PM

USD, Euro, Yen, Yuan, Ruble, Gold

There are three major phase changes happening in world financial markets. These are

Currency competition and pressures

World credit crisis and financial stress

Financial/stock volatility based on a weakening US economy


When I ask the question, who is going to blink on currencies, that is because the USD has broken decidedly below its recent low of 80 on the USDX, now in the 78 range. 80 has been a sort of benchmark for the economic order of things since 2002, a low. It reflected the situation of the expanding US real estate and credit bubble. Furthermore, EU bankers and industries have commented that 1.40 for the USD/Euro is a level that would call for intervention by the ECB and co to stop the Euros rise. We are in that range now.

Additionally, Japan has been intervening in the Yen/USD whenever it got near 110, and we are getting near that point now as well.

China has an ongoing controversy with the US regarding the Yuan/RMB, it now trading higher than its former peg above 8 to one at about 7.5. The Chinese even stated that they might use the ‘nuclear option’ to dump USD reserves if the US pressures China further on trade issues.

Russia is in the process of building the strength of the Ruble into a super resource currency, and is getting rich selling resources and oil with record prices in these.

The Euro is gaining stature as an alternative ‘reserve currency’ in world central banks, as there is concern the USD is losing its advantages. Reasons for this include the weakening US economy and huge trade and fiscal deficits and record debt. Also included is declining US interest rates which will reduce the interest rate premium US bonds have enjoyed, and supported the USD.

So, just from a currency standpoint, there are very strong opposing forces to either strengthen or weaken the ratios of these currencies, while key levels are being hit, such as 1.40 for the USD/Euro. The world central banks, as well as their economic constituencies are going to have to consider if they will allow or can stand key ratios of the past to be decidedly broken, as in the USD dropping to the 78 range on the USDX.

The currency situation is rebalancing, and even perhaps telling us that a major phase change is occurring with their ratios, meaning major changes in progress for the world economy, trade balances, and just about everything economic. Basically, the whole system has been based on a relatively strong USD (stronger than it really should be).

A key part of this currency situation is going to be rebalancing of large carry trades in the Yen and European currencies such as the Swiss Franc. This is going to be a major liquidity issue.

So, we are possibly at a major sea change for many aspect of the world economy. Much of this is being driven by pressures our trade partners will face as the USD is falling below what used to be a key benchmark, 80 on the USDX (US dollar index heavily weighted to the Euro).

Gold as a reserve currency

But gold is also playing a role here - as a currency in its own right. Now, before we continue, I do want to say that a lot of gold’s action recently is speculative activity. I also have to state that anytime gold rises as much as it has recently, it is subject to major liquidity driven selling if there is a serious world stock decline. But those caveats aside, gold is now reflecting its role as a currency and central bank reserve asset/currency, and is rising because of this emphasis.

Since the advent of the credit crisis in August, markets have been heavily pressured by deleveraging pressures and this has not abated. The central banks have flooded money into the credit and money markets, attempting to lower short term money rates, such as LIBOR (London interbank rate - short term money banks use to lend to each other). Even the BOE, until recently resisting such flooding, has been forced to relent and bail out banks and even go so far as to assure the public that they will guarantee deposits  further than their present 35000 pound deposit insurance. The mess with Northern Rock is an example of this.

Overall, I estimate world central banks, led by the EU have flooded over $700 billion worth of money into the credit and money markets to combat the credit crisis and the frozen CP markets in the last month. In the US alone, CP (short term commercial paper used for operating credit lines) has shrunk over $300 billion in the last month. That is out of a total US CP market of $2.2 Trillion. This situation is not fixed. This puts pressures on banks, institutions and companies to use/hoard cash as they cannot roll over short term credit. Basically, this is highly restrictive for economic activity. The EU faces similar and even more serious issues with their CP markets. The problems in the CP markets are a key reason EU and US banks are having major trouble.

Gold is now acting as a reserve currency in its own right, turning thumbs down on all this central bank intervention, as well as seeing flight to safety in gold as a haven. Much of gold’s recent bullishness up to July this year was related to the speculative gains that sector enjoyed from 2002. That picture is, for the moment, changing to a gold rally based on its reserve currency aspect which is asserting itself against falling interest rates, a falling USD and central bank flooding of liquidity.

IF this aspect maintains itself, gold may rise to totally new levels, easily exceeding $800 by year end, and may even carry on into 08 rising - I’ll hazard a guess - to over $1000 USD, a level that would truly reflect a change to gold now basing its rise on its more true nature - that as a true money, as interest rates drop world wide and there is flight into gold for financial safety, and as central banks have no alternative but to start monetizing losses from the collapsing credit and derivatives markets. IF there are further serious problems in credit markets, and large stock drops, interest rates will drop, and central banks will be again forced into big liquidity injections to at least try and stave of panic selling in many markets.

But, against this very gold bullish scenario, we have the prospects of further world stock declines. These may be larger and longer than anything we have seen for various reasons.

For one thing, the world is presently in the midst of an unwinding credit boom. There is so much leverage overhang on markets, that I do not expect they can escape a major shakeout in coming months, but certainly by 08. It seems the only force resisting this massive unwinding of the world credit financial bubble since roughly’95 is central bank efforts. I don’t particularly think there are good fundamental reasons for world financial markets to rise on their own, as the US economy in particular is having some serious and deepening problems.

Central banks cannot withstand the massive size of this credit unwinding. Eventually, their efforts will stall. Then, the deleveraging that wants to happen will happen. In fact, much of the central bank efforts so far have been ineffective in liquefying the critical CP markets.

So, while gold seems to now be switching to a very monetary bull phase, there are some serious issue with potential profits built up in the gold complex, meaning that, should there be a big world stock crash, gold will again sell off hard so investors can raise cash.

However, longer term, I expect gold to do quite well. This year in fact, every time gold sold off hard in liquidity driven selling in stock crashes, it quickly regained its previous price levels, something we are seeing right now.

There is one final issue, Friday is a quadruple witching day. That means that investors will have to roll over stock index futures and options. Look for some interesting action in the last hour. If something were to jostle things in this dicey financial situation, that just might be it. Also, I have not seen much follow on to the Dow rally after the Fed announced its half point cuts in the target and discount rates.

The Prudent Squirrel newsletter is my financial and gold commentary. Subscribers have had up to two days notice on the 3 major world stock sell offs in 07. There are 44 newsletter issues a year, as well as mid week email alerts as needed. We have closely tracked developments of the credit crisis.

Stop by and have a look.


Christopher Laird



Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter, is general market commentary only. It is not intended as specific advice. You should talk to your own investment professionals for specific advice.

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