Thursday May 25, 2006
It Started on May 11

On May 9, 2006 the price of gold rallied above $700 an ounce for the first time in nearly 26-years.  On May 10, 2006 the Dow Jones Industrial Average reached an intraday/year high of 11,709.09, or less than 200-points away from a record intraday high. On May 11, 2006 the gates of hell opened, and began swallowing financial markets whole…

Drama aside, increased volatility in countless financial markets since May 11 is a potential warning sign that the bear has reemerged.  Moreover, that this volatility has arrived after one of the least volatile periods in financial markets history suggests that the good times are indeed over.



Not oblivious to this uptick in volatility, Stephen Roach is already questioning his newfound optimism.  To be sure, on May 1 Mr. Roach suggested that “Central banks are carefully adjusting the liquidity spigot”, but Roach now says that “A new approach to monetary policy is urgently needed.”  Also on May 1, Roach said “the stewards of globalization -- especially the G-7 and the IMF -- have finally come to grips with the imperatives of facing up to the perils of global imbalances.”  With Japan almost immediately contradicting G-7 statements and Eurozone officials recently balking at king Euro speculations, G-7 harmony speculations have vanished.  For that matter, the new IMF global imbalances team – which has no actual powers mind you – continues to repeat what has been said since late 2004, and these words continue to fall on deaf ears:

“Global imbalances must eventually unwind. The risk is that they will be unwound in an abrupt and disorderly way.  Over the coming year, I see a particular need for multilateral consultations to deal with the growing economic imbalances which threaten the world's prosperity.”
IMF managing director Rodrigo Rato

Run For Cover Into USD?

In the last two weeks emerging markets – beneficiaries of a record influx of foreign capital to begin 2006 – have been hammered, many commodity laden markets (Australia and Canada) have been shaken, and previously dormant US dollar crisis fears have been stirred. Surprisingly, with the exception of technology stocks, the major US markets have held up remarkably well.

Obviously the trend of global instability/US financial market calm could change, and with the S&P 500 and Dow threatening to bust below important technical/psychological trading levels change could come quickly.  Nevertheless, recent capital flow trends, along with the sharp correction in gold, suggest that the US is still regarded as the destinaton during times of financial trouble. Ironically, the US dollar, which must decline according to the IMF, G-7, Roach, and countless others - has been attracting safe haven flows...

Another Fabled Soft Landing?

Despite the expectation for at least one more Fed rate hike, a slow down in the US economy could quickly come into focus, and if and when a slow down takes hold so to will the hope that the Fed can engineer a soft landing. Despite the precarious situation in the US housing market, stock market overvaluation, and poor consumer debt/savings fundamentals, there is reason to believe that the Fed is in fair shape to respond to market challenges. Quite frankly, with plenty of ammo and US dollar hegemony not under an immediate threat, the Fed may well be able to engineer another short lived recession. Perhaps Roach is right to be optimistic after all, even if he was early in making the flip. 

As for those who argue that the US dollar is doomed because Iran/Russia/Venezuela will soon accept only Euros for their oil/gas, and because more central banks are about to diversify reserves away from USD, recent trends suggest that the most influential central banks will react to US dollar weakness with defiance by rather than acceptance. This doesn’t necessarily mean that a US dollar decline/crisis can be avoided longer-term, but it does suggest that imbalances (US trade balance) will be allowed to fester for a little while longer.

With no asset class screaming undervaluation, no major world currency guaranteed to gain versus USD in the medium term, and precious metals trying to change their focus from inflation to crisis hedge, these are indeed extremely uncertain times. Something was unleashed on May 11, but as yet we cannot be sure exactly what.