MARKET COMPLACENCY MAY SOON BE TESTED

By Chris Temple, Editor

Wednesday, February 18, 2004

            The rather helter-skelter behavior of the markets today is a strong indication that investors have become far too complacent in recent months.  Pretty much everyone has come to expect a gradual—nay, monotonous—decline in the U.S. dollar.  Many have bet on such a trend, and quite profitably so, including us.  As I wrote at length in February’s issue, it’s a trend that is likely to continue generally for some time to come, particularly with Fed Chairman Alan Greenspan being abetted by Japan as he attempts to “export” monetary inflation to the whole world.  Thus, currency traders have come to expect that the ability to generate easy, profitable “dollar contrary” trades has virtually become a new Law of Nature.

As I also wrote in this month’s issue, Wall Street stock traders have become complacent as well.   Bullishness is near record levels.  Volatility and the put/call ratio have been near their lowest levels of the last few years.  Stocks’ slow, steady grind higher in recent months also seems to be something that everyone has become quite comfortable with.  Maybe too comfortable.

Aided by the breathtaking intervention of late by Japan, the U.S. Treasury market has also become boring in its predictability.  Sure, we all know that long-term interest rates (the 10-year Treasury Note, for instance, at a smidgen above 4%) have absolutely no business being this low, what with soaring commodity prices, record U.S. budget and trade deficits, a declining dollar and all the rest.    Yet they are; and abetted by Japan (which in January ALONE pumped some $70 billion into supporting Treasuries and keeping the yen’s rise in check) and Greenspan’s dovish comments in front of Congress last week, the picture has emerged that interest rates across the board will stay low for quite some time to come.

This is all quite a neat little package; especially if you’re Greenspan, and have no choice but to try to keep the status quo in tact.  He needs to inflate like there’s no tomorrow.  We can argue that if he fails, there may not be one.  Faced with such a prospect, I presently have little doubt that, in the end, Greenspan will succeed for a time in keeping Asia on board in supporting Treasuries (and, by extension, America’s ultimately suicidal spending habits.)   Further, though they’ll bellyache about it, it’s only a matter of time before Europe relents and joins the Fed in this new, U.S.-led competitive devaluation of the world’s major currencies.

Investors must keep in mind, though, that even such Herculean efforts as these by the world’s most powerful figures are only postponing the inevitable consequences of (primarily) government and the private sector being too deeply in debt.  Trying to cover up the glaring imbalances that exist in economies and markets may indeed work for a while, if you can get everyone to sing from the same song sheet.  Such a thing is fraught with risk, however.  Markets whose participants are all pretty much on “the same side of the boat” can shift with dizzying speed if people begin to smell trouble.   Those caught unprepared could at the same time see their portfolios—comprised of what have been “sure things” for months now—suddenly shrivel.

Today, we got just a small taste of what could become an intermediate-term event for most markets, and change their directions.  It started with the dollar, which—after reaching yet a new low versus the euro North of $1.29—suddenly spiked against it and other currencies.  As CNBC’s Rick Santelli put it, the greenback suddenly went “from being shellacked to being Chiraced” this afternoon, following some jawboning by French President Jacques Chirac insinuating that Europe may finally be tired enough of a strong euro to do something to change its direction, or at least stem its advance.

Within what seemed like mere minutes, the dollar surged to a level of under $1.27 per euro.  Gold predictably sold off sharply.  Interestingly, so too did Treasuries; and therein lies the biggest near-term problem for the markets.

Were the dollar’s rise this afternoon to gain some speed, its rebound would soon feed on itself, as all those above-referenced traders scrambled for position on the opposite side of the boat.    What it would also bring—somewhat paradoxically—would be a sharp spike higher in long-term interest rates.   On the surface, that wouldn’t make sense; but that’s no less so than the way in which a falling dollar has resulted in a strong Treasury market.  Simply put, bonds would sell off—and interest rates would rise—if the dollar strengthens, if for no other reason than that Japan would not be compelled to buy so darn many of those I.O.U.’s bearing John Snow’s signature.  This is likely why Treasuries weakened as the day went on, as the perception correctly grew that Japan would not be as supportive of the bond market if the dollar continued to rise.

With the stock and commodities markets heavily long in response to the “Goldilocks environment” we’ve been in, the danger is that an unraveling of both Japanese support and the bond “carry trade” I wrote about in January’s issue could undermine all of this, and give the cocky “longs” some headaches.  It won’t take many days like today before declining Treasury prices and rising yields prompt some traders to unwind their positions, as they fear that the Fed might finally be losing its power to keep rates so artificially low.  Once we see the 10-year Note’s yield move back up toward its 4.5-4.6% peak of last year with some conviction, this selling would also begin to feed on itself.  By that time, most everything that has risen in recent months will be bending more noticeably as well.

I need to stress here the word EVERYTHING.  Just as gold and gold shares, for instance, have generally been carried higher by the same factors that have carried stocks higher generally so, too, will they suffer once the overall market corrects.  “Gold bugs” who think that a fall on Wall Street must somehow automatically result in precious metals rising will find out the hard way that they won’t.  Other commodities and commodity-related stocks will also be vulnerable for a while, though a few—chiefly, in my opinion, in the energy area—may prove fairly immune.

Greenspan and his partners have moved everything from commodity prices, to stocks to housing values this far over the last year due to the Fed chairman successfully making “cash” trash.   Fewer people have been willing to sit and earn pitifully low interest rates while they’ve watched others profit in the Fed’s new/renewed bubbles.  Were sudden changes like today’s in these long-standing trends of a weak dollar and low interest rates to gather momentum, cash will suddenly look awfully good for a while, though, as it’s likely that little would be immune from the long-overdue corrections in the prices of virtually all financial assets and commodities. 

Particularly if the dollar’s sharp reversal and the accompanying weakness in bonds, stocks, gold and elsewhere turn out to be more than just the latest one-day wonder, I’ll shortly be issuing a between-issues alert to subscribers to lock in some of our gains in these areas.   And even if today’s activity does not presage an immediate correction, we must take it, at least, as a “shot across the bow.”  After all, markets generally like to confound the greatest number of players possible; and there’s no denying that the kind of complacency evident almost everywhere recently is fertile ground for “Mr. Market” to throw everyone a big curve ball.

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