Risk as the missing variable

Much has been made of the ability of certain physical commodity markets, gold and crude oil among them, to rise under the weight of investor funds regardless of fundamentals. In the case of crude oil in particular, futures markets cannot be regarded as inventory scorecards as much as the fully insured forward costs of a replacement barrel. It’s as if the market is daring you to go short in the face of supply risk.

We now see this operating in the currency market. Despite the messages sent from these key quantitative indicators and others reflecting sounder fundamentals for the USD, the market is convinced the U.S. will undertake a repudiation of its substantial international debts by debasing the USD. After all, this was the official policy of the U.S. in 1985-1986 and again in 1993-1995. With the U.S. twin deficits claiming an ever-larger share of world savings, the risk of debasement is huge.

But there is no need to simply dwell on the oft-stated negatives for the USD. In the case of the JPY in particular, it would be simplistic to state the USD is going to weaken against the JPY. A far better description is the currency and equity markets together agree Japan’s relative growth prospects are stronger than those for the U.S. at this point in the cycle. This will increase both Japanese interest rates and demand for yen-denominated assets. While the net effect is going to be the same — a stronger JPY — we should not regard it ipso facto as a repudiation of the dollar.

And, of course, the vagaries of the European political economy should give pause to those who might like to see the EUR emerge as a reserve currency. The last two years have seen the rejection of the EU constitution and a widening of French and Italian sovereign debt spreads vis-à-vis Germany.

The conclusion we reach is there are no single rules for the currency world. Each situation, each market environment is different in critical aspects, and what worked well last year can fail spectacularly today. There is a name for watching the market and making decisions: Speculation, derived from the Latin word “to watch.” It is an honorable endeavor, one we should all recommend to others in an uncertain world.