ôThe high level of risk aversion today is supportive of the dollar. Risky carry trades are out, and repatriation to the US by US investors, for example, is in,ö states Dwyfor Evans, a currency specialist at State Street in Hong Kong.
ôIn the past, certain carry trades hurt the dollar, as interest rates were more attractive elsewhere û in New Zealand, perhaps, where interest rates are 8%. But interest differentials are no longer a driving force in the currency market,ö says Evans.
But the dollarÆs revival will come at a cost, and that cost will be a gloomy global economy. Referring to the remarkable rally in the Hong Kong stockmarket on Wednesday, one bankers says: öIÆve heard the phrase ædead cat bounce' so often today, IÆm sick of it.ö Another comments: ôEveryone's talking about a pretty serious bear market."
In this scenario, no one is quite sure about the status of emerging-market stockmarkets. Do they have a disproportionate number of stupid investors, or are they the anchor which will prop up the world economy this year? One answer may be in ChinaÆs GDP figures, released tomorrow. Strong figures would strengthen the case of economic decoupling long touted by emerging-market bulls.
This schizophrenia is nothing new û bond and equity investors in Western markets have been at variance as well. Perhaps thatÆs because stocks attract retail investors, while bonds are still mainly the preserve of the professional. Bonds yields in the US (until recently), for example, have been much lower than the current Fed fund rates û even as equity markets sailed on.
ôOne theory goes that emerging markets have belatedly caught on to the fact that (US Federal Reserve chairman) Ben Bernanke is seriously worried about future growth. That realisation sank in on Monday and Tuesday and the markets crashed,ö says one strategist. In other words, emerging market investors converged with pessimistic US investors, just as US investors earlier converged with the bond bears.
One London-based banker wants even more blood on the streets: öDespite the falls over the past two weeks, commodities and emerging markets are massively over-priced. Until those two assets correct properly, IÆm not calling a bottom.ö
But what about inflation? Here a situation exists which one specialist describes as "central bank extremism". Bernanke has repeatedly softened his tone about inflation in recent weeks and emphasised the risk of a major growth slowdown. The European Central Bank, on the other hand, failed to follow the Fed by cutting rates. For the ECB, inflation is still a major risk.
Surging commodity prices have long been described as triggering inflation. But State StreetÆs Evans doesnÆt agree. ôInflation is not a strong danger in the US, given the fall in the housing market. A weaker global environment will also reduce the inflationary risk posed by rising commodity prices. So the latter will inevitably come off,ö he says. A strengthening dollar should also dampen commodity prices.
Hong Kong residents are likely to benefit from another bonus: negative interest rates, which is sure to boost the local property market. Those levels are likely to very quickly become feverish û as always happens when Hong KongÆs dysfunctional peg arrangement imports US stimulus.
ôThe Hong Kong inter-bank offer rate (Hibor) is already 100bp below local inflation û the consumer price index is around 3.8% and Hibor is at 2.4%,ö says one forex expert at a leading investment bank. Given the rapid rise in property prices in recent months, the rise is likely to turbo charge the property market. And cheap money might have a similar effect on the stockmarket û at least in the short term.
China is likely to be very worried about inflation, and might even be grateful for a global slowdown. For a long time a source of low inflation, ChinaÆs ravenous demands are beginning to push prices up in a whole range of areas. ôInflation can bring governments down, and was a factor in the 1989 anti-government protests in China,ö says a currency expert in London.
The same strategist makes the simple point that inflation follows "over-potential" growth. They rarely co-exist. ôIf they did co-exist, inflation would be less of a problem. In practice, thereÆs a time lag. Over-potential growth always ends in inflation, and the longer the growth goes on, the greater the eventual inflation, which hits just as the economy is slowing and at its most vulnerable.ö This is precisely what happened in China in the late-1980s. The price was political unrest followed by a massive economic slowdown as the government stamped out inflation.
Over-potential growth may have also happened in the US, thanks to the cheap credit provided by countries like China. How ironic that the arrangement many touted as profitable for both, might now result in both falling into a similar economic hole.
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