Again we see inter-market tectonics shifting away from past behavior.

Market is playing the decline of the greenback as world's reserve currency. EuroZone woes seem temporarily forgotten...

MAJOR HEADLINES – PREVIOUS SESSION

  • UK Q1 GDP fell -1.9% QoQ as expected
  • Canada Mar. Retail Sales rose +0.3% MoM and fell -0.2% less Autos, vs. +0.5%/-0.1% expected, respectively

THEMES TO WATCH – UPCOMING SESSION

  • US Fed's Bernanke to Speak (1800)
  • US Fed's Kohn to speak (2000)

Market Comment:

Yesterday's intermarket behavior was the knock-out blow to past market behavior, in which the USD dependably rose whenever risk appetite headed south. The greenback sold off mercilessly despite a very ugly day on Wall Street yesterday, further proof that we need to find a new model for what is transpiring. Correlations were shaken and stirred across the board, in fact, as bonds also took a dive despite the bad day for equities. With bonds and stocks dropping, the only safe haven seemed to be "anti-dollar" trades - short the dollar and long commodities. The move lower in the USD may have been aggravated by thin markets be aggravated by the approach of the three day weekend in the US for Memorial Day and the UK, which also has a banking holiday.

So it appears that the long greenback trade is no longer a safe haven play. We expected the continued deleveraging and recession in the world economy to provide some support for the USD in the nearer term before it weakened somewhere down the line. But it seems that the market wants to have a look at the longer term devaluation theme for the USD now rather than later as the greenback continues to lose its reserve currency statues. This may be partly due to the seeming stability of financial markets and lack of pressure on credit spreads and risky assets considering the "nothing will be allowed to fail" mentality at central banks.

China is a leading actor in this play. The Chinese regime is painfully aware of the fact that the only way the US can get through its over-indebted state is to either destroy its totally unsustainable public and private debt levels through mass default or through a "bleeding default" (have we coined a new term?) via inflation - thus threatening the value of China's enormous stock of USD reserves. How can China respond? A "dollar dump" is not an option, as it would immediately deflate the value of the country's reserves and harm the spending power of one of its main customers, a customer that is already reining in consumption at record rates. At the same time, China can't simply sit back and do nothing while the US Fed and Treasury print money to their heart's content. So the end result is likely to be a game of cat and mouse. China moves in as many ways as possible to reduce its dollar holdings and dependency on the USD (two examples are non-USD trade agreements and the massive commodity buying program - which serves two purposes - it replaces greenbacks with hard goods and it prevents a collapse in the supply levels of key commodities for the future, which would guarantee a nasty inflationary spike if China recovers swiftly.) without becoming a huge outright seller of US treasuries.

The US response is to simply continue printing money while talking up future fiscal responsibility and a the laughable strong USD policy. If China's moves result in stable to rising commodity prices and a weaker US currency, it could eventually trigger more inflation in the US for imported goods and a possible shift to US-based production for certain goods, thus finally beginning a sustainable reduction in the country's current account deficit (although domestic sourcing of energy costs is another must for this scenario). With enough inflation over time, the US's national debt can be deflated to a manageable level. The assumption of this theme is that China can keep up its commodity buying binge and that it will continue to recover based on domestic and external demand and grow without any hiccups despite its already woeful production overcapacity. As for the US, it may be nice to have your debt reduced, but if incomes don't rise and the economy remains weak, non-demand triggered inflation could crush the economy even more harshly than we've seen to date. Regardless of the long-term sustainability of the theme, a theme it is and a very powerful one at the moment.

We can't, therefore, put a floor on the USD in the near term as long as theme persists, even if the market does look very stretched for the shortest term - a bit suspicious just before a long weekend. Next week, the US is expected to auction off $162 billion of treasuries - with $101 billion of that at maturities of two, five and seven years. US 10-year yields are hovering close to their highs for the cycle. The Fed can't be pleased. The bond market will be a key one to watch next week for measuring foreign demand.

For the longer term, we wonder how long the market can park the EuroZone's still festering problems in limbo, but these concerns have clearly been brushed to the side for the moment. AUD and CAD remain well bid despite the tones of risk aversion in places as the focus on higher commodity prices remains an important factor. And if this new theme is to blossom further, it might eventually rub GBP the wrong way, considering that the UK and the US are largely in the same boat. The JPY? If long rates continue to tick higher, this will be JPY negative at first blush.

On a side note, many speculate that the ratings agency's and their AAA ratings play an important part in this, but the real moves in the market are far more important, as we saw from yesterday's reaction and subsequent shrugging off of the S&P's change of outlook on the UK's sovereign debt. Ratings agencies are thoroughly discredited institutions after the CDS debacle. On another note, the FT has excellent coverage today of the various market participants' view of Geithner's PPIP program and its chances for success a must read.