USD supported by three legs – economic growth, yields and sentiment towards US

Outlook:

We get the Energy Dept inventory report today but the rest of the time can be spent licking wounds. The corrections in the dollar/yen and euro/dollar are classic corrections, complete with a secondary move back in the primary trend direction that lures fundamentalists into thinking they were right all along and it’s okay to buy dollars against the yen and sell euros against the dollar. But it ain’t over ‘til it’s over, and we hardly ever get only two or three zigzags. As noted yes-terday, you can trade with or against the primary trend in these situations and make a gain both ways, but your timing has to be really good. This is one of the times when the small trader has to acknowledge that he is at the mercy of the big players. And be careful about attributing moves to this factor or that factor. Often there is no factor, just the technical indicators on the chart.

We are distressed that the pro-dollar payrolls effect was so fleeting—one day! Everybody and his broth-er is naming divergent economies and central bank policies as the driver of a continuing dollar rally, with the WSJ and others whining about how multinational corporations that never bothered to learn how to hedge are going to take a big earnings hit. But while divergence is indeed the driver, it’s not the only driver—positioning counts, too, and in a vague way that is hard to pin down, so is sentiment toward the US.

Think of the dollar as being supported by three legs—economic growth, the yield differential and senti-ment toward the US. Trader positioning is not a leg—it’s the weight put on the three-legged stool, which is wobbly. Let’s say one leg, the economy, is sturdy. But a second leg, yield, is not rising as it “should” ahead of a First Rate Hike in only about six months. The discrepancy between what we think the Fed is saying and how the bond market is responding generates a wobble.

And the third leg, that vague sentiment toward the US, is almost always negative. Americans are too fat, too vulgar, and too stupid (Congress closes down the government) for people to want any more dollars than they already are forced to hold because the dollar is the reserve currency and the US has the biggest economy (proportional allocations). Anti-US sentiment means the US has to offer a yield premium to attract ever-rising dollar amounts, and as Greenspan put it a decade ago, there is a limit. Yesterday anti-US sentiment got a boost from the CIA torture memo, although the bad guys don’t really need any more fuel for their fire.

What the TV commentators and newspaper editors all missed was that the Fed finally stood up and took a swipe at moral hazard, arguably the most important development in finance since Graham-Dodd. The Fed announced it is forcing the big eight banks to raise capital more than the BIS is demanding (starting in 2016). According to the WSJ, “The eight largest U.S. banks would need to have an additional capital buffer of between 1% and 4.5% of their risk-weighted assets, based on the relative threat a bank poses to the financial system as calculated by the Fed. Banks would have to meet the surcharge with common equity—considered the highest-quality form of regulatory capital. That is on top of a base 7% common-equity capital requirement that most banks face.

“On average, the biggest U.S. banks will face a surcharge that is 1.8 times higher than the framework agreed to by international regulators.

“The specific impact on most of the eight banks was unclear. While Fed officials indicated that most of the banks already held the capital levels that would be required, analysts and bankers said they still were analyzing the complex calculations involved and were trying to understand some parts of the proposal that were vague.” JP Morgan seems to be the main sufferer, needing to raise another $21 billion. Anyone depending on bank dividends should be diversifying away from the financial sector. At the same time, keep an eye peeled for a re-structuring of the sector. When the government comes right out and says some banks are too big to fail, at some point they break up so they can start building again. We know these guys. They are huddled in back rooms all over Manhattan trying to figure out how to make a bunch of little silk purses out of sows’ ears—and offer them as IPO’s. If you can’t hose the customer with CDO’s, how about IPO’s?

As for risk aversion being on the rise and accounting for the dollar/yen, yield droop and gold breakout—we don’t buy it—yet. Yesterday the Market News fixed income analyst notes deep gloom and doom about the US economy (and a wildly successful 3-year note auction that drove yields down). Traders are talking about recession in the US arising from the deflationary effects of the oil price drop. This is worse than an exaggeration—it’s the wrong perspective altogether. Falling oil prices feed through to the con-sumer and to most businesses like a tax cut. The average household will save as much as $3000/year on lower gasoline and heating oil prices, and while consumer spending has yet to catch up (Thanksgiving sales down 11% y/y), just wait. To gyrate from joyous optimism on Friday to deep gloom the following Tuesday is too wide a swing and a cause for worry in its own right, but lacks a sound foundation. Maybe the bond boys will get more cheerful when the stock market comes back and draws away some of their demand.

To go back to our three-legged stool, the new bond market worries about the economy constitute a wob-ble in one leg while weakening the second (yield) leg. That leaves only the third leg, sentiment toward the US overall. We say the economy leg is okay and the sentiment leg should be okay (Fed reduces mor-al hazard and Congress funded the government this time), so it’s the yield leg that is out of whack. But you can’t fight the bond market.

We shall have to wait for the bond market sentiment to heal. We may have to wait for next week’s Fed meeting—Fed officials are in the blackout period ahead of that meeting and we can’t get any comments. We will get words, including perhaps an end to “considerable period,” plus the dots representing mem-bers’ forecasts about raising rates. Remember, the Fed is not watching oil or gold or Russia or China or the ECB. It’s watching the US economy. Stay tuned.