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Correlation is not causation

By Dan Denning - posted Monday, 4 October 2010


It’s an all-out attack on the greenback and everyone else is winning! The Aussie dollar has reached parity with the Canadian dollar (the Loonie) and is fast approaching its previous highs against America’s number one export (the US dollar). So is this a turning point in the currency wars?

Well, like all wars, a sensible question to ask is, what are we fighting for?

Are we fighting for honest money that doesn’t lose purchasing power? Are we fighting for low deficits and strong growth? And who are we fighting anyway? The Chinese? The Europeans? Team America?

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The point we’re trying to make is that metaphors are only useful if they reveal some insight into a problem that you can’t get in a straight forward way. Are nation’s using currencies as a weapon against each other? Well, maybe. But it’s more likely that each nation seeks to maximise its trading advantage by managing its currency in a certain way.

In the post World War II era, for example, it’s been sensible to keep your currency cheap relative to the US dollar. Americans were big spenders, even when they didn’t have money. And from the American perspective, what a great trade! You send paper to people ... and they send you real goods and services in exchange. And you get to make as much paper as you want because the rest of the world can’t get enough of it!

It does seem like kind of a fraud. But then, money is a fraud, when it’s not backed by anything tangible. When money is backed by confidence (or a large economy, or the rule of law, or a blue water navy, or a large nuclear arsenal) people don’t ask a lot of questions until it’s too late and the currency is fatally compromised by massive debts incurred in it.

Is it too late for the US dollar? The last time the Aussie neared parity, the whole world fell apart. Correlation is not causation. There’s no reason why the Aussie can’t smash through parity and go beyond. After all, Australia’s terms of trade remain high. And the Treasury expects the roaring commodity trade with Asia to deliver the Federal budget into surplus in just a few years.

Frankly, it all seems just a bit too neat. But over the last few years, we’ve found that our first week from a major overseas trip has been marked by a fuzzy brain. It’s probably something chemical. But you look at the markets right now and it just looks too good to be true. We realise that is an utterly superficial and shallow level of analysis. But it’s our first intuition, so we’re going to keep investigating.

One thing to watch for: the end of the quarter. With such a good month for stocks topping off a good quarter, it will be worth watching to see what the smart fund money does next. We use the word “smart” loosely. September surprised everyone with how good it was. You normally see a lot of “window dressing” by fund managers at the end of the month. They buy whatever went up so it looks like they owned it all along.

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But getting ready for the next quarter may require less following and more leading. For example, yields on four-week T-Bills in the US have fallen by 45 per cent in the last few days. They’re down by 60 per cent since late August. This indicates a preference for near-cash, low-yield instruments that are not stocks. It’s an indication of risk aversion.

Will the risk trade go off the boil now? “The ASX is sinking like a stone this morning,” a colleague chimed in from across the room. “But all the gold stocks are up,” said another. “And BHP and Rio are down.” “So what’s falling?”

It must be the banks!

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First published in The Daily Reckoning on September 30, 2010.



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About the Author

Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). Dan draws on his network of global contacts from his base in Melbourne. Hes the managing editor of resource newsletter Diggers and Drillers and the editor of The Daily Reckoning Australia.

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