Australian Dollar's Double Jeopardy

This week it feels like the AUD was punished twice for what is essentially the same "crime". On Monday morning Asian time, the Producer Price Index (PPI) disappoints, coming out 0.6% lower than expected. The Australian dollar promptly sells off against the USD and JPY. This makes perfect sense - lower PPI generally feeds into lower inflation, thus an increased likelihood of a rate cut at the next RBA meeting. So far so good.

Overnight, SPX stabilizes and most "risk" currencies bounce a little in line with the equity market. On Tue morning Asian time, Australia's Consumer Price Index disappoints by a roughly equivalent amount. On this data release, the AUD drops again.

More Cracks Appear in AUD's Facade

According to Marketwatch and other sources, Fitch has lowered the ratings of three of the top four Australian banks. As discussed previously, the action has been flagged well in advance. The Marketwatch article says the AUD dropped and it probably did to a small extent right after the announcement. Overall though, the market is still quite complacent of the issues "down under" and trades with a built-in expectation of continued strength in the Australian economy. The focus has been almost exclusively on the Greek drama and the Iran standoff and its impact on the world supply of oil. It appears that investors are still not really making the link between the weakness in China and its suppliers of raw materials.

Japan Logs Annual Trade Deficit in Calendar 2011

On the back of bad numbers for Nov (see Japan Nov Trade Deficit Worsens - Usd/Jpy to Turn the Corner Soon) Japan has logged another negative surprise for Dec, as announced on The Ministry of Finance website today. This makes the first annual trade deficit in 30 years. The income earned on foreign exchange reserves will likely partially offset that but there is no doubt that Japan's fiscal and current account position is only getting worse. Once the market starts pricing that in, we would expect an upside breakout of Usd/Jpy with an intermediate target in 85.00 area.

(For more on Japan's fiscal situation see Japan's Budget Mess. This WhatIf post is from about month ago but the analysis is still valid.)

AUD a New Safe Heaven? Bad Joke

As WhatIf has mentioned earlier, the fundamentals are not looking good for Australia. All the non-resource sectors appear to be stagnating, to a large extent hurt by the strong currency. At the same time material exports, while very strong at the moment, are mostly going to China. And China is slowing down.

There has been some talk in the market / media of the AUD becoming a new safe heaven as one of the very few remaining AAA economies. It's a nice story but clearly not true - a minor hiccup in equities still sends Aud/Usd tumbling. As it should, seeing as Australia's economy is to a large extent just a leveraged, liquid bet on China.

Greek Talks Break Down

Equity markets and the Euro have rallied hard last week in anticipation of a deal to be reached between Greece and its private creditors during negotiations in Athens. However the negotiators on the creditors' side left Athens on Saturday without an agreement having been announced. It appears that the talks have hit a snag yet again. The Institute of International Finance was quick to deny it but that rings hollow. If Dallara and Lemierre had really planned to leave on Saturday, the reduced time frame should have been taken into account during the talks. Sometimes there is no better confirmation than an official denial!

Australia's Markets Defying Gravity (For Now)

Today the Aussie employment numbers surprised on the negative side. About 30k jobs were lost in December according to the Australian Bureau of Statistics press release. This compares to a consensus estimate of a net creation of 10k jobs, for a negative surprise of -40k. Both the Aussie stock index and the Aud/Usd fx rate met this with slightly more than a yawn.

The -40k surprise may not seem like a whole lot, but normalized by population size (22mm in Australia vs 310mm in the United States) this would be equivalent to US payrolls disappointing by approx 560k and such news would have completely tanked the SPX!

The Aussie (the currency that is) has been trading in line with global risk sentiment and out of synch with the fundamentals of the local economy. Other currencies have done that in the recent past, most notably the Euro. However when the regime shifts and the market starts pricing in the negative fundamentals the moves can be quite large. We just need to wait for the decoupling.

Mass S&P Downgrade Will Help Further European Fiscal Consolidation

The analysts at S&P love the limelight. The timing of their announcements plus the multiple rumours and leaks (sometimes subsequently denied) seems to indicate so. But putting that aside, the mass downgrade issued on Friday has had a few interesting side-effects. Finally France has had to face the reality that there is only one regional superpower in Europe and it is not them. Also the revision of the outlook on Germany's credit rating from negative to stable has shown that the core is still strong and has probably contributed to the relative strength of the Euro. (As a large exporter Germany is the main beneficiary of the common currency - please refer to The Flip Side of Germany's European Bailouts).

The pundits have been quite negative on the "European experiment" in the aftermath. And admittedly the economic situation in the European Union certainly does not look rosy. But one should not forget that the Euro is first and foremost a political project. It is an attempt to bring a fractious continent together and avoid the political and military mistakes of past centuries. And sometimes the only way to push through painful reforms is when there is simply no alternative. By escalating the European credit crisis, rating agencies will ultimately help Europe on the path to harmonization of fiscal policies.

Gold No Longer a Hedge Against Currency Debasement

On Friday after the close, S&P issued a credit downgrade on a number of European countries. This had been anticipated ever since they had been placed on credit watch in December. As would be expected, the Euro dropped to a new multi-month low against the USD and stock markets followed. What may not have been fully expected is that Gold also dropped with the news and tracked the US equity market. Gold was supposed to represent a hedge against fiat currencies (read "paper money") and should have spiked when the European situation worsened. Yet this did not happen and it traded like any old investment asset in line with overall risk sentiment. Buy at your own risk. (For more details, refer to Gold Appears to have Lost its Shine and a more recent WhatIf post Technical Bounce in Gold To Present a Selling Opportunity)

Imminent Greek Exit Positive for the Euro

The drive for ever more "austerity" in Greece is having the opposite results. It is pushing the Greek economy further into recession, reducing tax revenues, worsening the country's fiscal deficit and debt load, and thus only necessitating further belt-tightening. It is a vicious cycle with no way out. Even the IMF has acknowledged that and it is now becoming clear that the only choice is bankruptcy or a Euro exit. An option that was politically inconceivable 6 months ago is currently on the table. (See Greek Euro Exit Weighed By German Lawmakers on Bloomberg.)

From the beginning it has been somewhat ill-defined notions of contagion, exacerbated by forced "voluntary" debt forgiveness that has lead the crisis to spread into Spain and Italy. So much so that even the troubles in non-Eurozone Hungary lead panicked investors to dump EU government bonds and the currency (see previous WhatIf post).

With Greece out, the situation would appear manageable and in retrospect Fitch's warning of "cataclysmic' collapse of the common currency would likely mark the low for the Euro against other G-7 currencies. At the time the panic was running so high that investors were willing to pay to lend their money to safe-haven Germany (see prior WhatIf post on negative German yields). Time is running out for Greece and it will likely reintroduce the drachma, putting an end to this chapter of the Euro crisis and giving a major boost to the Euro.

US Sanctions on Iran May Backfire

On Saturday Obama signed the most recent and toughest US sanctions on Iran, effectively shutting out Iran's central bank from transactions denominated in USD (see Reuters article). Their aim is to provide Iran with an incentive to end its nuclear program but has so far only prompted Iran's navy to threaten closing the Strait of Hormuz (through which 40% of world's crude oil is transported). So far nothing out of the ordinary - politics does get boring without a little brinkmanship. What the US probably miscalculated is the internal economic collapse this has caused - Iran's currency has dropped around 30% since the sanctions were announced. This will certainly punish the regime but will also drastically affect the lives of ordinary people and provide further domestic support for the government to play tough with the US. North Korea is a good example against driving an opponent into a condition where he has nothing left to lose. The last thing anyone wants is an Iranian submarine sinking a US warship and potentially taking the conflict to the brink of an all-out war.