Chuck Butler

Well… It looks as though that perfect storm I talked about two weeks ago, has hit the shoreline… The Fed is out on the dance floor twisting the night away, and home prices continue to decline… But… The dollar is rallying this morning, folks… Strange but true!

Yes, the perfect storm that was brewing for a dollar rally, and short term period of dollar strength, hit the shoreline last night… And the dollar is in the driver’s seat this morning… I guess, the overnight markets believe that the Fed’s latest, greatest, move to stimulate the US economy will work, and everyone will want to own dollars going forward… Hmmm… I’m not buying that… But apparently someone is, because the currencies have a look about them this morning that they haven’t been seen with in some time!

And gold… Is backing up big time… Hmmm… So, let me get this straight… The Fed announced that they were going to provide additional liquidity to the system “to help support the economic recovery.” This is what they call “Operation Twist”. The Fed said that they would allocate $400 billion toward a program to purchase Treasuries of 6 and 30-year maturities, and sell an equal amount of Treasuries with maturities of 3 years or less. The Fed believes this program will “help make broader financial conditions more accommodative.” They also believe that the upward pressure on the short maturities that they sell would be a non-event, given their insistence on leaving short term rates near zero for some time to come.

So… The Fed is going to attempt to drive longer-term yields down… And for this, the dollar gets to rally? And against the high yielders, too! Face it, folks… interest rates in this country are going to stay at record low levels, to promote growth… Well, at least there were 3 Fed Heads, (Fisher, Kocherlakota, and Plosser) that declined to dance… Maybe if it was a slow song? But the Twist? No way they were getting out on the dance floor to imitate Chubby Checker! Good for them!

One would think that if 3 members of a small group of people dissent, that the others would step back, and discuss further whether this was a good idea… But… Just like when Big Al Greenspan ran the show, When Big Ben Bernanke wants to direct Fed policy, he does…

OK… So… The Fed is going to mess around with Treasuries, and the dollar rallies? Strange but true… But against the high yielders (or against gold, for that matter) is what really doesn’t make sense to me. One of the things that has helped gold push higher these past 10 years, is that as interest rates fell, gold didn’t have to compete with deposit rates any longer… Well, that obviously hasn’t changed, but gold got ambushed last night… I bet the alleged price manipulators were happy…

The Fed admitted yesterday that the US economy was still facing “significant downside risks”… You think? Well… I’ve said all along that the US economy never really left the recession (I’ve called it a depression) and that the Fed would feel the need to put their hands in the cookie jar, and provide more stimulus… This isn’t what I was thinking they would do, because… This Operation Twist was done before, and did not have the effect on the economy that the policymakers thought it would… Back in the ’60s this was attempted, and they saw a 15 basis point move down in long rates… Ooooohhhh… Sign me up for some of that! NOT!

So… What to do now? Well, folks, I told you a couple of weeks ago that we could very well be in store for a period of dollar strength… So, this should come as no surprise to you. But the strength of the overnight move is a surprise to me, especially after the Fed admitted that the US economy was going nowhere fast, and rates were going to remain low, and go lower in the long end… But just like I say when I hear bad news… It is what it is… Now let’s go fix it…

To fix this, we’ll have to not panic… If you find that this is just too much for you to deal with, then go ahead and attempt to catch the falling knife, but be careful, because that knife is sharp! Batten down the hatches, and look for opportunities to buy at cheaper levels… Remember what I told you last week about dollar cost averaging? Well, that’s what we would be doing at this time. If you batten down the hatches, it would be better to not go checking the currency levels every day for a while… You don’t want to be tempted by the fruit of another…

And… The other thing that’s on my mind about this new direction for the Fed… Let’s see… They are 0 for 4 and wearing the collar right now… They cut interest rates to the bone… They printed money… They implemented two rounds of quantitative easing, and nothing worked… We simply began looking more like the Japanese… So, why are the markets “all-in” on this latest direction for the Fed? I doubt it works… Or it will line the pockets of the brokers dealing in Treasuries, and it will flatten the yield curve; but what does any of that have to do with creating jobs? Restoring home prices?

OK… So the damage overnight has been widespread, and didn’t stop with the euro (EUR)… The Aussie dollar (AUD), kiwi (NZD), and even the Swiss franc (CHF) were sold like funnel cakes at a state fair. The one currency that held steady was Japanese yen (JPY)… Shoot Rudy, even the Chinese renminbi (CNY) got sold overnight! But yen didn’t… Hmmm… Two peas in a pod, the US and Japan… With their debt, aging population and inability of either one to stimulate their economy… When all they really need to do, is to leave small businesses alone, reduce their taxes, allow them to fire people, etc. and watch the employment problem get better, which will allow the housing debacle to get better, and voila! You’ll have an economy on the move!

Speaking of housing… Sales of Existing Homes for August increased 7.7% versus July… And that sounds good, right? Well, not if you consider that foreclosures are counted here… And not if you consider that the median home price was $168,300, a decline of 5.1% from the same period last year. July prices were revised lower to $171,200 from an initially reported $174,000. So… Home prices continue to fall, like I told you they would… And they will continue to do so, until they reach a level that buyers believe represents value…

On a side bar here… If Chuck ruled the world… I would get appraisals out of the home price negotiations… Sure they can be done as a guideline, but not dictate what the loan will be based on… If two people, a buyer and a seller agree to a price, then that’s THE MARKET! Not some appraisal! Just another of the many things Chuck would change if he ruled the world…

OK… Back to the task at hand… So… How long will this period of dollar strength last, I hear you asking? Now that’s a good question! I wish I had the answer, but I don’t… It could be a few months of banging on us by dollar bulls…

Global growth prospects took it on the chin yesterday, with the Fed statement, talking about “significant downside risks”… And that shot to the chin was quite evident in the Aussie dollar… And the emerging markets currencies like Brazilian real (BRL), and South African rand (ZAR)… In the 1995-2002 strong dollar trend, the Mexican peso (MXN) rallied alongside the dollar… But not this time… And as I’ve explained many times in the past… These emerging markets need to pay a “risk premium” to investors. This is akin to paying for their sins of the past… Well, if the emerging markets decide (prematurely, I might add) that they are “ready for prime time” and drop their rates (thus removing the risk premium) they will soon find out that they aren’t ready for prime time, as investors will quickly unload/sell their holdings… Because… There’s no risk premium…

Well… Mexico removed its risk premium and have yet to bring it back, and the peso gets rocked. The Brazilian real removed part of their risk premium, and they have gotten taken to the woodshed… So… I sure hope the Finance Ministers of these emerging market countries take a note here… Note to self… Need to bring back the risk premium!

In New Zealand overnight… Second quarter GDP printed softer than expected, rising just 0.1% versus the previous quarter. Hmmm… Well the first quarter GDP report printed stronger than expected, so maybe, if we just throw both quarters together, we get a better view of the New Zealand economy… First quarter was 0.5% growth, so if my new math skills are working today, that would be 0.3% growth for the first half of the year…

In addition… I received this note from ANZ Bank… “The latest information reveal that the total reinsurance claims arising from the Canterbury earthquakes are higher than initially thought, and the claims settlement much slower, meaning that there is still a lot of reinsurance flows still to come and will likely take longer than first assumed. This means that reinsurance flows will keep NZD well supported on dips for some time, likely over the next two to three years.”

Hmm… Well that’s their opinion, and they have some hard facts to support it…

Remember when the Eurozone debt problems got really heated; I told you that if I were in charge over there, I would demand that each country agree to issue a Eurozone bond… I know, the sovereignty issue… But as I said before, each country gave up their sovereignty when they turned in their legacy currency for euros… And… Think about this… Part of Greece’s problem (I’ll just mention Greece here, but you can do a ditto for all the GIIPS) has been their ability to borrow (in the past) at lower rates because the markets believed that by being a part of the euro, Greece was backed by Germany… And once they realized that that was not the case, the wolves were at Greece’s door… So… If it helped before, imagine what it could do now if a Eurozone bond was issued…

Well… Someone in the Eurozone agrees with me… European Commission President Jose Barroso said, “Issuing joint euro-area bonds and developing integration tools to make that possible is a must, even if German opposition means it can’t be done immediately.”

Then there was this… OK… So the world had come to a standstill… The cable news stations were all flashing text that they were “Waiting for Fed Announcement”… And the time came and there was no Fed announcement… And then we finally got the news that the Fed had chosen to implement Twist and Shout… I mean, Operation Twist… What was the delay? Ahhh grasshopper… You wouldn’t believe it, but apparently there was a copier jam in the press room! Yes, the news release was delayed 10 minutes because the copier jammed! HAHAHAHAHAHAHAHA!

To recap… The Fed did announce a different plan yesterday, called Operation Twist, in which they will purchase 6 year and 30 year Treasuries to the tune of $400 billion, and sell an equal amount of Treasuries 3 years and less to maturity. This has pushed the dollar to the front of the class, and the only standing currency other than dollars is the Japanese yen… The perfect storm for a period of dollar strength that I talked about a couple of weeks ago has hit the shoreline… Better batten down the hatches…

Chuck Butler
for The Daily Reckoning

Chuck Butler

Chuck Butler is President of EverBank

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