Volatility Continues to Dominate the Markets

The Japanese crisis continues to dominate the news stories, as 4 of the 6 reactors at the Fukushima power plant remain unstable. Radiation level increases have been reported as far south as Tokyo, but Japanese officials say the levels outside the nuclear facility are not dangerous. The unstable conditions at the Japanese nuclear plant, combined with more violence in the Middle East increased volatility in the markets. Currencies, metals, and most commodities had an incredibly volatile day with many investors shifting back into the “safe haven” of US treasuries.

The price movement of gold and silver caught me by surprise, as we have long viewed the precious metals as an “uncertainty hedge.” As I hit the send button yesterday morning, gold was still holding above $1400, but by the time I had walked over to fill my coffee cup it had moved down $20! Gold has rallied back up to trade right above $1,400 again this morning, but shouldn’t it be rallying with so much uncertainty in the markets? I searched for answers yesterday and settled on one scenario that seemed to make sense. Investors were selling gold and silver because they were some of the assets that had the most gains. The drop in equity markets and commodities in general have many investors facing margin calls. With a need for quick cash, the gains in precious metals were an obvious place to raise money. This points out one of the advantages of the metals markets: liquidity is usually not a problem, even in the times of crisis.

The volatility seems to have quieted down overnight, as equity markets in Asia seem to have bottomed and the European markets are opening slightly higher. Oil prices have begun to rise again as traders start to focus back on the Middle East. Oil has been more than volatile, as supply concerns over the Middle East unrest have competed with the lower demand caused by the earthquake in Japan. This morning oil is back within spitting distance of $100 as events in Bahrain heat up. Like most investors, I haven’t focused much on the Middle East, as the Japanese quake has dominated the news. But the arrival of Saudi and UAE forces in Bahrain has certainly raised the stakes a bit. The latest news suggests that the government forces have been firing on protesters in the streets, so things are not looking good. Continued violence in the Middle East will push oil prices back up which could be a drag on the global recovery.

The FOMC used the prospect of higher oil prices to justify a continuation of QE2 and their decision to keep rates near zero. As expected, the statement after the FOMC’s one day meeting was upbeat, but they did caution that the higher commodity costs could have a “temporary” impact on growth. “The economic recovery is on firmer footing, and overall conditions in the labor market appear to be improving gradually,” the Federal Open Market Committee said yesterday. The stock jockeys liked what they heard (and why wouldn’t they when the FOMC is saying they will continue to pump money into their markets!).

Other data released in the US yesterday showed that US homebuilder confidence is at the highest level since May of last year. But isn’t this just a sign of the season? Every builder/developer I know gets excited in the springtime, as summer is always their best season. Another report showed that manufacturing in the New York area accelerated in March at the fastest rate in nine months. The TIC flows, which reflect global demand for US stocks, bonds, and other financial assets fell in January from a month earlier. But the markets largely shrugged this number off as purchases of US Treasuries have definitely increased again after the Japanese catastrophe. While the markets may be ignoring this data, we still think investors should keep a keen eye on these TIC flows as they are a good indicator of global confidence in the US dollar. The deficits that our government continues to run can only be financed with a steady stream of foreign investments. If and when these foreign investors’ appetites for US Treasuries start to sour, interest rates in the US will begin to move up very quickly. And higher rates are exactly what the Fed is fighting against, so we definitely need to keep a keen eye on these TIC flows.

We will get more data on the housing market this morning, with the release of housing starts, building permits, and mortgage applications. With yesterday’s positive data you would think these numbers would be positive. But builder confidence and actual home starts are different animals. Builders may be more confident that things will get better, but the starts and permits reflect what is actually happening on the ground. We get a look at inflation with the Producer Price Index for February. The FOMC says they are keeping a close eye on inflation, so it will be interesting to see just were the PPI numbers come in. With commodity prices on the increase, I would expect to see a surge in the PPI numbers, which may cause some to question just how long the FOMC can keep up QE2.

European inflation accelerated to the fastest in more than two years in February, rising 2.4% compared to a 2.3% rate the month before. This is the fastest since October 2008, and is the third month in a row that inflation has exceeded the ECB’s 2% limit. While the US FOMC apparently isn’t concerned with rising prices, the ECB has a mandate to keep prices under control, so the higher inflation numbers are definitely increasing pressure on the ECB. The Japanese disaster may release some of this pressure for a rate increase, but all indications still point toward an April increase.

The Swiss franc (CHF) surged to a record versus the US dollar yesterday as investors searched for safe havens. Traditionally, the Japanese yen (JPY), US dollar, and Swiss francs have been seen as “safe haven” currencies. But since the catastrophe is located in Japan, investors shifted more of their funds to the Swiss franc and US dollar. All indications are that the Swiss will continue to benefit from the events in both the Middle East and Japan. An article appearing on my Bloomberg this morning had the following quote: “Given the domestic risk in Japan, which is leaving the yen’s safe haven status more questionable, the Swiss franc is the clear alternative and is benefiting,” said Adam Cole, head of global currency strategy at RBC in London. “Markets will stay nervous, at least for the next couple of days. That probably will continue to support the franc.”

With investors scrambling to find an alternative “safe haven” to Japan, Norway has caught many investors eye. We have long said Norway should be at the top of the list for those looking for a fundamentally sound economy, and Norway’s krone (NOK) is an excellent alternative to the Japanese yen. The Norges Bank will announce a rate decision today, but are widely expected to leave rates unchanged. Even with no change in rates, Norway still enjoys a positive rate differential to most of Europe, and the Norges Bank continues to take a hawkish tone. As inflation climbs, the Norges bank will definitely be in the front of those central banks raising rates, which should be very positive for the krone.

The biggest loser of the currency markets over the past 24 hours has been the South African rand (ZAR) which is off nearly 2.5% versus the US dollar. The rand was a popular investment choice for Japanese investors, and the repatriation of funds has caused many of these investors to sell their rand positions. This sell off was magnified as investors started to move away from risk trades, and further selling is expected today. The Australian dollar (AUD) and Brazilian real (BRL) were also sold as investors exited “carry trades.” Again, the selloff was initially due to Japanese investors repatriating funds, but continued as other investors exited these “riskier” currencies.

The Aussie dollar was probably due for a correction, so this sell off isn’t overly concerning. Minutes of the Reserve Bank of Australia’s March 1 meeting were released yesterday, and showed that policymakers were happy with a “mildly restrictive stance of policy.” Slower household borrowing offset a mining investment boom, causing the RBA to keep rates unchanged at their March 1 meeting. The RBA was concerned about the run-up in the value of the Aussie dollar, and the possibility of further gains caused by an interest rate increase. But the recent drop in the Aussie dollar may give the RBA Governor a bit more breathing room and enable him to increase rates again at the next meeting.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning