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It is always difficult to distinguish between the fundamental and the speculative when markets are experiencing turmoil, generally because they tend to work in tandem.

The plunges in equity markets and gyrations in currency markets were clearly triggered by something quite fundamental – the belated realisation after 12 months of deceptive calm in markets that the legacy of the global financial crisis was rather more threatening and immediate than previously recognised.

The crisis in Greece spilled over into a more general fear about the state of the eurozone, the mounting levels of sovereign debt in its weaker economies and the inter-dependence of both the weak and the strong created by the euro and the European banking system. The best efforts of the European regulators to avert a sovereign debt crisis with yet more debt proved only a fleeting remedy.

So, there is good reason to be concerned about Europe. But, given the still-anaemic state of the US economy, and the relatively rude health of the Australian economy, why has there been a flight of capital to the US and an exodus from this market?

The simplistic answer would be the usual – that in time of uncertainty money floods towards the reserve currency. No doubt there is an element of that.

There might also be a concern that with Europe, if it can stabilise its position, destined for a very protracted period of very low growth and the US probably facing something similar, the Asian economies that underwrite our growth will struggle to maintain momentum.

The Rudd government’s proposed resource super profits tax won’t have helped the confidence of foreign investors, who tend to see Australia and Canada as resource economies and a safe way to gain exposure to the Asian growth story without actually investing in Asia.

There is also, no doubt, a speculative overlay to the volatility and dramatic shifts in markets.

Once the markets stabilised last year the carry trades came back, with hedge funds, banks and investment banks borrowing short in low-interest rate economies, like the US, Europe and Japan, to invest in long positions in higher-yielding economies, like Australia. Apart from the financial leverage some of the trades seem to have had another element – the shorting of the currency where the funds were being borrowed.

The European Central Bank has noted that during and after the financial crisis risk-averse investors piled into AAA-rated sovereign debt and that more recently the steep shape of the European yield curve attracted the carry traders.

The problem for both groups is that as the concerns about eurozone sovereign debt issues mounted, the yield curve has steepened further and quite sharply. While that would presumably produce more profitable trades within Europe, it would also generate sizeable mark-to-market losses for the investors, particularly the leveraged carry traders.

There is probably a European element to the plunge in the Australian dollar and equity markets to go with the self-inflicted damage caused by the RSPT and the way it was sprung on the markets.

Because the eurozone economies were weak and likely to remain so for some years as a result of both the levels of sovereign debt and the harsh measures European governments are being forced to adopt to deal with them, there was an expectation that the ECB would keep official rates low in the near to medium term.

Borrowing euros or yen to buy the Australian dollar and then shorting the funding currency was a big winning strategy until the past few weeks, when it abruptly turned into a nightmare as the rug disappeared from under the dollar.

The damage done when popular carry trades reverse is almost always greater than the fundamentals would suggest – and not always directly linked to them – because once the tide turns all the traders are trying to climb aboard the same boat.

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1 Comment

Michael wrote:

Risk-averse investors should pile into gold according to the following article.

http://capitalflows.wordpress.com/

While this potential crisis is clearly deflationary in nature, it would seem that gold is not reacting to this. As GFC V1.0 demonstrated, even deflationary contractions in asset prices are not necessarily correlated with gold – in fact, they are more likely to be inversely correlated to gold. Gold underperformed from major stock market bottoms and outperformed from major stock market tops. However, throughout the course of the crisis gold only managed to dip into negative territory for just a few weeks.

(See The dollar and the damage done, June 7.)

It is now my contention that gold acts more like a currency than an asset class.

It is a shadow currency that represents the world's real productive potential – distinct from the fiat currencies that represent not only their respective economies but, to a greater extent, the layer upon layer of 'financial froth' on top. Deflationary movements in the broader asset markets, spurred by credit contraction, only strengthen gold's relative outperformance.

Any increases in the supply of competing currencies (i.e. quantitative easing) are met with increases in the gold price even though such actions would have practically no effect on inflation (due to the excess spare capacity that exists in most developed nations – idle factories and labour).

If GFC V2.0 were to ensue here, the developed nations would almost certainly turn to quantitative easing. It is unimaginable that the current establishment of neo-Keysians and their myopic electorates would allow for a true deflationary contraction. The entire developed world is up to their eyeballs in debt, whether it be at a national, state or individual level. It therefore benefits the majority to keep the printing presses rolling, devaluing the debt they have to pay.

7 Jun 2010 8:29 PM

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