There isn’t a single person who can get a clear read on the stock, bond, currency and commodity markets. Central banks, most notably the Federal Reserve, European Central Bank and the Bank of Japan, are printing trillions of dollars to prop up mainly developed, mature economies. They’ve effectively herded the entire investment world into the same side of the trade, and all investors can do now is stay there and hope to get out before the carnage begins.
In times like these, it’s helpful to get back to basics. The late Sir John Templeton, my friend and mentor, was the most disciplined investor I’ve ever known. The billionaire investor began each trading day the same way, and one thing he said that has stuck with me: “The first chart you should look at every morning is the U.S. dollar, because that will tell you what all the other markets are doing.”
In markets that are behaving what I call normally — that is, prices move according to fundamentals — a declining dollar is bullish for stocks and commodities, and bearish for bonds. And a rising dollar is bearish for stocks and commodities, and bullish for bonds.
But as I’ve been telling readers and subscribers to my investment services over the past couple of months, these markets are not behaving normally. Traditional relationships among asset classes have been thrown out of whack because of central banks’ stimulus programs. We are living in a QE world, like it or not.
QE’s Effect on the Dollar
Despite the upheavals caused by central banks’ bond-buying programs, or quantitative easing, it’s still instructive to look at the performance of the U.S. dollar.
Through the first half of last month, the dollar index (which measures the U.S. currency against a basket of six competing currencies) rose steadily. The advance was mainly due to concerns about Europe’s economic health and Japan’s newest, more aggressive quantitative-easing policy, which depressed the value of the yen.
|Despite the upheavals caused by central banks, it’s still instructive to look at the performance of the U.S. dollar.|
I’ll talk more about Japan in a moment, but for now, I want to focus on the dollar’s relationship to the euro, because that pair’s movement last week sums up why it has become so difficult to trade in these markets.
Early last week, European Central Bank President Mario Draghi put on his rose-colored glasses once again and gave a typically sunny prognosis for the euro-zone economy. Investors momentarily forgot some inconvenient facts, such as stagnating growth and record unemployment, and the euro surged against the dollar.
But just a couple of days later, the U.S. government released a relatively strong employment report for May. And all of a sudden, the dollar was back in favor, and investors remembered how dire the situation in the euro zone is.
The weeklong yo-yoing in the dollar-euro trade is a microcosm of what’s happening in other markets. And, unfortunately, this type of manic behavior is going to become the norm.
QE’s Effect on Japan
More than any other marketplace, Japan’s is emblematic of the warping effect, and the volatility, caused by quantitative easing.
The turbo-charged QE policy put in place by new Prime Minister Shinzo Abe initially worked as intended — driving Japanese stocks up and the yen down, making the country’s exports more attractive on the international market.
But the policy had the unintended consequence of destroying the yen carry trade. The strong yen enabled investors to borrow in that currency, convert the funds into U.S. dollars, and then buy stocks or other assets at a lower price, relative to what they would have cost in yen.
This carry trade is a type of leverage that can be incredibly profitable — if the exchange rate between the two currencies used remains constant.
But thanks to Japan’s massive new quantitative easing policy, the exchange rate changed dramatically. Investors were forced to exit their carry trades, and some took heavy losses.
But now, the initial euphoria about Japan’s bold experiment seems to be fading. Investors are becoming skeptical about the program’s long-term impact, and their main concern has switched from leveraging their gains to protecting themselves from losses. They don’t want to be left looking for a chair when the music stops. As a result, the Japanese markets are snapping back.
Japanese Yen vs. U.S. Dollar
As you can see, the yen didn’t remain depressed for long. Over the past month, the Japanese currency has staged a 7 percent rally against the U.S. dollar, and last Thursday, the yen jumped nearly 3 percent in one day! That is simply unheard of in the currency markets.
Meanwhile, after about six weeks of steady gains, Japanese stocks are experiencing their own reversal.
Nikkei 225 Index
In less than a month, Japan’s benchmark Nikkei 225 index has plunged 17 percent!
QE’s Effect on Gold
Another troubling example of this recent volatility hits closer to home. Gold has been on its own roller-coaster over the past few months, trading between a high above $1,800 an ounce (last October) and a low near $1,300 an ounce (about two months ago).
At the moment, gold is close to the bottom of that range, and investors continue to sell out of any minor rally. But the market stubbornly refuses to break down entirely. And the longer that continues, the more nervous the bears will become.
Remember: All reversals in downtrends begin with short-covering. I’m not saying this downtrend is about to turn into an uptrend; short-covering is not enough to build a lasting rally upon. The true test will be whether new money begins flowing into gold.
Written By Douglas Davenport From Money And Markets
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