Where can we find more sand to stick our heads into? It would seem that the desert we currently find our head firmly buried beneath is just not deep enough to prevent us from hearing more and more bad news. An American retail sales decline of twice the market expectation confirms the inactivity of west coast ports where trade volumes have dropped off a cliff. That has led to a magical narrowing of the U.S. trade deficit to $40 billion – but that's not a good thing because it means global manufacturing and production are fast vanishing. In this environment we continue to favor the world's reserve currency, not because it's least tarnished, which it isn't, but because it's economic status is the cause and therefore the likely cure.
The hour glass of woes continues to flow today. Canada's Nortel, once one of the world's biggest supplier of networking solutions and bellwether of the technology market, has finally filed for Chapter 11 bankruptcy protection. Deutsche Bank, Germany's biggest bank announced some horrible losses in its quarterly filing today stemming from equity trading and losses related to bonds hedged with credit default swaps. London's HSBC is rumored to need to raise a further $30 billion in capital as its assets have been eroded. Its shares have fallen in response to increasing media coverage of that point – accurate or otherwise.
But our point is that Vikram Pandit's woes as he scraps Citigroup's old business model, or the challenge facing General Electric's Jeff Immelt are no different to those faced by corporations around the globe in these difficult times. We find it hard to argue that there is another more favorable currency than the dollar when the global economy continues to be fed through the shredder with a grim outlook on the other side.
One candidate might be the Japanese yen. It's not that their economy has been left unaffected by the global rout. Rather there is a perception that the yen is the ultimate global barometer of risk aversion. It's hard to find a currency article in which a rapidly appreciating yen isn't explained away by unwinding of the carry trade. In such activities an investor sells the low yielding yen and buys other higher yielding currencies, where the investor can then purchase assets such as stocks and bonds that might appreciate at a more appealing rate than the yen.
The yen's ascent allegedly continues to be fuelled by investors unwinding these trades. Our question is how long this can go on for? The yen has strengthened against the dollar since July 2007, which is pretty much when the credit markets backed up. At that time the dollar bought ¥123 and recently the yen rose in value such that the dollar only bought ¥87. The euro stopped rising against the yen in July 2008, just as the price of oil peaked and has since fallen from ¥170 to ¥115. But our point is twofold. This unwind has been continuing for six months. Second, the unwind has more than likely triggered stops along the way creating more selling. But our in conclusion here stems around problem that we can't tell how many positions were ever out there nor do we know how many positions are left.
Our quest is to find out what is driving the yen and whether its future performance will continue. The yen's weakness during a period of global growth during which carry trades came about reminds us of a submissive Geisha girl. The theory that the yen would be prostituted for gains in other asset areas created a self-fulfilling prophecy. But now that the yen is on the rise, much like a Japanese warrior, we have to question whether its strength is well-founded as a real risk-barometer or whether it's simply because investors fear the warrior because of his menacing uniform. Ultimately, there will be no one left in carry trades and we may well be at that point – it's just that nobody knows it. One day we'll find that the equity markets are in freefall yet the yen isn't up to the task because investors will realize that short yen/long anything else is a trade well past its sell-by date.
We provoke that thought this week in response to a huge build in put option activity on the yen as measured by the PHLX World Currency Options. These options use a reciprocal index for the yen, which moves up with yen strength and down when it declines against the dollar. A dollar/yen rate of ¥89.04 is equivalent to a yen price of 112.30 today. That's the opposite of the conventional measure of dollar yen. We have seen a 30,000 lot build in put positions, which adds to last week's put open interest of 39,000 and so you can tell that this is a large amount of bear positioning going on.
Investors have been paying around 2.0 to buy protection against of fall of the yen from its current 112.30 by March at the 105 strike. (In conventional terms that would be a rally in the dollar's value from ¥89 to ¥95.) Perhaps other investors are questioning the yen's strength too. What has the yen got going for it in terms of becoming a replacement for the dollar as the world's major reserve?
Perhaps these investors are speculating that before the end of the first quarter all of the bad news will have washed through the economy and driven out the last bear in which case the yen's value of a risk barometer is over and done with.
Option implied volatility marked time during the week and is barely moved. If anything the declines in the commodity market have harmed currency prospects for export-reliant Canada and Australia where implied volatility readings are a little higher. But domestic news in both Australia and New Zealand confirm better housing markets and seem to prove that looser monetary policy is working. The problem for Australia though remains that China recently became its largest trading partner and the domestic uproar over job-losses paints a rather negative picture for any sustainable rebound in the Australian economy.
The weakness in the British pound has been brutal. Sad tale after tale can be told of economic weakness with house sales per surveyor slipping to a 30-year low and the weakest retail season for a December in 14 years. We've also noted pound put buying across the WCOs expiring in March. The pound recently rallied to back above $1.50 but when it does it takes an almighty beating courtesy of the negative sentiment surrounding the economic mess. We doubt Prime Minister Brown's £500 million employment package aimed at stimulating demand will do the trick. Investors are now targeting a pound back into the $1.30s.