Dog from the Disney movie UP

Source: YouTube – Disney Movie Trailers Channel

In the Disney movie “Up”, the dog is equipped with a collar that allows him to speak to our fearless adventurers. However, the dog interrupts himself mid-sentence to exclaim “Squirrel” (@ 1:28 of this 2:31 minute trailer), thus demonstrating that no amount of technology will improve upon the distracted dog brain that is behind the voice.

The markets around the world on Tuesday looked much the same as this “clever dog” in the picture above. The Chinese Central Bank decided to nudge the one year lending rate a massive 25 basis points (to 5.56%) and deposit rates to 2.5%. This was enough to clobber the Aussie dollar and impact markets around the world. And then, on the 20th, it was all over.

But is it really over?

The 25bp hike was a “Squirrel” moment because the global financial markets are overly sensitized to any change in interest rates.

First, the move itself won’t have much of an impact on Chinese demand, inflation or the “firehose of liquidity” that is pouring into China and the rest of Asia. It is a one-off “shot across the bow”. Don’t hold your breath for unilateral follow up.

Second, the larger issue is the brewing currency war between China and the US (see this and related FT articles). Simply stated, the US wants to depreciate the US dollar to pump up growth and inflation so as to transfer both short term and long term economic pain to the current account surplus countries. At the same time China, fearing an inflationary/hot money bubble, is unwilling to play along. For China, a revaluation of the RMB will transfer a healthy bulk of the US’s economic pain to its own export dependent economy while doing next to nothing to discourage hot money in the short to medium term. But it is not a two dog fight. The rest of the world (or at least the bit with trading currencies) is caught up in this dispute. Brazil’s finance minister, Guido Mantega, cancelled his trip to Seoul’s G20 meeting because he was too busy dealing with the forex situation in Brazil.

Will this result in another “Plaza Accord”? Probably yes and probably sooner than the finance ministers in Seoul realize. The US cannot afford to depreciate the dollar in a chaotic manner because it risks plunging the country into some very unpleasant economic circumstances. China will eventually sign on to some sort of deal because it can afford neither the inflation that has already started to bubble up nor a disruption in its biggest export market. The rest of the world will sign on just to keep the US from resorting to drastic capital and trade barrier tactics which threaten to nip the strong global recovery (at close to 4.5%) in the bud.

How should investors play a new “Plaza Accord”?

There is no question that the US dollar will get much cheaper but that does not automatically translate into Gold at $3,000 per ounce. Gold may rise further and certainly the Fund King System is positively disposed towards the yellow metal and the companies that extract it from the earth. However, much of the momentum on gold is tied to the uncertainty which has waxed and waned for the last decade. Once a level of multilateral certainty returns to the market, we may see the momentum behind gold leveling off at these lofty prices.

For US dollar based investors, it is a good time to evaluate your liabilities and see how much of your future expenditures are related to foreign currency. You might want to start rebalancing your investment portfolio to account for the 15%-20% forex exposure that wealth managers suggest is a “neutral weighting” for most middle and upper-middle class American families (“oh, you mean THAT BMW in my garage…”).

Once you have attended to the serious business of making sure that your assets will meet your future liabilities, it is time to look at some of the shorter term options.

The first option is UUP/UDN, which are the Bullish/Bearish US dollar ETNs offered by Powershares. That may not be exciting enough for some because it tracks the USDX Futures contract which is currently 57% Euro, 13.6% Yen and 11.9% British Pound. If you have a particular currency in mind, there are many choices (FXY, FXE, FXB, FXA, BZF…) in the ETF space to gain direct exposure to foreign exchange without having to learn what a pip is. If you want to play the RMB directly, CYB is far more liquid than CNY.

Another way to play the upcoming events might be found in VXX, the ETN that tracks the S&P500 short term VIX volatility index. At a close of just under 13 on Friday, it is flashing a surprisingly comfortable indication to a market that is faced with mid-term elections in the US and a potential currency/trade war. Unless the agreement is already stitched up, it is safe to assume that we will hit some turbulence before the new “Plaza Accord” takes effect.

The markets are set for a period of heightened volatility. Now is a good time to do some portfolio cleaning to make sure that you are not dragging any deadweight assets along for this ride.

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Filed under: CurrencyETFInvestment IdeasMarket Psychology

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