DEFLATING GOVERNMENT COMPLAINTS / BARRON´S ( RECOMMENDED READING )

Thursday, July 9, 2009

UP AND DOWN WALL STREET DAILY

Deflating Government Complaints

By RANDALL W. FORSYTH

Prices slide as the reflation trade fades across markets.

GOVERNMENTS ON BOTH SIDES OF THE ATLANTIC declared war on commodity speculators and prices slid across the board Wednesday. Don't be too quick to tie cause and effect, however.

After the head of the U.S. Commodity Futures Trading Commission, Gary Gensler, was joined by British Prime Minister Gordon Brown and French President Nicolas Sarkozy in calling for curbs on speculative trading in vital markets such as energy products, crude oil slumped to just over $60 a barrel. Just a week ago, a rogue trader supposedly sent crude spiking to $73 with some errant trades, as if to underline the assertion that so crucial a product is too important to be left to the vagaries of the market.

Yet even more powerful than government regulators is the deflationary undertow has come back with full force, neutralizing the so-called reflationary trade that was the big winner in the second quarter.

That was evidenced not only by the broad decline in all manner of currencies but also in moves in the currency and bond markets, all pointing in the same direction -- lower prices and a retreat from risk.

Taking those factors from the bottom, the 10-year Treasury note, the financial equivalent of the ugly guy with a pocket protector in high school, suddenly became Mr. Popularity in a blow-out auction Wednesday. After getting dissed around the world as its yield rose to a peak of 4% nearly a month ago, almost double the level at the turn of the year, the 10-year note has staged a stealth rally that has taken the its yield back down to 3.30%.

Over that span, nutty notions of the Federal Reserve tightening policy by year-end or early 2010 were erased, especially after last week's dismal June employment report. But beyond the always revision-prone government data, the commodities markets were sending their own signals of weakness, entirely in harmony with the Treasury market.

While the stock market was forming its much-commented-about head-and-shoulders formation on the charts (Getting Technical, July 8), the copper was seeing a similar pattern, as MF Global market watcher John Brady points out. That commodity is also known as Dr. Copper, the market with a PhD in economics, for its ability to forecast trends in the economy.

Yet the currency market may be giving the clearest sign of renewed risk aversion. The euro-yen cross rate has been a reliable barometer of risk appetite for several years. A high euro versus the yen means investors are buying relatively risky assets in Europe and borrowing yen to fund those positions, which pushes down the Japanese currency. When the position is reversed, the euro tends to fall against the yen. Not surprisingly, euro-yen tends to move in tandem with stocks and other risk assets.

Dennis Gartman, editor of the widely read Gartman Letter, Wednesday morning pointed to a sharp break in euro-yen as a caution flag for markets. The yen surged further against the dollar, which in turn rose against other currencies, notably the euro. The Japanese and U.S. currencies are the usual refuges from risk. And as funding currencies for carry trades, the yen and the dollar typically get bid up when risk is shunned. That was happening in spades Wednesday.

It's ironic that the U.S. and European government would voice their complaints about rising commodity prices just as they seem about to break. The real objection to speculators' trading is that they gave an unnaturally healthy glow to the markets and, by extension, expectations about the economy.

It's equally ironic that governments should object to manipulation of the prices of key inputs when they are responsible for pegging the key prices in the economy no differently from the former Soviet Union. No nation allows its currency to float freely, and exchange rates are perhaps the most important price in the economy. That's not just true of China and the yuan but also the major, convertible currencies such as the dollar, the euro and yen.

Indeed, as the Group of Eight meets in Italy, the communiqué is apt to call for exchange-rate stability, which would justify intervention. And notwithstanding calls for a new world currency to supplant the dollar, it's likely the major nations will continue to support the greenback while there is no credible substitute. They don't want their own currencies' values to rise and crimp their own export competitiveness. Neither do they want the value of their billions in dollar-denominated assets to decline. So foreign governments continue to support Treasury auctions even as they bemoan the U.S. budget deficit.

There's a key difference when governments complain about speculators even as they intervene ever more deeply into the markets. When speculators do it, governments call it manipulation.

When governments do it, it's called monetary policy.

But neither speculators nor governments are likely to be strong enough to fight the deflationary undertow.

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