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Boy, what is it with the markets? Each week there are more and more elements of uncertainty piling on - the not-so-well hung German election, Rita following Katrina on the Gulf Coast, and gold shooting to a multi-year high of $ 475 an ounce.

Looking at gold, in particular, the market seems remarkably uninterested. Other than the well-considered crazies (like Jim Rogers, who has long predicted $ 800+ gold and a collapse of the paper money system), nobody, but nobody - except me, that is - is talking about $ 500 an ounce. It's a nice round number, it would seem. And, if the market were thinking right, whatever that is, forecasts of $ 500 and even $ 550 would be everywhere.

Equally interesting to - and perhaps explaining - this lack of interest is the fact that over the past three of four months, the correlation of gold with the Euro (in particular, and non-dollar currencies, in general) has fallen sharply to close to zero. Now, most of time, gold moves with a reasonably high correlation with the Euro - often over 90%. This means that when the dollar strengthens against the Euro, it strengthens against gold as well, and vice versa. But over the past few months, this correlation has broken down. The last time this happened was in October 2002, at which time gold was around $ 310 an ounce and the Euro was at about 90 U.S. cents. Shortly after this, the market turned, and the dollar fell steadily, hitting a low of 1.36 to the Euro with gold soaring to $ 475 an ounce. Now, it is hard to say whether the breakdown of the correlation between gold and the Euro was a causative factor in the change of trend - they may well both have been the result of something else.

For instance, it could have been that the correlation broke down because gold had fallen out of favor with speculators, since you couldn't make money in the gold market for years; as a result, there may have been very little interest in the gold market, which could (at least partly) explain the lack of correlation. Now, nothing stays out of the limelight forever - remember Andy Warhol's comment that "in the future, everybody will be famous for 15 minutes". So, it could simply be that investors/speculators/whoever suddenly rediscovered gold and started buying it wildly; this pushed the dollar lower and triggered the long awaited turnaround.

Hmmm.

Or, of course, it could be something else. As I said earlier, correlations are tricky items to use for decision-making.

Returning to the current gold market, the correlation has fallen apart - that much we know. It also seems unlikely that the gold price would be rising if, as a few years ago, people had lost interest in gold. So, what does it mean?

Could it be that gold is going to continue to rise against all currencies, including the dollar, but the dollar's trend against other currencies remains indeterminate? Or, in a throwback to the last event, could it be that this indiscriminate - i.e., without correlation - rise in gold is signaling a change in the dollar trend, turning it bearish again? Or, again, could it be something else entirely.

I was discussing this with an old friend of mine - he is a shy man, so I will simply call him Dr. Risk. By coincidence, we were talking on his birthday - Happy Birthday (in print), Dr. Risk. He was silent for a few moments - he is quite unlike me, in many ways. And then he said, "Well, could it be that since the U.S. long bond yield has remained low for so long, creating Greenspan's much-reported conundrum, it is no longer a measure of incipient inflation?" [Historically, and from classical economics, higher long term yields signal higher inflation expectations. Currently, U.S. bond yields are extremely low - the 10-year bond yields barely 4.25% - and the "conundrum" is that these yields have barely moved despite the Fed having raised short term interest rates 11 times since June last year (to 3.75%). Under normal circumstances, the long bond yield would have risen in sympathy. Of course, no circumstances are normal and we have a range of explanations been touted - for instance, China and its Asian cohorts are buying U.S. treasuries to invest the dollars they buy to ensure that their currencies remain competitive; global inflation expectations are permanently lowered since China and India are bringing in huge amounts of supply in manufacturing and services, respectively. And so forth.]

Dr. Risk's comment was, as usual, elegantly insightful. He meant that if, for some reason (including, perhaps, those cited above), the U.S. long bond is no longer able to do one of its key jobs - viz., signaling inflation expectations - could it be that gold (again, let's not forget that historically gold has always been an inflation hedge) is signaling in its stead?

Are we on the cusp of a serious rise in inflation? Well, oil prices are sky-high, and everybody is surprised that inflation hasn't taken off. But then, complacency - this time it's different - is a very comfortable sofa.

Let's explore this. An exogenous price shock - e.g., oil at $ 70 a barrel - becomes inflationary only if the users of the price shock are able to pass the price increase along to their customers. This will happen if the economy is doing well and/or if margins are very tight. We note that already two U.S. airlines have filed for bankruptcy, so it is clear that there are some sectors where margins are extremely tight. On the other side, global growth is strong; consumers - particularly U.S. consumers, who are enjoying an unbelievable wealth effect from the housing sector - seem happy to spend more and more and more money. So, it is not inconceivable that prices would start to rise - perhaps, sharply - some time soon. It's happened every time before. [I did read a very interesting explanation why prices have not risen so far. The writer pointed out that oil producers have become much more sophisticated than during earlier oil price shocks, so their surpluses are more efficiently recycled. In other words, they are buying more financial assets than palaces in the desert. Which is a very astute observation.]

Let's stick with this idea and see what happens. So, as inflation rises - say, the U.S. core CPI, currently at around 2%, pushes higher to 3, then 3.5%. Clearly, the U.S. Fed, in any case, hawkish on inflation, will be compelled to keep to its schedule of tightening monetary policy. Higher rates should mean a higher dollar - against the Euro and other currencies, not gold, which, let us remember, is holding the inflation beacon high. Another factor - not so incidental, perhaps - suggesting a continuation of the dollar bull trend is the result of the German election. An unhappy coalition - as we know well in India - is a certain recipe for doing nothing. And doing nothing means increasing uncertainty. And increasing uncertainty means lower investment interest and, probably, a weaker Euro.

U.S. growth, which would normally be hit by higher rates, may have a bit of a respite as the rebuilding from Hurricanes Katrina and Rita will pump probably $ 200 billion plus into the economy. In fact, as I have argued earlier, it is possible that there may be a permanent shift in the nature of the U.S. government - they may become more interventionist to try and rebuild a reasonable safety net for its poor people. All this could avert an immediate slowdown, keep the Fed tightening and keep the dollar well bid.

This could continue till the U.S. housing bubble bursts under the continuing attack of higher and higher interest rates. Growth would spiral lower, both in the U.S. and globally, as U.S. demand withered. And the dollar would - finally - head lower again. Perhaps viciously.

Unless, of course, the bubble didn't burst. Perhaps, this time it really is different.

What do you think, Dr. Risk?

currency markets view: rupee and majors

INR
Fortnightly movement: O: 43.80 H: 43.97 L: 43.80 C: 43.90
Sentiment: Turning weak, partly in response to overseas dollar strength
One month range: 43.70 - 44.20
Three month range: 43.50 - 44.50
Rupee traded in a 17 paise range during the last fortnight before closing 6 paise weaker at 43.90. Cautious import demand due to high volatility in the international crude oil prices kept the rupee in a defensive mode for most of the fortnight; however any significant decline in the domestic unit was prevented by sporadic RBI intervention and good FII inflows. SEBI registered more than USD 1 billion FII investment so far in the month of September, bringing total FII investment so far this year to more than the USD 8.5 billion registered in all of the previous year.

Perhaps the most notable factor is that RBI appears to have become more tolerant of volatility and appears to be happy managing the rupee in a broad 43.50 to 44.00 range. [200 day] Volatiliy has, indeed, risen to about 3.5%, from around 2% a couple of months ago.

On the fundamentals, despite the favorable medium term scenario, there is increasing uncertainty about the short-term direction. At a seminar I conducted last week, there were more people who expected the rupee to be sub-44 in the near term than those who expected it to be stronger than 44; even over the medium term (12-15 months), anecdotal sentiment seems to be looking for a weaker rupee. Certain international banks have also been forecasting a much weaker rupee - beyond 45 to the dollar - although, since they are also players in the marekt, it is hard to know whether this is their genuine research belief of simply a market positioning.

While market sentiment is clearly the driver, we do believe that RBI will intervene beyond the 44 level (particularly to protect the battered oil sector), and so do not expect it to fall much more than that in the near term.

Going further out (3 months), we note three forces - (1) sentiment seems to be for a weaker rupee, (2) RBI is likely to be quite aggressive in containing any rupee decline, and (3) while there does appear to be reasonably strong technical resistance to further falls, it is clear that the upside for the rupee is clearly limited - it is hard to see the long-term resistance of 43.25 being broken - but the downside is not. Thus, while it is likely that the current ranges may hold with, perhaps, a slightly weaker bias, the risks of a break-out are in the direction of a weaker rupee are higher. We would use call options to protect against this.

EUR
Fortnightly movement: O-1.2414 H- 1.2415 L-1.2038 C-1.2038
Sentiment - negative
Expected range for 1 Month: 1.1875-1.2350
Expected range for 3 Months: 1.1650-1.2500

Last fortnight was a nightmare for the major currencies vis-a-vis the US dollar. Optimism of post-Katrina reconstruction, lower than expected US trade deficit, an extremely upbeat TICS report on net capital inflows into the US, a hung German Paliament, and a sanguine Fed shrugging off adverse effects of Katrina as being transitory and hinting further rate hikes even after last week's hike; all contributed to the euro's collapse to just under 1.2050. Besides, the market seems to have shrugged off sharp drops in the Univ. of Michigan consumer sentiment index and Philadelphia Fed manufacturing index.

The euro's medium-term downtrend may have resumed. However, it appears oversold in the very near term and an upward correction towards the 1.2250-1.2350 resistance area could begin soon from the low 1.20s or the 1.1950-1.1875 strong support zone.

Can anything once again reverse market sentiment quickly? If there is a renewed surge in oil prices or the US ISM manufacturing index falls below 50 into the contraction territory and, if there is a quick amicable end to the German political impasse, the market could flip-flop again, pushing the euro higher, perhaps all the way to 1.26 plus. Clearly, uncertainty is higher than it's been in a while; the good news is the volatilities haven't yet risen so options may be a good bet.

GBP
Fortnightly movement: O-1.8424 H- 1.8426 L-1.7749 C-1.7750
Sentiment: negative
Expected range for 1 Month: 1.7600-1.8200
Expected range for 3 Months: 1.7000-1.8200

In addition to the US factors, sentiment for sterling was spooked by market disappointment on the UK retail sales and manufacturing fronts. The medium-trend seems to have turned down but sterling also appears oversold and a corrective rally to 1.8150-1.8200 is quite likely from the 1.77-1.76 area.

JPY
Fortnightly movement: O-109.19 H- 112.51 L-109.18 C-112.48
Sentiment: negative (for yen)
Expected range for 1 Month: 110.00-113.75
Expected range for 3 Months: 106.50-115.00

It appears the Prime Minister Koizumi's victory in the September 11 (!!!) elections was fully discounted by the forex market and there was no follow-through yen strength thereafter. On the other hand, larger-than-expected declines in the Japanese All Industry index and trade surplus bolstered the dollar apart from the US factors mentioned earlier. Moreover, some remarks from BOJ officials seemed to have suggested that the central bank is in no hurry to alter monetary policy even though the long period of Japanese deflation is expected to end soon.

Another factor confirming the surprising yen weakness was market's reaction to China's latest decision to widen the yuan's fluctuation band against the euro and yen. After a knee-jerk strengthening to 111, the yen promptly weakened back to 112.60, where it had been before the announcement. While, in general, yuan strength against the dollar should support the yen, this was merely a technical move by China - to enable it to continue to hold the yuan within a 0.3% band against the dollar, it needed to permit it to move in a wider band against other currencies, which are much more volatile against the dollar. [Incidentally, this quick move reminded me of how slowly RBI used to move in the face of market realities. In the early 1980's, the USD/INR forward rates were determined by overseas rates and RBI's fixed 60 points a month selling rate for forward sterling; they held this level fixed for years, opening up an arbitrage window for smart bankers, till 1998, when they changed the discount to 40 points a month. This still represented an arbitrage opportunity since it created a synthetic borrowing opportunity at 1-2% lower than the sterling base rate. It also created a structural disincentive for exports, since the forwards were extremely unattractive. No wonder then, that we moved rapidly to devaluation in 1991.]

Returning to the yen, it does appear that the dollar bull trend has returned, but overbought conditions may prompt a corrective dip to the 111-110 area before a break above 113.75.

On the other hand, the yen's weakness against the dollar masks its strength against the Euro; EUR/JPY is actively testing a support at 135, which, if it breaks - not unlikely given the uncertainties surrounding the German election - could see considerable yen gains. It is also possible that this could trigger a broader reversal of sentiment, which could re-open prospects of 106.50 and 105 USD/JPY.

Clearly, options are the order of the day!