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Tuesday, January 22, 2008 9:25 AM

Global Decoupling Myth Shattered In Equity Selloff

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The world did not wait for the US markets to open on Tuesday. A Global Bloodbath took place on Monday without us. What's happening is a forced unwind of leverage, especially in various anti-dollar and Yen carry trade plays. The credit bubble is clearly unwinding and it has much further to go.

As the Asymmetrical Unwind of the Credit Bubble continues, please think about how pervasive anti-dollar sentiment is in context of Things That "Can't" Happen.

With that sentiment in mind, let's take a look at things from the perspective of various currencies and the carry trade.

Canadian Decoupling Theory Frays

The Globe & Mail is reporting Loonie at September lows as decoupling theory frays.

The loonie tumbled to a four-month low as traders looked past tomorrow's widely-expected interest rate cut to how a pronounced U.S. economic slowdown would impact Canada.

“The idea that the global economy is decoupling from the U.S. slowdown is lying in ashes as you watch what is going on in global equity markets,” David Watt, senior currency analyst for RBC Dominion Securities, said in an interview.

“The decoupling story is fraying at the edges,” Mr. Watt said. “People did not want to give up the bullish Canada view, whereas now it is becoming clearer that story just does not hold water. The U.S. economy still carries a lot of weight and the global economy is showing the strain.”
Loonie vs. US$ Weekly

click on chart for sharper image

If the test of the 50EMA fails, and I expect it to, look for the Loonie to test the 200EMA at 87.5. Such a move would completely unwind nearly the entire 2007 liftoff.

Eurozone Credit Squeeze

The Financial Times is reporting Eurozone borrowing hit severely by credit squeeze.
The ECB reported a "sharp tightening" of standards applied to lending to business, largely because of the changing economic outlook. The net percentage of banks reporting that they had tightened credit conditions in the final quarter of 2007 on loans to business rose to 41 per cent, from 31 per cent in October's survey - which was already the highest since the survey began in early 2003.

Demand in corporate loans also deteriorated further compared with October's results - largely because of the decline in financing needed for mergers and acquisitions and corporate restructuring. At the same time, banks reported that "securitisation activity was severely hampered" at the end of last year.

Banks also reported a further significant tightening of credit standards for people borrowing to buy houses and a sharp drop in demand for such loans. Net demand was "significantly negative," the ECB reported.
The ECB hawks have been stressing concerns over inflation for months but those concerns are misguided. Tightening lending standards and a demand for loans that are "significantly negative", do not provide an inflationary backdrop. Nor do housing prices crashes in places like Spain.

Kiss goodbye the idea that the Eurozone will decouple from the US credit crunch. The next move by the ECB will be a rate cut. Are currency traders prepared for that move?

Euro vs. US$ Weekly

click on chart for sharper image

The Euro is way overextended, both fundamentally and technically. The chart also sports a nice double top. If anything it almost looks too perfect. However, a pullback to the trendline seems like a very reasonable bet. That trendline also sits right on the 50EMA. If we get there, I doubt it holds. I am looking for a retest of the breakout area near 135. There is also strong support at 130.

British Pound Sinks On Retail Sales

The Telegraph is reporting Sterling shunned as UK retail sales slide.
The pound has given up its brief recovery after official figures confirmed that shoppers abandoned the high street over Christmas, despite almost unprecedented price cuts. Britain's non-food retailers were forced to slash their prices at the fastest rate for over 25 years last month, taking a massive hit on their margins in order to try to lure customers in over Christmas, the Office for National Statistics said.

Department stores were among the hardest-hit, with sales slumping by 4.3pc - the biggest drop since 1994.

The news sent the pound lower against other major currencies. Sterling dropped more than two cents against the dollar to $1.9538, and was close to breaking through the 75p mark against the euro, up to 74.86p. An increasing number of economists are speculating that the Bank of England may cut rates by a full half percentage point at its next meeting - rather than the quarter point move it is accustomed to.
Kiss goodbye the idea that the UK would decouple from the US credit crunch.

British Pound vs. US$ Weekly

click on chart for sharper image

The technical picture of the British Pound is weak. There has been a major trendline break, the 50EMA seems to be rolling over, and there is a big cross under the 50EMA. A pullback to the 200EMA seems likely. There is a good chance the entire runup from the April 2006 low is retraced.

Spotlight On The Yen

The lovefest with the Euro and British Pound seems way overdone, but I do like the Yen vs. the dollar.

Bloomberg is reporting Yen Reaches Strongest Since 2005 as U.S. Economic Concern Rises.
The yen reached the strongest since May 2005 against the dollar as concern mounted that the U.S. is headed for recession, prompting investors to sell higher-yielding assets funded by loans made in Japan.

The Japanese currency gained against all of the 16 most-actively traded currencies this week as a U.S. manufacturing index fell to a six-year low. The Standard & Poor's 500 Index of shares had its biggest weekly loss in five years, sapping investors' confidence in assets tied to global growth prospects.
Yen vs. US$ Weekly

The Pain Trade Combination
  • A rising Yen vs. everything
  • A rising dollar vs. the Euro
  • A rising dollar vs. the British Pound
  • A rising dollar vs. the Loonie
  • Falling interest rates in Western economies
  • Rising interest rates in Japan and Asia
That combination is at hand (at least most of it) and it will force an unwind of the carry trade in Yen, and an unwind of anti-dollar plays hiding out in commodities and the Euro. Most commodity funds, hedge funds, and individual investors are looking the other way, expecting a complete collapse of the dollar.

An unwind of leverage could cause violent as well as unwelcome reactions for many investors.

The Pain Trade In Pictures

click on chart for sharper image

Should the credit bubble and the Yen carry trade bubbles continue to unwind, 2008 may just be the year where there are few places to hide other than much despised US Treasuries. For both sides of the Treasury debate please read Time To Short Treasuries?

Global Recoupling is clearly in progress (in a negative fashion). In addition, the Commodity Boom Is Over For Now. How many are prepared for this parlay?

Mike "Mish" Shedlock
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