What The Australian Dollar Is Telling Me …

According to the financial markets, the world has become a very calm and comfortable place again. But has it?

Just a year ago markets were crashing all around us …

The U.S. housing market had started the snowball rolling far earlier. Then the U.S. stock market finally turned over. Later, other markets, like commodities and currencies, woke up to the realization that a crisis in the U.S. economy had tentacles reaching around the world! And the music stopped …

Investors went running for the exits, markets collapsed and U.S. Treasuries and the U.S. dollar soared as capital around the world fled to safety. The theory of global diversification crumbled. And the risk gauge for financial markets skyrocketed.

A good pulse of the market’s assessment of risk shows up in “implied volatility.” Here’s a brief explanation of what I’m talking about:

Actual volatility is the dispersion of prices around the mean - simply a market’s price volatility. On the other hand, implied volatility is determined by market participants. It’s the perception of how volatile the markets will be and how certain (or uncertain) the outcomes will be.

This makes implied volatility a good risk barometer. And that’s why it’s a key component in pricing options, where market participants typically go for protection when the perception of risk in the financial markets rises.

So what was the market saying about risk this time last year? Here’s a look at a chart on implied volatility in the Australian dollar and the S&P 500 (^GSPC) …

Source: Bloomberg

As you can see, the massive surge beginning last September was nearly a five-fold jump in the fear gauge - a clear panic in financial markets.

And the trigger was …

First, a huge third-quarter loss from Lehman Brothers and a downgraded estimate for Merrill Lynch.

Then, a weekend takeover of Merrill Lynch by Bank of America.

And finally, the announcement of Lehman Brothers’ bankruptcy.

But here’s the thing …

Wall Street Has Proven to Be Lousy At Estimating Risk …

Just prior to the September 2008 spike in volatility, Wall Street’s mood was pretty rosy, despite the trail of disaster that had already been delivered:

• Morgan Stanley (MS) lowered expectations for global growth from 5 percent to between “3.5 percent and 4 percent.” Global growth went negative.
• Lehman Brothers said they expected stocks to “climb at least 17 percent by December 31.” Eight days later Lehman Brothers was bankrupt.
• Citibank (C) said they expected 2008 to mark the biggest year-end rally in stocks in a decade.
• And JP Morgan (JPM) was looking for an 11 percent rally into the year end.

Stocks never made a tick higher and finished the year down another 29 percent.

This is a good example of how complacency and unwarranted optimism can end abruptly. And I think that’s what we’re going to see … again.

Since the middle of last year, financial markets have traded distinctly in one of two camps: Either risky or safe. When volatility was soaring, global investors fled all things risky for a safe place to park their capital. The dollar benefited and so did U.S. Treasury prices.

But since March of this year, triggered by the Fed Chairman’s finding of “green shoots” in the economy, this risk aversion trade has reversed. Capital has steadily and aggressively moved out of safety and into riskier, higher-return investments.

Will we see another spike in fear when a negative surprise hits the markets? I think we will. And I think the setback for the global economy will be considerable …

Investor and consumer confidence, when burned again, will be very difficult to regain. And that creates a scenario for prolonged weakness in economies and prolonged weakness in financial markets.

Market Position Signals Risk Appetite Is Vulnerable …

The Australian dollar has been the high-beta trade among major currencies in this run-up in risky assets. In other words, the Australian dollar has gained nearly 2 percent for every 1 percent in the euro or the British pound.

And as you can see in the chart below, it has gained more in percentage terms than it lost at the height of fear in the global economy. Even the optimists have to agree, things aren’t that good today!

Source: Bloomberg

Technically speaking, the currency is also running up against an important retracement level.

And more investors have gone “long” the Australian dollar than at any time since July of last year - which by no coincidence was the same time the currency reached its highs and turned sharply lower.

So be very cautious of this run-up in risk appetite. Based on the action in the Australian dollar, and considering the market’s vulnerability to another dose of fear, the dollar and the risk aversion trade look more likely to return.

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.

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Comment by Graeme Simpson

2009-08-14 11:35:35

My compliments to Bryan Rich for writing a very truthful & informative article, most people particularly those with limited experience are fed up with being fed lies & deceipt by people, companies & governments with vested interests telling them how fine things are going, this not only destroys further any remaining faith but reinforces just how stupid these powers that be think Joe & Jill Public are.
The thing that worries me the most is that unless leaders don’t start very soon talking with people, telling them the truth, explaining why the world cannot go back to the lifestyle we enjoyed & why we all have to make fundemantal changes to our wants & expectations in life, society as we know it will collapse with war & mayhem everywhere.
One thing that history can certainly prove to us if we’re willing to listen & learn from it is that nothing is safe from radical change no-matter how great some of mankind think they have become.
Anyway, thanks again in telling things the way they are, I hope others in the field take notice & do the same instead of reporting & saying whatever propoganda they are told to.
Kind regards
Graeme

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