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The King & His "Beauties"

All paper currencies are considered ugly against Gold Bullion – the king of currencies...

a winning trade in the foreign exchange market is similar to judging a "reverse beauty" contest, writes Gary Dorsch, editor of Global Money Trends.

In other words, one must be able to identify the least ugly currency among its peers, at any given moment in time. Because all paper currencies are considered to be ugly when compared to the "king of currencies" – Gold Bullion – since central bankers are apt to print vast quantities of fiat currency at the behest of government officials who have appointed them to run the printing presses.

"By this means, government may secretly and unobserved, confiscate the wealth of the people, and not one man in a million will detect the theft," observed the late John Maynard Keynes, the father of modern macro-economics.

In the arcane world of foreign exchange, the old axiom that "the trend is your friend" is a very valuable piece of advice. Trends in currency pairs can extend for many months, or even years, often leading to double-digit returns. And while the Australian Dollar is among the most volatile of currencies, due to its tight linkages to base metals and other commodities – and so is now viewed as a global barometer for risk-taking – the Euro has also been exceptionally volatile this year, plunging by as much as 20% against the US Dollar.

Hitting a four-year low of $1.1875, the Euro fell on Europe's festering debt troubles, giving traders flashbacks to the Lehman Bros bankruptcy, when paralyzed bank lending nearly triggered a global depression. Traders are now worried that European banks could face huge losses on some of the $1.3 trillion of loans extended to banks and private institutions in Greece, Spain, and Portugal.

The hysteria over the solvency of the Club-Med countries – Greece, Portugal and Spain – was whipped into a frenzy, with questions being asked about the long-term viability of the Euro itself.

There was speculation that the 11-year-old currency could collapse if Athens defaults on its debts and opts out of the Euro, in return for setting up its own central bank and regaining the ability to print Drachmas at will.

Concern quickly spread beyond a possible default by Greece, with Portuguese and Spanish bond yields also turning sharply higher. Private-sector debt in the Club-Med countries is a further worry, because when governments must pay more for financing, so must corporate and private borrowers. Sharply higher interests can deepen an economic downturn, and lead to more corporate defaults. And already, the 16-nation Eurozone's M3 money supply measure has been stagnant for six months, with Eurozone bank loans to the private sector stalled at 0.3% growth from a year ago.

Analysts estimate that European banks have lent about €2.2 trillion to Greece, Spain, and Portugal, with about €567 billion plowed into government debt, €534bn to companies in the private sector, and €1trn to other banks. While Greece is the weakest debtor, much more was lent to Spain and its private sector, about €1.5trn, compared with Greece's €338bn.

The European Central Bank estimates that the Eurozone's largest banks will write-off €123bn (US$150bn) for bad loans this year, and an additional €105bn in 2011. According to the credit default swap markets (where debt-holders can insure their bonds against default by the issuing country), Greece is the most likely candidate to default. One-year CDS rates catapulted upwards to a record 1,325 basis points (bps) in April and June (equivalent to 13.25% of the bond's value), after hovering around 80 bps last year.

In the foreign exchange market, the US Dollar index turned higher against the Euro, British Pound, Swiss Franc and other currencies (with the exception of the Japanese Yen), tracking the upward spike in Greek CDS rates.

The US Dollar, a heavily inflated and debt-ridden currency itself, was utilized as a temporary "safe haven" – a depository for scared money fleeing the uglier looking Euro. A violent shakeout in industrial commodities, triggered by the sharp slide in Shanghai's red-chip stock market, also swept the Aussie and Canadian petro-Dollars lower.

The US Dollar index continued to surge higher towards the 88-level, tracking the Greek CDS market. At the same time, the US Dollar's surge made American goods less competitively priced in world markets, meaning the US trade deficit widened to $42.3 billion in May, the highest level in 18 months.

The deficit with Europe rose to $6.2 billion as imports rose by 3.2%, outpacing a 1.9% rise in US exports to the single currency region. Still, the biggest "culprit" behind the widening US trade deficit was China. The US-Sino deficit jumped 15.4% in May to $22.3 billion, and now equals 53% of the total US shortfall.

Thus, the US Dollar's most glaring overvaluation is against the Chinese Yuan, perhaps by as much as 40%. On a trade-weighted basis, the US-Dollar index looks increasingly vulnerable to a sustained decline. However, the primary driver behind the US Dollar index is capital flows into and out of global bonds and stocks, while trade flows generally have little influence.

European and International Monetary Fund officials took quick steps to guarantee Club-Med's debts, unveiling a €750 billion lending facility for weaker nations to raise capital at affordable interest rates.

Teetering on the edge of default, Europe's banking oligarchs thus averted catastrophe with another short-term fix. The latest bailout is a wealth transfer from taxpayers that flows directly to German, French and other foreign banks, which are creditors of Greek, Portuguese, and Spanish debt. Among the biggest winners are Banco Santander, BBVA, Société Générale, BNP Paribas, and Unicredit.

As part of the Euro-IMF rescue, Eurozone central banks – including the Bank of Italy, Bank of France, the Bank of Finland, the Slovenian central bank, and the German Bundesbank – started to buy government bonds on May 10th, reversing the ECB's long-held resistance to full-scale asset purchases. ECB chief Jean "Tricky" Trichet gave no indication of how much the ECB's agents were prepared to buy. Boosting its firepower further, the ECB restarted a US Dollar swap program with the Federal Reserve, in order to inject emergency US Dollar liquidity in the global money markets.

To date, the ECB's efforts to contain the wildfire in the Greek and Spanish bond markets are starting to show signs of sustained success, and in turn, aiding the recovery of the Euro currency to $1.30 this week. The "shock-and-awe" effect of the rescue operation, initially drove yields on Greece's 10-year bond sharply lower, from a record high of 17.35%, to as low as 7.43% in a single day!

Since then, Greek bond yields have drifted upwards, but are now contained within a narrow range between 10.50% and 11.50%. Greek CDS rates are still dangerously high, but have tapered off dramatically from that record 1,325 bps on June 30th, down to as low as 960 bps by mid-July and indicating much less fear of a Greek default or restructuring. Likewise, Spain's 10-year bond yield has been capped at 5%, and Spanish CDS rates have also tumbled 80 bps in recent weeks.

Spain, however, remains the biggest ticking time bomb in the Eurozone. On the surface, Spain's debt load appears manageable. Its government debt relative to gross domestic product is 54%, compared with 120% for Greece and 80% for Portugal. But Spain's private sector debt is 178% of GDP, and it is heavily dependent upon fickle foreign investors for financing. Spain has €225bn in debt coming due this year, an amount that is about the size of Greece's entire economy.

Following Standard & Poor's decision to slash Greece's debt rating to BB+ in May, otherwise known as "junk" status, the Euro began to cascade lower, losing 10% of its value in an orderly fashion, within five weeks time. The impetus for the Euro's devaluation were heightened expectations that the ECB would unleash its nuclear option of "Quantitative Easing" (QE), or printing vast quantities of Euros on its electronic printing press in order to monetize the debt of the Eurozone's biggest borrowers and delinquents.

The climax of the Euro's selling spree was reached on June 4th, when it skidded below $1.20 after a spokesman for Hungarian prime minister Viktor Orban told reporters that Hungary's public finances were in a much worse shape than previously thought, and said there was only a slim chance that Budapest could avoid a Greek-style scenario. However, as fate would have it, the deep-seated pessimism engulfing the beleaguered Euro would soon dissipate, as the ECB took remedial action.

Whereas the currency markets were bracing for the ECB to open up the floodgates of Euro liquidity – with massive purchases of bonds, similar to the actions of the Fed, Bank of England, and Bank of Japan – just the opposite began to happen.

"These purchases of bonds will be very limited. Their only goal is to restore the efficient functioning of bond markets and the monetary policy transmission mechanism. The liquidity which would be introduced, would again be sterilized," said Bundesbank chief Axel Weber, on May 10th.

Yet few traders trusted Weber's vow at the time.

The ECB's bond buying spree, which began with a flurry of €16.5 billion in the first week of operations, was whittled down to only €1bn in the week ended July 7th. Some top ECB policymakers are already hinting at an early end to the QE-scheme amid signs that Greek and Spanish bond markets are stabilizing. The ECB has bought a total of €60bn-worth of sovereign bonds so far, but has also drained €60bn in cash from the banking system by offering to pay 0.56% on one-week deposits held at the central bank – a move known as "sterilization" to offset any potentially inflationary risk from the bond-buying.

Amid signals that the ECB is winding down its QE-scheme by an earlier than expected date, short-term German Schatz bond yields have begun to shoot higher, climbing from a record low of 43 basis points on June 8th to 77 basis points one month later.

Schatz traders were pricing in the likelihood of a half-point ECB rate cut to 0.50% by year's end, but now, that speculation looks far fetched. In a separate operation, the ECB drained €200bn out of the banking system on July 13th, lifting short-term interest rates higher in the open market, and giving an extra boost to the Euro currency.

Since the Euro hit bottom at $1.1875 on June 7th, the interest rate spreads between Germany's benchmark 2-year Schatz and the US Treasury's 2-year note have widened significantly in the Euro's favor. Germany's 2-year Schatz now yields 15 basis points more than comparable US Treasury notes, far higher than the minus 35 bps of a few weeks prior. The 50-basis point swing in favor of German Schatz yields lifted the Euro by roughly eleven US cents, taking it to a high of $1.30.

Another reason for the Euro's recovery is that, while the ECB appears to be winding down its mini-QE campaign – and is sterilizing its bond-buying program by withdrawing equal sums of cash from the banking system – the Federal Reserve is now starting to send the opposite signals to the marketplace.

At the late-June meeting of the Fed's policy board, the consensus opinion agreed that further policy stimulus (QE) might become appropriate, if the economic outlook were to worsen appreciably.

Long-term holders of Gold Bullion – the king of currencies – have suspected for quite some time that the Fed would eventually re-activate its nuclear QE weapon, in order to monetize Washington's debts and those of state governments, which are going broke.

On July 13th, Boston Fed chief Eric Rosengren warned that the Fed hasn't run out of ammunition just because the federal funds interest-rate is now at zero.

"There are several policy options if we think the economy is weaker than we would like," he said.

Rosengren added that he was nervous about the prospect of a deflationary spiral...

"The risk of deflation has gone up and is more of a risk than I would like to see at this point."

The prospect of more money printing by the Fed continues to buoy the Gold Bullion market, at least on the longer-term view. But in the short-term, a rebounding Euro, an up-tick in German Schatz yields, and a sizeable slide in Greek CDS rate, have all conspired to knock gold off its all-time highs.

Eurozone politicians are trying to refurbish the Euro's stature, by adopting fiscal austerity measures to reduce their bloated budget deficits. At the same time, the ECB has begun to tweak its monetary policy, by jigging-up German Schatz rates and sterilizing its debt purchases. Looking ahead, the Euro could look less ugly compared to the US Dollar, especially if the Fed cranks up its money-printing operations.

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GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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