the gestalt shift

The Capital Markets’ Mattress

Note: This article was put together initially on 10 December (last week) although it wasn’t completed and submitted until now.

The financial markets have done the equivalent of stuffing their money underneath their collective mattresses during bad times. 3 mo. US Treasury Bill real yields plunged into negative territory, meaning that investors are actually now paying a premium to store their money safely. Normally safe havens consist of cash or commodities such as gold, but in these times risk aversion flows have gone to the “safest” asset in the world, US government debt.

This event signals some change ahead to me. When fearful allocation into assets happens like this it is usually unstable and one can expect a rebalancing to happen. There are other “safe” places to allocate assets in troubled times, and when one realizes that there are credit default swaps (insurance on default) for US debt, one must acknowledge that the US might not be as safe as it appears. Investors will need to find a better place to put their money as volatility drifts lower.

A confluence of other events seems to support the idea that there might be a shift from current safe haven flows. For example, the strong positive correlation between equities and the US dollar (against all currencies except the Yen) has begun to break down (see figure). Correlation breakdown usually signals a change in psychology/perspective in the market (i.e., a Gestalt Shift). The ugly US fundamentals exemplified particularly by the recent auto industry crisis is finally surfacing in the psyche of traders and causing a selloff.

Note the recent divergence of price paths in the two contracts

Furthermore, it is in the US government’s best interest to keep the dollar weak, despite what Hank Paulson says. Debt is rising to unprecedented levels and if the US doesn’t keep the greenback weak,  exporters will not be competitive enough to keep the debt at manageable, albeit high levels.

So how can we construct a position out of this? Gold and the Euro seem to be prime candidates, since the former has always served as a safe haven as a physical commodity, although it has been sold off along with all the other commodities due to the deleveraging earlier this year, and the latter is benefiting from the perception that the ECB is in a better position to deal with the crisis because of their handling of monetary policy. I would not expect EUR/USD to extend all the way to 1.50 since that would require a considerable buildup of risk apetite and liquidity of funds, however it could reasonably range above and below 1.40. In a similar scenario XAU/USD could reach $900/oz. Volatility will continue to prevail as the market awaits the outcome of the auto industry bailout.

KM

Tuesday, December 16th, 2008, by kristophm and is filed under "Uncategorized ". You can leave a response here, or send a Trackback from your own site.