It’s obvious that something strange is afoot.
Just look at the chart below. In the top pane is the S&P 500 SPDRs, which are supposed to trade based on things like earnings and risk premiums. The bottom pane shows the euro versus the U.S. dollar. Exchange rates are supposed to trade based on factors like relative interest rates, GDP growth and inflation expectations.
What’s the cause? Anecdotal evidence suggests this is the work of computer-driven, trend-following, algorithmic traders — the same folks who contributed to the May 6 “flash crash” — who are being fueled by ultra-cheap money from the Fed and the anticipation of another round of money printing.
Instead of trading to their own natural harmonics, these two completely different asset classes are mirroring each other minute by minute. This isn’t the work of human hands. This isn’t how markets are supposed to work.
Something historical and unprecedented is happening. Never before has the world experienced what we are seeing now: A massive debasement of the global monetary system as central bankers around the world engage in a competitive currency war to boost exports. Before, the gold standard or international currency accords prevented unencumbered money printing. But not anymore.
Really, what we are seeing is a trade way being played out in the foreign exchange markets. And instead of tariffs and import restrictions, we are seeing central bankers try to convince traders they are the ones being the most irresponsible by creating too much money and devaluing their unit of exchange. They all want to be punished. They all want people to sell their currency. When everyone tries to do this at the same time, currency valuations don’t really change — but the financial system gets flooded with money.
This is exciting and frightening at the same time; and the consequences will be felt for years to come.
All this easy money is being used by the robot traders to bid up assets of all types. Eventually, it will all come crashing down as inflation expectations get jacked higher — pushing interest rates up and threatening the global economy. For now, that’s a worry for another day.
It all comes down to this: A new bubble, bigger than the tech and housing bubbles, is being created.
There is still a chance to stop this if the Fed follows in the footsteps of the European Central Bank and adheres to its inflation-fighting mandate by slowly withdrawing stimulus now that the financial crisis has passed.
But if the Fed follows Japan’s footsteps by announcing another round of “quantitative easing” — as the market now expects — it will make former Fed chairman Alan Greenspan’s period of too-low interest rates in 2003 and 2004 look like child’s play. God help us when this new bubble explodes.
For now, the only asset that offers a measure of protection should this highly correlated dollar-drop driven risk rally fall apart is volatility — specifically, the CBOE Volatility Index (VIX) or “fear gauge” — which still maintains its inverse relationship with stocks and other risky assets. The iPath Short-Term S&P 500 VIX (
VXX) is a great buy at current levels.
Disclosure: The author does not own or control a position in any company mentioned.
