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The Irony of “Risk” in the Markets

Written by: Sean Hyman

Article Overview: Right now in the markets, there are essentially 2 trades: risk-taking and risk-averting. The risk-taking trade can be summarized as US dollar and Japanese yen down, bonds down, everything else up. Risk-averting is just the opposite. Oh sure, you get the occasional stock that goes down because of blatant corporate mismanagement, but overall stocks will go up if the dollar declines.

The Irony of “Risk” in the Markets

Right now in the markets, there are essentially 2 trades: risk-taking and risk-averting. The risk-taking trade can be summarized as US dollar and Japanese yen down, bonds down, everything else up. Risk-averting is just the opposite. Oh sure, you get the occasional stock that goes down because of blatant corporate mismanagement, but overall stocks will go up if the dollar declines. With this in mind, it still amazes me that people talk about individual company fundamentals when analyzing stocks as if it matters. In reality, the only thing one really needs to look at is the strength of the US dollar.

The thing about analyzing currencies is that they do not trade in a vacuum, but rather in relation to one another. Think about it like a beauty contest, where the winner is not the most beautiful, but the most beautiful ON STAGE AT THAT TIME and compared to the others. One of my favorite sayings in regard to this market is from that great market prognosticator, Rodney Dangerfield; "If you want to look skinny, hang out with fat people!"

So let's compare two "hypothetical" currencies:

Currency A: This country's currency is very weak, yields almost no interest (ZIRP), its banks are questionable as to solvency, its economy is teetering on the brink of disaster, it is taking on debt like it's going out of style, and confidence is near an all-time low.

Currency B: This country was largely unaffected by the credit crisis and the Great Recession, just raised its benchmark interest rate 25bp to 3.25% and is about to go another 25bp higher, is currently worried about too fast a recovery and inflation, and appears to have its fiscal house in order.

So which currency is the greater "risk"?

Well if you said currency A, then you are WRONG! Or at least that's what the world markets tell us

In the above example, Currency A is the US dollar and Currency B is the Australian dollar.

So it sometimes seems comical that in order to avoid risk, you would sell a higher yielding currency from a financially sound country in favor of a declining wreck with no interest from the country with possibly the worst fiscal situation on the planet!

Yet that's how it goes. For now. But at what point does this decouple?

Obviously the US dollar benefits from its status as the world's reserve currency, but right now in my opinion it is one of the riskiest assets out there! Just because the US government has never defaulted on its debt obligations, doesn't mean it couldn't happen. After all, wasn't it the brain-trusts at the Investment Banks and in Washington who thought the sub-prime game could go on forever? This could be one of the biggest black swans ever conceived!

With the massive amount

of debt on its books right now, unless the FED can encourage hyper-inflation, the US may have a very hard time meeting its debt service. Why would anyone want to take on that risk? So as Bernanke et al keep interest rates extraordinarily low and the dollar continues to drop in value, I'd much rather hold the Aussie. Go ahead and call me a "risk-taker", I consider myself more of a risk averter.

But semantics aside, as long as fiat currencies still exist, then there is no reason why USD should benefit from the "flight to safety" trade. None.

So just because the US dollar is the medium of choice for oil, gold, and other commodities, doesn't mean that is always going to be the case. In reality, the US dollar is just that, a medium of exchange and not a holder of value.

Would you take an Australian dollar which you could park in an Australian 2-year note yielding 4.71% for your goods or services, or a US dollar which you could put in a 2-year note yielding 1.02%?

Yep, me too!

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Article Tags: australian dollar, beauty contest, benchmark interest rate, bonds, brink of disaster, company fundamentals, credit crisis, currency, favorite sayings, individual company, inflation, japanese yen, mismanagement, prognosticator, recession, risk taking, rodney dangerfield, solvency, vacuum, world markets



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