FX Trading ??“ Choppy Waters: China Speaks and Subprime Festers

Yesterday, over the course of one trading session, we start with extreme across-the-board dollar weakness and finished off the day mixed with a smell of risk-aversion in the air.

The big news: China excited the currency markets with anti-dollar rhetoric and U.S. stocks traded sharply lower with the four-letter R-word in mind.

Bad Dollar! Bad!

A couple strong comments from a couple key Chinese officials started the stampede that crushed the dollar in the early-going.

* Vice Chairman of the National People??™s Congress, Cheng Siwei said ...

 ???We will favor stronger currencies over weaker ones, and will readjust accordingly ...???

???Excessive liquidity poses a risk to China's economy ...???

* A member of the People??™s Bank of China, Xu said ...

???The world's currency structure has changed; the dollar is losing its status as the world currency... ???

* And of the Chinese Academy of Social Sciences in Beijing, Peng Xingyun said ...

???China will inevitably reduce U.S. dollar holdings as the currency is being challenged by the euro and currencies of other emerging market economies...???

I think these guys succeeded in sending a clear message; they??™re sick and tired of holding excess U.S. dollars that are losing value by the day.

What was most notable in the wake of these comments was the Japanese yen rally. The dollar, in its long downtrend, has weakened substantially versus all major currencies except the yen. Yen rallies have been confined to periods of increased risk-aversion when investors seek to cover loans they??™ve taken in Japanese yen.

But yesterday was a different story. The dollar got whacked. But broad dollar weakness to start the day pushed the yen sharply higher along with the rest of the pack this time.

Bad Subprime! Bad!

Are the equities markets trying to tell us something? We think so.

The Dow Jones Industrial Average forfeited a sizeable 350+ points in yesterday??™s session. The S&P 500 gave up nearly 3%.

And despite a horrible looking earnings bomb by General Motors, we think growing risks of subprime losses are troubling investors and leading to sizeable and choppy price action.

Morgan Stanley was the latest victim of subprime-related losses. And in addition to their recent $3.7 billion loss, their outlook for the fourth quarter is depressing. Morgan Stanley??™s CEO sparked concern that these problems will last longer than originally thought ??¦

???The healing process will take longer,???

And ??¦

???The dislocation in the market has been quite severe, liquidity has dried up.???

Lookout everyone; the sky is falling!

Chinese officials have the ability to flex their muscles and do what they want to with the Chinese currency. It??™s likely they??™ll maintain a comfortable appreciation in the yuan ??“ enough to appease its critics and enough to balance the economic advantages and disadvantages in their favor.

We??™ll have to see what steps they??™re willing to take, and how soon they??™re willing to take them, on their way to diversifying out of the dollar reserves. There??™s no doubt this will be closely monitored.

As we continue to write in our newsletter services and discuss in the pages of Currency Currents, we feel the subprime mess is far from over. We??™ve been waiting to see an extended period of risk-aversion dominate the markets.

And if you??™ve been reading this missive for a while, you know that one of our, dare we say it, ???dollar bullish alternatives??? is part and parcel to risk aversion i.e. the dollar catching a safe haven bid as the big boys with a lot of money overseas run to hide in short-term Treasuries.  Problem with this alternative is that lately we??™ve been seeing risk aversion lead to sending more money overseas.  This suggests the decoupling theme, which means the world will grow without the US, is likely now gone mainstream.
The chart below compares the US$ Index Inverted (red line) vs. the S&P 500 Index (black line).  The point we are trying to make is that this pair has diverged of late. 

[See PDF format to view chart] 

The waters are choppy. Be careful out there.

John Ross Crooks III
Black Swan Capital