October 31, 2012 at 03:07 AM EDT
Currency Wars; Who Will Win the Race to the Bottom?

Currency WarsAs the U.S. dollar continues its slump, central banks around the world are questioning the value of their own currencies. The reasons for this are very simple. As the greenback declines in value, other countries are experiencing higher American prices for their exports, stunting demand.

To fight the falling U.S. dollar, world central banks are taking matters into their own hands. They are either printing more of their own money or buying U.S. dollars using reverse-dollar swaps. But no matter what technique these central banks choose to devalue their currency, inflation is the ultimate destination for their country.

The Central Bank of Brazil is continually intervening in its currency market. Brazil’s central bank is holding its country’s currency, the Brazilian real, below the two-reais-per-dollar level. The central bank believes that this level is sufficient to see continued growth in its exports. (Source: Reuters, October 23, 2012.)

Similarly, the Central Bank of Peru made a big U.S. dollar purchase over the past six weeks to fight the rising value of the its currency, the Peruvian sol. This central bank bought $130 million in U.S. dollars to keep the sol from appreciating. (Source: Bloomberg, October 15, 2012.) This is aside from its $158-billion purchase of U.S. .dollars near the end of August.

On the other side of the world, the Hong Kong dollar has also been feeling pressures due to the falling U.S. dollar, even though the currency is pegged at 7.80 Hong Kong dollars to one U.S. dollar. The Hong Kong Monetary Authority, Hong Kong’s central bank, has flooded the currency market with 14.3 Hong Kong dollars to keep the currency from rising. (Source: BBC, October 24, 2012.)

Along with these central banks continuing to devalue their currencies, the South Korean central bank is being warned by think-tank Hyundai Research Institute (HRI) to intervene in the currency market. The reason for intervention? The rising U.S. dollar will destroy profits for the local exporters. (Source: China Daily, October 24, 2012.)

What we are seeing is an ongoing debasement of world currencies. This looks like the beginning; more central banks will certainly follow suit. Unfortunately, they are forgetting that inflation will become a huge problem as they print more fiat money.

There is no end to the problem of currencies being created out of thin air. The world will pay dearly for the decision of President Nixon’s Administration to leave the gold standard for the Bretton Woods agreement.

Michael’s Personal Notes:

As we witness one of the worst earnings seasons in years, fear is starting to creep into the key stock indices.

Companies in key stock indices, such as the S&P 500, are on track to losing 2.3% in earnings this quarter and expectations for fourth-quarter corporate earnings are being slashed. (Source: FactSet, October 22, 2012.)

If that’s not enough reason to leave the stock market, there’s more.

Two indicators that show the amount of risk and gauge investor sentiment are flashing red signals. This shouldn’t go unnoticed.

First on the list is the Chicago Board Options Exchange Market Volatility Index (VIX). This index shows the volatility of investor sentiment on key stock indices over the short term. When investor sentiment is bearish, the VIX goes higher, and vice versa when investors are bullish.

Since June of this year, the VIX was trending lower. After the recent selloff in the key stock indices, the VIX broke its downtrend and edged above its 200-day moving average (MA)—a big move in favor of bears. The chart below illustrates this:

Volatility Index-New Methodology Chart

Chart courtesy of www.StockCharts.com

The VIX breaking above its downtrend means investor sentiment is increasing towards the bearish territory in key stock indices. I have warned about this before; the VIX never made new lows as key stock indices continuously made new highs—blatant non-confirmation of a bull market.

Next, investor sentiment is moving towards bond markets. Yes, I know bonds nowadays are providing next-to-nothing yields, but more investors are moving towards bonds, meaning they are becoming risk-averse.

Since the beginning of this September to October 10, $43.4 billion has gone into long-term bond mutual funds. In the same period, $29.9 billion has been taken out of long-term equity mutual funds. (Source: Investment Company Institute, October 17, 2012.)

These two indicators are yelling that investor sentiment is changing. The rise we saw in key stock indices is slowly losing its glory. As more companies announce their earnings and slash their profit outlooks, the key stock indices will decline. We have all the ingredients for a market sell-off. Be very careful in this market.

Where the Market Stands; Where It’s Headed:

We are near the top of a bear market rally in stocks that started in March of 2009. I’m becoming increasingly convinced this rally (what I refer to as the “bounce” or “sucker’s rally”) is getting very close to its end.

What He Said:

“You’ve been reading my articles over the past few months and have seen how negative I’ve become on the U.S. economy. Particularly, I believe it’s the ramifications of the faltering housing sector that is being underestimated by economists. A recession doesn’t take much to happen. It’s disappointing more hasn’t been written on the popular financial sites and in the newspapers about the real threat of a recession happening in 2007. I want my readers to be fully aware of my economic opinion: I wouldn’t be surprised to see the U.S. economy in a recession sometime in 2007. In fact, I expect it.” Michael Lombardi in PROFIT CONFIDENTIAL, November 13, 2006. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.

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