One reason markets tend to get a little nervous in September is that it’s time for investors to ponder about their asset allocation for the remainder of the year and beyond. With the markets at or near record highs and the US dollar on a roll, what could possibly go wrong? Let’s look at what’s next for the dollar, gold, and currencies.
A couple of highlights:
Equity markets are at or near record highs; Measures of complacency are near record levels (for example, the VIX index, a measure of implied stock market volatility, is near historical lows). 10 Year U. S. Treasuries are yielding around 2.4%, near record lows. The theory is that with the U. S. pulling ahead, the greenback must win. A couple of caveats to this theory:
The U. S. recovery might not be as healthy as it appears: the housing market remains vulnerable; many retailers have challenges; inventory stuffing might be happening at some tech firms; and how can the U. S. recover when Europe and parts of emerging markets are slowing down? U. S. real interest rates are increasingly more negative than Eurozone real interest rates. With the Fed all but promising to be late in raising rates, odds are that the differential will increase. In this context, the notion of an exit appears absurd. There is no historical correlation between a rising interest rate environment and a stronger dollar. That’s because U. S. Treasuries might lose in value as rates rise, providing a disincentive for foreigners to hold the greenback. In our analysis, the Fed’s actions have made risky assets appear, well, less risky, causing everything from stock prices to junk bonds to be more expensive. This is referred to as a compression of risk premia. We go as far as arguing that our recovery is based on asset price inflation. As such, should the Fed truly pursue an ‘exit’, risk premia might expand once again, putting not only asset prices, but the entire recovery at risk. As a result, we have warned investors about a potential crash.
This post was published at Silver Bear Cafe on September 12, 2014.