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To see a World in a Grain of Sand

And a Heaven in a Wild Flower,

Hold Infinity in the palm of your hand

And Eternity in an hour.

                             William Blake

FX Trading – China & Eurozone connection…

Errrrrttt…That was the sound of tightening; if I knew Chinese, I would give you the translation. I guess there’s no need for that, as the markets seem to be translating it just fine this morning.

China surprised the markets with an announcement they would tighten reserve requirements yet again in an effort to reign in some bubble-iscious-ness thanks to excess credit pumped into the hermetically sealed kingdom, i.e. capital controls, among other types. The dollar, gold, oil, stocks, and the bonds played along with the script…with buck moving higher, while the rest of the pack went south.

Dollar (green)/S&P 500 (red)/Gold (purple)/Oil (gold) 4-hour chart:

Dollar, S&P 500, Gold, Oil 4-hour chart

May this be an overreaction to Chinese tightening we already knew was in the works? Absolutely!

But the risk:reward opportunities seem very much skewed to the downside for all the above asset classes, except one—the US dollar.

A self-reinforcing process might be in the works; effectively this would represent two sides of the same coin?

  • Demand for Chinese goods from Europe has likely evaporated as Eurozone growth stalls.
  • China demand for European bonds has likely evaporated given the growing risk of European sovereign bonds and internal credit tightening.

In this environment, sad to say, Uncle Sam, warts and all, wins the very ugly contest by default—again.

But what about a Eurozone bailout of Greece, won’t that change things? Talk is cheap.

Any bailout of Greece will have to be extended to Spain and Portugal, and likely Italy and Ireland. And let’s not forget the sleeper country with a big debt profile—good old Belgium. Can you say moral hazard to the fourth power?

With German growth grinding down it is highly unlikely Angela Merkel would commit political suicide by placing German taxpayers on the hook for what many in Germany see as southern tier spend thrift sunbathers—no matter how much Mr. Sarkozy is baiting them.

This goes to the heart the problem—the Eurozone is not fertile ground for a common currency precisely because there is very little, if any, political/cultural unity. This, among other things, is one of the giant differences between the US and the European Union—and a key reason why the 50 US states are fertile ground for a common currency.

Remember when Mr. Soros made his multi-billion dollar profit on Black Wednesday, September 16th 1992? It came when the UK dropped out of the Exchange Rate Mechanism in 1992. Interesting thing about that was that Mr. Soros’ bet was based on politics as much as economics. He bet UK politicians would balk, knowing raising interest rates—to match Germany’s rate hike at the time to draw in capital to fund the East German takeover—would be tantamount to political suicide as the UK was entering recession. He was right—UK left the system and the rest is history.

Maybe the analogy isn’t perfect. But, if we add into the equation that German incentives for keeping this experiment called the euro alive are fading fast, the probability of saving the core fiscal basket case countries falls dramatically.

And the ripple effect of sovereign default in the southern tier? Contagion! All across Eastern and Central Europe as the European banking system pulls in credit lines in an effort to save itself.

So, much is at stake. Upside limited to a bounce—then grinding reality of real reform. The downside looks a lot less limited. And that’s our bet for now!

Happy Friday!