The Market is Bigger than Any One Central Bank

Businessman analyzing investment charts at his workplace
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After taking a few weeks off for R&R, I’m back and ready to go for 2015.

The common theme so far? Volatility. Get used to it, because it’s here to stay. The market may be up strongly today, but that’s just a reaction from last week’s hammering.

Aussie stocks are caught in so many cross-currents they don’t know which way to go. The benchmark index, the ASX 200, is well off last year’s highs and is pretty much at the same level as it was in late 2013.

If you’re a bull, the good news is that as long as the lows from mid-December and mid-October hold (which are in the 5,100 to 5,200 point range on the ASX 200), then there is still the possibility that the upward trend in prices will continue.

I’m bearish and have been for some time. But to confirm my view, the ASX 200 needs to break below the support levels mentioned above. Until then, the market continues to be in a volatile holding pattern.

But that doesn’t mean there aren’t good opportunities out there. The stock pick I made in the December issue of Sound Money. Sound Investments. is already up over 40%, and I don’t even consider it a highly speculative play. It’s just an undervalued company coming onto investors’ radars.

My mate Tim Dohrmann, who writes the Australian Small Cap Investigator, had a cracker last year with his stock picks and he’s ready to go in 2015 too. If things work out for his latest pick, Tim reckons the upside potential is in excess of 700%.

There’s also a very big name behind this tiny company. You can read about Tim’s latest investment idea here.

While day-to-day market volatility makes for interesting viewing, it can detract from focusing on some big picture forces. So today’s Daily Reckoning will take a step back from the noise and look at what’s going on in a broader sense.

The Swiss National Bank’s shock decision last week gives us a big clue.

As you probably know, the Swiss Central bank ended their euro peg experiment last week, which ended in massive losses for many FX traders.

The important point to keep in mind is that this isn’t an isolated event. The Swiss pegged the franc to the euro in 2011 to help maintain competitiveness. To do so, they had to buy massive amounts of euro debt to offset the flood of safe-haven money coming into the country.

With the first blast of euro QE (debt monetisation) likely coming this week, the Swiss realised that they would need to buy a whole bunch more euro debt just to maintain the peg. Doing so would end up costing the Swiss a huge amount of money, as the peg is effectively a Swiss subsidisation of the Eurozone.

Actually, it’s already cost them a bundle, and they didn’t want to get in any deeper.

So what clue does the Swiss move give us?

Well, it’s all about capital flowing around the world looking for safety. And the safe spots are getting fewer and fewer. Europe’s grand currency union looks shaky. Japan is hell-bent on devaluation to help revive its long suffering economy.

That leaves the US dollar as the only genuine safe-haven currency. It means capital will continue to flow towards the dollar, but this trend will have disastrous consequences.

Why? Because the US dollar is a global currency. Many nations have pegged their currencies to the dollar in an attempt to gain currency stability and respectability.

But the last thing anyone wants is a strong currency in this global environment of weak demand. So as the US dollar continues to strengthen, it will hobble many other nations.

This big picture trend has major implications for Australia. Perhaps the biggest currency peg in the world is the yuan/US dollar peg. For China to maintain this peg, it must buy huge amounts of US dollars. That’s why its FX reserves are massive at nearly US$4 trillion.

But there are flow on effects. Maintaining currency pegs when there is a fundamental difference between the value of the currencies involved leads to other market distortions.

In Switzerland’s case, trying to peg the franc to the euro led to a blow out in FX reserves and a destabilising property boom. Pretty much the same thing happened in China.

If currency values were left to the market, and not to politicians, you would not get such destabilising reserve build-ups or asset price booms. The yuan/US dollar peg is one of the reasons China’s economy is so imbalanced.

As the US dollar continues to strengthen, my prediction is that China will have to abandon the peg. What the ramifications of this will be I don’t yet know. It’s my first day back on the beat…

It’s likely to have some major implications for the US treasury market as China holds a huge amount of the outstanding stock of US debt. I don’t think it will happen for a while yet, but the chances are that it will happen.

When it does, expect ever greater amounts of volatility in currency and asset markets.

In fact, you can expect increasing volatility from now on, thanks again to last week’s action of the Swiss central bank.

More than anything, the decision to end the peg was a big blow to confidence. That is, confidence in central bankers to maintain control. The fact that the Swiss made the decision out of the blue meant big losses for many players.

The market just isn’t used to, and doesn’t like, central banks that don’t telegraph their moves months and weeks ahead of time. It will certainly create some nervousness in the future and mean fewer speculators take a central bank at its word, especially if the economics of a certain policy look dubious.

The point is, the market is bigger than any one central bank. Market forces will eventually overwhelm any central bank erected barriers — and those betting with the bank will lose big time.

In the language of the market, these players are ‘picking up pennies in front of a steamroller’.

So is this a crack in the central bank confidence game? It certainly is. The only question is whether the damage is limited or whether things start to deteriorate quickly from here.

We’ll find out as the year unfolds.

But for today, the message is this:

The whole post-1971 financial architecture is breaking apart. The euro project is in real trouble, and as the US dollar strengthens because of it, the global dollar pegs (China, other parts of Asia and the Middle East) will fall by the wayside too. Eventually, the deflationary effect of a strong US dollar will claim the US economy too.

By that stage we’ll have to start all over again with a new monetary system. But that’s still a few years into the future. And a story for another day….

Regards,

Greg Canavan+
For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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