Warning Flags: Gold … and Emerging Currencies

Two Thursdays ago President Obama threw a crack at South Korea:

“… while they’re adding teachers in places like South Korea, we’re laying them off in droves. It’s unfair to our kids. It undermines their future and ours. And it has to stop. Pass this bill, and put our teachers back in the classroom where they belong.

“If Americans can buy Kias and Hyundais, I want to see folks in South Korea driving Fords and Chevys and Chryslers.”

Come on, Mr. Obama — what did South Korea ever do to you?

Maybe it was a patriotic sucker punch, since South Korea is now bolstering its industrial sector while the U.S. economy is fighting to keep its alive. After all, he needed to rally the troops for passage of his jobs bill.

But sticking with South Korea, and the rest of Asia for that matter, things are going fairly well. This shouldn’t come as too big a surprise since there are plenty of analysts who love to point out Asia’s economic growth superiority.

Asia has been spotlighted as leading the charge out of the global recession that followed the 2008 credit crunch. Since then growth has never been a concern for Asia in the way it has for the West. But there has been a concern with the global currency wars.

I’m willing to bet you’ve heard about the Federal Reserve’s weak dollar policy. And we know that China has suppressed the value of its currency for the sake of its export competitiveness. The Bank of England has been very soft on monetary policy; so has the European Central Bank.

The result of action taken by these major central banks, plus the unattractive growth backdrops of their economies, is that capital (hot money) seeks returns — conservative and speculative — elsewhere. That elsewhere has been emerging markets, particularly in Asia.

And that’s when we start having a problem …

Hot Money Can Stoke Inflation

Inflation can wreak havoc on an economy. Just ask Brazil. Their finance minister was the first to officially call out the games being played between central banks as a currency war, even though the dynamic was not new. Brazil even found it necessary to enact capital controls, to keep money from flowing in too quickly, inflating the assets, appreciating the currency, pressuring Brazil’s consumers and reducing their export competitiveness.

But Brazil is a big, important, and well-known player in the global economy. They are one of the famous BRICS.

While some smaller emerging economies in Asia, such as Thailand, engaged some form of capital controls, Asia has so far been able to mitigate the impact of global currency wars; though inflation is still a concern.

A bigger concern, perhaps, is that these capital flows reverse. This is from a Reuters’ columnist:

“A stampede for safety has sent many of Asia’s currencies diving and the cost of insuring its debt soaring. The retreat says less about the region’s financial health than Europe’s. It’s a reminder that hot money is most dangerous not when it pours in, but when it pulls out.”

As for the cost to insure the debt, here are the 5-yr credit default swaps (CDSs) of Thailand, Indonesia, Korea, India and China:

Pretty substantial increases relative to the last 12 months. But for a gauge on how much further these CDSs could climb, let’s pull back to include 2008 data:

Hmmmm. Now, there’s nothing guaranteeing these CDSs will climb to 2008 highs; there’s nothing guaranteeing these CDSs will climb any further at all. But if a confluence of expectations and economic data signal a real credit crunch in Europe, you could safely bet these have not yet peaked.

BRICS to the Rescue?

Months ago at some indistinct point along the timeline of the euro zone’s slow speed financial train wreck, China pledged to purchase sovereign debt in an attempt to support confidence in Europe’s debt markets. And courtesy of the Brazilian Finance Minister, the BRICS nations will discuss the potential for similar efforts now.

It is not sure whether the BRICS nations will come in and simply buy European government bonds or if they’ll use sovereign wealth funds to recapitalize banks, thereby acquiring some influence in important European banks. Even if it happens, the impact will likely be negligible anyway.

You can’t fault Russia, China, and even Brazil for being worried about a collapse in the euro-zone economy — the euro zone represents a huge chunk of demand for Chinese goods; Russia is already very much exposed to euro-denominated securities; and Brazil’s fate rests very much on its largest trading partner’s (China) access to euro-zone demand.

It is believed China will avoid a hard landing and keep the broader Asian economy from a significant slowdown; but China cannot save the euro zone from recession.

I’ve said it many times before and recently brought it up in a webinar I delivered: In an environment of deleveraging and aggregate demand deterioration the deficit nations (particularly those with a domestic consumer base like the U.S.) hold the highest hand … as the surplus nations growth model suffocates.

That is what’s happening now.

George Soros, an extremely smart (but equally misguided) man admits it. On several occasions he’s come out warning of the dire consequences Europe faces if they cannot enact some type of bailout, or reform, or restructuring, or whatever. He recently came out with this:

“The political will to create a common European treasury was absent in the first place; and since the time when the euro was created the political cohesion of the European Union has greatly deteriorated. As a result there is no clearly visible solution to the euro crisis. In its absence the authorities have been trying to buy time.”

A common treasury in the euro zone among sovereign nations would be a step in this experiment aimed at creating global centralization. Too bad the BRICS will ultimately find it unappealing and their potential support efforts futile.

Maybe this is why German Chancellor Angela Merkel is sticking to her guns, saying:

“Eurobonds are absolutely wrong.

“In order to bring about common interest rates, you need similar competitiveness levels, similar budget situations. You don’t get them by collectivising debts.”

In other words: Germany, who is most tied to the troubled euro-zone nations, doesn’t want to be forced into an arrangement where they must bear the majority of the burden in supporting the troubled periphery nations.

And if the problem is not fixed soon …

Gold and Emerging Currencies
May Reveal the Markets’ Fate

Take a look at this chart of select European banks’ credit default swap (CDS) rates:

This CDS insurance now costs nearly as much as it did at the height of concern during and immediately after the 2008 financial crisis. Keep in mind, though, the 2008 crisis and concern emanated from U.S. banks and the U.S. subprime mortgage market.

This time the euro zone is ground zero.

And I point to the banks not because they are some dark and hidden risk of which only I understand the potential consequences. No — the chart above shows that investors are well aware that there are major risks among major banks in Europe … and to a lesser extent in the U.S. Here is another chart to that point:

Rising interbank lending rates signals credit markets growing tighter. We all remember how Libor was heavily watched back in 2008 as an indication of a tightening or loosening credit market. This time it is Euribor (the average rate of borrowing amongst 50 European banks) that needs to be watched:

Euribor has risen dramatically this year; and it has tacked on 35 basis points (almost 30 percent) in August alone. This means banks are growing stingier with their money when it comes to lending to other banks, highlighting deterioration in confidence.

The reason I mention all of this is to show the parallels to 2008 — a credit crunch, a banking crisis. What’s more, gold and Asian currencies took a dive back then, even though the former represents a safe haven and the latter pose solid underlying economic fundamentals.

Gold circa 2008:

Emerging currencies circa 2008 (Singapore dollar, Korean Won, Brazilian real, South African rand, Turkish Lira, Hungarian forint):

Will it be déjà vu all over again? In short: Tread carefully.

Best wishes,

Jack