Why it’s time for currency traders to batten down the hatches!

A couple of weeks ago I shared my view on why the emerging market currencies were poised to feel the pain of slowdown in global money flow. I based it on the premise that money flows outward to emerging markets (aka periphery) from the developed world capital markets (aka center).

Here are two new pieces of evidence that I believe increase the probability this view is correct …

First, there is a major disconnect between the amount of money being created to support the global banking system and its ability to trigger real growth. Take Australia as an example. From May to June, its money supply increased 4.8 percent, yet the economy contracted. The story was similar for others as you can see in the chart below.

Furthermore, Purchasing Managers Index (PMI) numbers show an increasing number of economies across the world are contracting.

Click the table for a larger view.

Second, because EM economies are more highly leveraged to global growth and low volatility, money flow to these economies could indeed decline going forward, which would put pressure on their currencies.

The latest evidence is in, and it’s not pretty for emerging market currencies. If it is “déjà vu all over again,” as Yogi would say, it is time for currency traders to batten down the hatches.

Focusing on the grey bars in the next chart, notice how the decline in money flow that started back in early 2007 foreshadowed the last crisis. Now notice the precipitous decline in global money flow to EMs that began in March 2010. Hmmm …

Click the chart for a larger view.

Next, take a look at the chart below, considering the real money decline dates that took place in EMs in 2007 to March 2008 and what is happening now. The chart has three moving parts: The Dow Jones Industrial Average (DJIA); the Emerging Market Stock Index (EM Stk Index); and the U.S. dollar index (US$ Index).

As stock markets peaked back in late 2007, early 2008, then turned down, money began to flow in earnest to the US dollar and out of emerging markets evidence by the bottom in the dollar in March 2008 corresponding to a bottom in EM money flow during the same quarter in 2008.

Now it appears we may be seeing a bit of re-play. Stock markets may have peaked last year as money drained from the EM world. The U.S. dollar appears to have put in a double-bottom at the same time markets peaked last year.

The chart analysis validates the view money is indeed moving back to the center. But this time, it also seems the dollar is rallying from a higher base, confirming my longer term dollar bullish view.

Now many believe there is no need to worry about emerging markets because China will not let things get “out of control.” There is an expectation that China will step in soon with a major stimulus program that will once again buoy stocks and commodities. The view makes sense. But there is, however, evidence to the contrary …

• China cut interest rates on Thursday along with the European Central Bank. There was a collective yawn by the markets, and commodities moved lower on the news. This was price action that definitely was not in line with the news.
• According to Bloomberg Businessweek, “China plans to retain a cap on loans at 75 percent of deposits and may add further requirements that constrain credit growth under draft rules, a senior official at the banking regulator said.”

This suggests to me that China is still reeling from inflation and asset bubbles created inside the country from the last round of major stimulus it issued during the credit crunch and realizes that money stimulus may not be the answer this time.

China’s 4 trillion yuan stimulus package unveiled in 2008 led to an unprecedented 17.5 trillion yuan of loans in the following two years, pushing up property prices and inflation while raising concerns over banks’ asset quality, according to the state-run Xinhua News Agency.

So if China doesn’t come to the rescue, this trend in money flow back to the center is likely to intensify. And precisely because it may soon appear this trend could be particularly dangerous to China’s still bubbly markets, it could hit the Asian-block EM currencies especially hard.

So if you think my EM money flow story makes sense, one way to play it from a currency perspective is by selling short Barclays Global Emerging Market Strategy (GEMS) Asia 8 Index. This fund seeks to replicate the movement of eight Asian market currencies relative to the U.S. dollar.

Best wishes,

Jack

P.S. The British pound is under pressure, too. That’s why last week I sent my World Currency Trader members a reco so they can get positioned for what I believe will be the pound’s major leg down against the U.S. dollar. Click here to learn how you can join them, RISK-FREE.