Friday, April 08, 2005

So what do you want to do now?

Let's put together some thoughts:
  1. If China revalues its currency, there will be less Treasury bond purchases, more of a deficit issue and hence USD being worse off. China will not revalue if hard landing occurs before any further change in capital control or foreign exchange policies.
  2. Fed is unlikely to hike aggressively even though US growth is building strength and inflation may be creeping through. However inflation is mainly due to demand driven commodity price rally. This consumer demand in US has been largely been supported by the mighty housing market. Hence Fed would not want to derail this consumer welfare. If they hike too fast, a possible shock to the system can lead to housing bubble burst and subsequent recession and deflation.
  3. The housing bubble has two exit plans: bubble can burst or leak. While an aggressive Fed can lead to the prior case, a more "measured" Fed lead to the latter case. Just look at UK, the booming housing market reacted a series of measure rate hike. Gradually, the marginal buyers and first time buyers are priced out of the market. Rental lodgers are in vogue and investors began to hit bids. It all happened in a normal, non-chaotic fashion. So all I am saying is that US can too experience a normalization of the housing market without undergoing a bubble bursting experience.

Trades:

We believe that USD remains in its long term bear trend. Carry unwind will simply allow entry of short USD at a better level since the effect of Chinese revaluation will push DXY to new lows. Furthermore, Asian currency will benefit most while EUR remains the de-facto benefactor of this currency movement. A basket of currencies will be a good way to set up this trade. In addition to buying EUR and JPY, we also like 1. Gold for its flight to quality and inflation hedge qualities, 2. AUD for the country's rich resource, relatively politically independent and commodity linked economy.

For now, we like to trade range for US 10y note: 4.30- 4.70%. With this economic backdrop, S&P looks overvalued versus dollar, bonds and oil price.