What I'm Thinking

In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust. ~ George Soros, 1985 (The Alchemy of Finance)

A very topical quote for the current situation. Written over 20 years ago when we had nowhere near the level of sophistication in credit creation. This summary is a good reason why I think the longer-term outlook is deflation. But I'm beginning to think that won't happen until we have our current little run with price inflation.

And since EUR/USD broke through the psychologically significant 1.60 today, I think it's very likely we could see a run-up to 1.63 and eventually 1.65 in the next 3 weeks. The economic situation in the U.S. is deteriorating, price inflation through oil and food remain, but above all long EUR/USD has remained a very profitable trade since November of 2006. This has been a self reinforcing process (here I go with the Soros reflexivity stuff). The longer it remains profitable the more it will attract speculators. And we have recent hawkish commentary from the ECB and China sitting on over $1 Trillion USD to boot. The ECB is dying to raise rates it seems. The updated statements from various officials made it clear that it's not really relative currency values that are concerning them but currency volatility. And it's essential to remember that the ECB is much more of a hawkish organization than the Fed is. The ECB is actually mandated to prick bubbles whereas the Fed claims that bubbles can only be truly known until after they burst. Basically ECB will control asset prices while the U.S. will not. If anything I think the argument can be made that the market considers the Fed as a supporter of asset prices. Soo all and all I really just won't fight this trend. I want to trade this trend. I think 1.65 is very likely, 1.75 a definite possibility. As I've mentioned previously the endgame here is coordinated central bank intervention. We're not there yet.

Eventually... I won't try to put a date on it.. but eventually, we'll see the slowdown in the U.S. spill over to the Eurozone in a material way. Spain, the U.K., and Ireland all have/had housing bubbles of their own that are popping. This will cause deflationary pressures and a de-emphasis on the hawkish stance of the ECB. When the slowdown becomes apparent in the eyes of the market, THAT's when we'll see EUR/USD fade. But as I said, I'm not looking for that to happen anytime in the immediate future. Long EUR/USD seems like the best option. But....

If and when the EUR/USD retracement comes, I see the potential to make a boatload. I'd look for a period of low vol where you could get a really nice risk/reward ratio. We're not there yet, but we're certainly getting closer. I'm thinking you'll be able to get a 10/1+ ratio on some bearish EUR/USD options.

On an equities note, I'm adding UNH to my equity value watchlist. They reported earnings today that were not to investors' liking. They're trading at a 3-year low with a trailing of P/E of 10. Won't go into any depth here but I'll keep my eye on them. They join Weyerhaeuser as the second equity on my value watch list.