Staged theatre from the Fed chair

The first ever FOMC press conference headed by Fed Chairman Ben Bernanke was like a staged theatre performance and could remove what was left of the Fed's credibility. The media questions seemed pre-placed and, to borrow the words of a colleague, “it smelled too much of Madison Avenue (PR)”.

The press conference, therefore, may be the catalyst for a true U.S. dollar crisis, which in itself could start a Crisis 2.0. Chairman Bernanke is walking a tightrope and his/the Fed's analysis is incoherent:

• Inflation (core) is rising in the Fed's outlook, but it keeps using the word ‘transitory’ to describe both inflation spikes and growth downgrades…
• The Fed ignores referring to the S&P downgrade, only to say: It’s the politicians job... and we have strong US dollar policy... (Please check the charts Mr. Chairman!)
• Growth is out for Q1 later this week – revised down from  +3 pct to now 1.75% - which Bernanke almost confirmed in the press conference.

While the idea of a press conference seemed like a good idea, I think it’s sad that the Senate Committee hearing with Bernanke had better a Q&A session than did the media. I regret to see the weak and almost apologetic questions and no one went to the core of the present issues. If I had been there I would have asked the following:

• “How can you say the US has a strong US dollar policy when it’s clearly collapsing?”
• “How do you explain the exploding prices of Silver, Crude and Gold relative to your inflationary expectations and wording about this being anchored?”
• “What is the end game here?”
• “Reinvesting maturing debt - isn’t that the equivalent of QE3 light?”
• “How come you have so much faith in the Fed’s model when it failed to see the 2008 crisis coming, and almost any major financial event within the last twenty years?”

Fed model vs. reality
I could go on with a list of questions, but the main problem probably lies with my final question: Why is there so much faith in internal Fed model, when they clearly have failed in the past? This is the essence of why communication between Fed/FOMC and the market is disingenuous. Chairman Bernanke always talks from the book of Fed projections, never acknowledging these are special times as we have zero interest rates, exploding commodity prices, and rising inflation expectations. The problem being that in model-lingo this translates to 'noise'. In other words, these are factors which distort the explanation of the value of the models and hence they become “transitory” in central bank speak.

I had the pleasure of being an intern at Danske Bank’s economics department in the 1980s – a time where M3 numbers where more important than unemployment, by the way (a sign of Pre and Post Greenspan!) - but I learned some scary model facts (stop smiling – this is not what you think !)

In the Current Account measurement errors and non-explained factors are more than 25% - yes 25%! Any output can be produced by fitting the numbers. The inflation outlook drives real growth, hence the need to sustain “measured inflation low”. Translated to Fed or, for that matter, ECB projections – these models deal with NORMAL TIMES.

An upcoming US dollar crisis?
The combination of an extended period of low interest rates in the U.S., while Asia and Europe start hiking rates, is an interesting constellation which could ultimately create a U.S. dollar crisis.

We could see accelerated U.S. weakness and, if volatility starts to creep up, we could see 1.60 and even 1.70 in the EURUSD. More importantly, however, U.S. dollar weakness should be seen through the eyes of a broader basket of currencies versus the USD. We like CHF and JPY versus USD. USD/JPY down is one of my top three trades for 2011 and 2012 with a medium-term projection of 75.00 and long-term of 65.00.

Meanwhile, in the FX retail space there is surprisingly a continued disbelief in the weaker U.S. dollar, mainly versus the euro, but also overall. The size of the position is presently in the territory of a 'Grey Swan' event and would make even George Soros smile. But it defies logic: Why are private investors fading?

I guess my reaction would be: because unlike professional investors they don’t respect Jakobsen’s first law of central bank watching, which reads: 'It’s not what the policy makers say, but what they do, that is important'.

When looking at a potential acceleration in the U.S. dollar's weakness it is often practical to find an analogy to compare it with. The best I can find is to compare the present momentum with the 1980s. The stock market was on a roll, interest rates came down from 16% to 7.5% before spiking to 8.5%, growth was in range of 8% to minus 2.25%, with a low in 1982 and a high in 1984 before we saw steady erosion into 1990. Below are two key charts. The USD as measured by USD/DEM and SPX vs. USD/DEM.

Source: Bloomberg, Saxo Bank

Source: Bloomberg, Saxo Bank

Let’s hope I am wrong as I think a true U.S. dollar crisis would be the starting point for a Crisis 2.0. But for now, and with the balance provided by Q2 and Q3, the impact should be: low interest rates for longer; QE3 light initiated with reinvestment of maturing debt; higher energy, metal and agriculture prices; a momentum high in S&P to 1385/1400. We have collated these thoughts under the theme of “Investment under stress:”

• Equity does relatively better in an inflationary environment, but not in high inflation
• Debasing/Quantitative Easing means metals, energy and agriculture continue to rise
• Bank refinancing creates opportunity, but pain first
• Credit is scarce for those who need it and rich for those who don’t - look at companies with emerging market/Asian exposure and having credit
• Russia, a relative emerging market winner with its natural gas
• Themes: Amazon model (non-VAT, free delivery) versus Dell; Energy (Coal, LNG); dividend yields; Real  Estate; EPS cycle peaked; Average Crude price of 100$ plus
• Japan & Korea medium-long term winner in FX and Equities
• Asset allocation: Out of Fixed income into “tangible stocks” – momentum high in S&P (1400.00?)