Daily Forex Commentary
By Jack Crooks

Key News
- Japan's central bank is focusing more on rising land prices, its policy board minutes showed on Tuesday, while one of its most hawkish members said in an interview that it could discuss a rate hike as early as July. (Reuters)

Key Reports
7:45am: ICSC chain store sales. Previous: +0.8%.
8:55am: Redbook retail sales index. Previous: +2.5%.
10:00am: May Richmond Fed Manufacturing Index. Previous: -11.
5:00pm: ABC/Washington Post consumer confidence. Previous: -7.

Quotable
"During times of universal deceit, telling the truth becomes a revolutionary act." - George Orwell

FX Trading - No one is innocent in bubble land
We live in a virtuous circle world predicated on the belief that credit will continue to sustain economic growth. The total outstanding value of all derivatives has surged to over $400 trillion in 2006; rising a third since 2005, from a total of $297 trillion, says the Bank of International Settlements. Yikes!

Analysts can rationalize until the cows come home about high stock prices justified on earnings and qualified private equity deals creating efficiency. This is a bubble driven by the raw material of credit that is manufactured night and day at the world's top investment banks - you don't think Hank Paulson became US Treasury Secretary on his intellect alone, do you!

We are told that risk is transferred through the use of derivatives. And we are told our elite banks have spent a lot of money on computers and stress testing. Derivatives are counterparty vehicles as we understand them. How does one stress-test a counterparty? And how much scrutiny of counterparties really happens given the manufacturers of derivatives are paid fees not just for production but sale of said? Though we admittedly know close to nothing about the alphabet soup of derivatives, we have to believe there are numerous "subprime" borrowers - ie very weak counterparties - who will act as hidden time bombs in this market.

Even if all is hunky dory on the stress-test front, isn't there some logical saturation point at which no matter how carefully risk is parceled out by the credit manufacturers the system has reached a max risk level? Is $400 trillion enough? Will it be $600 trillion - a number we will blow past very soon given the rate of growth? Does anyone really believe the underlying collateral (real value) of the global financial system has grown as quickly as the credit piled on top of it?

There is much talk about economic decoupling - this is bandied about to suggest there is less risk in the world when other countries, besides the US, can take up the slack. But because this global asset bubble is part and parcel to production of credit, global financial markets have become incredibly coupled with one another. This suggests that real economies will likely become highly correlated on the downside once the music stops. Virtuous will become vicious as all the warts in the derivative and private equity world rush to the surface.

We know not when the music stops - but we have confidence it will. Thus we continue to believe shorting pound-yen, Aussie-yen, or Kiwi-yen will sooner or later pay off big time.

Jeremy Grantham of GMO LLC:
"Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong 'animal spirits', reflected statistically in a low-risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.

"… But this time, everyone, everywhere is reinforcing one another. Wherever you travel you will hear it confirmed that 'they don't make any more land', and that 'with these growth rates and low interest rates, equity markets must keep rising', and 'private equity will continue to drive the markets'. To say the least, there has never ever been anything like the uniformity of this reinforcement."

Stephen Roach of Morgan Stanley:
"China's equity bubble is an offshoot of this same problem. Washington's China bashers appear to be drawing on the same game plan of forced currency revaluation that wreaked havoc on the Japanese economy in the 1990s. As was the case with the endaka (strong yen) of the late 1980s, yuan appreciation is now taken as a given by domestic and international investors - only questions of degree and timing remain unanswered. There is an eerie similarity between currency-driven outcomes in the two equity markets. In both cases, one-way currency bets turned equities into the asset of choice for the "hot money" of liquidity-fueled investors. Is it a coincidence that China's A-shares began their recent run only a few months after the pegged-currency regime was abandoned in July 2005. Similarly, was it a coincidence that the Japanese equity bubble emerged in the late 1980s in the aftermath of a Plaza accord that steered the yen/dollar cross rate from 254 in early 1985 to 145 in early 1990? Given the lack of alternative assets in a still undeveloped Chinese financial system, the equity bubble may be even more of a foregone conclusion in China than it was in Japan."