The markets have clearly started to signal that further weakness in the US$ is no longer a positive development for the macro-environment (see A Roadmap for the Coming Changes in Fed Policy). After all, with the US trade deficit being almost entirely made up by China and oil, a weaker US$ from here probably means a deteriorating trade balance for the US' non-China/non energy trade partners (a theme we will explore further in an upcoming ad-hoc). Simultaneously, a weaker US$ accentuates inflationary pressures around the world, eating into margins and forcing other central banks (e.g., Poland's surprise rate hike yesterday) to adopt tighter monetary policies...
However, the real reason most of the clients we have talked to lately seem to be so uncomfortable is the growing perception that, with QE2, the "weights and measures" of our financial system have been tinkered with and who knows what consequences this will have? Indeed, investing is all about "value"-figuring out where the value is and why "values" move over time. To measure this we use money-even if it is very hard to explain why money itself has any "value," since, in our world of fiat money the marginal cost of producing money is zero. So the investment business has two sides. The easy side is trying to understand how the values are going to move versus one another (i.e., equities vs bonds, or Japan vs China...), making in the meantime the assumption that the value of money will not. The difficult side is trying to understand whether the value of money itself is about to change.
Now money has two prices: a domestic price (interest rates), and an international price (the exchange rate). Thus, the only way for a fiat monetary system to work is if the different monies, each corresponding to different economic and political systems, can compete freely against one another. Which is why things are so tricky today: there are three major economic blocks (US, EMU, China...) which now account for more than half of global GDP. But their currencies are completely out of whack and heavily manipulated by governments and central banks. This leaves investors without a proper "weight and measure" system to establish how to invest-and the feeling that this status quo cannot last. No wonder the level of discomfort is high.
