Sand Spring Advisors LLC

Coiling Toward Trouble: GBP/DEM

March 24, 2002

by, Barclay T. Leib

While we were away last week, the Fed made mumbles about eventually taking back some of the 11 rate cuts that transpired in 2001 -- should the economy continue to show signs of life. This was obviously a shock to the likes of CNBC's Larry Kudlow (who perrenially urges the Fed to err on the side of lower rates) and it was not well received by the U.S. stock market either.

The news was well received by the U.S. dollar, however, which vaulted higher once again against the yen and rose as well against the euro. This latter reaction was understandable. While the Bush administration is privately starting to understand the damage that an overly strong dollar can do to American business (the steel import tariffs showing part of this understanding), Greenspan may finally be recognizing another problem: With the long-bond continuing to decline and gold continuing to advance, the markets are clearly worried about an overly loosy-goosy Fed and the inflationary implications thereof. It was time for a bit of verbiage to combat this trend.

Avid readers will remember that our long-term stance has been that the euro is still missing one more new low toward the .7700-.7800 area. We continue to feel this way, even if fundamentally we recognize that dollar strength is detrimental to the U.S. economy, and is also incompatible with the horrific U.S. current account balance.

Chart produced using Advanced GET End-of-Day

One sign that this move toward a .7750ish target may be set to begin sooner rather than later is the "coiling" behavior of the old cross Sterling/Deutsche Mark (which we continue to have a better intuitive feel for than its modern-day and upside-down Euro-Sterling replacement). We picture this huge coil/pennant formation on the right below. For simple comparison, we show on the left a similar "coil" formation that occurred in the chart of Global Crossing in early 2000. In that prior instance, first came a false but dramatic break higher out of the "coil," but with an eventual collapse lower. GBLX is of course in bankruptcy today.

Chart produced using Advanced GET End-of-Day

We feel something similar may now be in the offing for GBP/DEM. Let's presume GBP/DEM could vault up to 3.5070, and our .7750 euro/usd target is reached at the same time. Using the 1.95583 euro-deutsche mark fixed conversion peg, this would put USD/DEM at 2.5237 (somewhere between a 50% and 61.8% retracement of the 1985 to 1995 USD/DEM decline), and GBP/USD at 1.3896 --all very possible targets.

If Greenspan wants to reinstill confidence in his Fed before he retires, he needs to stop the current decline in the U.S. long bond and stem gold's advance. Unfortunately, any indication that the Fed is being more vigilant risks sending the U.S. dollar higher -- thereby hurting U.S. business profitability (and the stock market) even more. It's a strange set of circumstances -- a Pandora's box of poor policy choices so to speak -- but short term, it looks to us that stocks could go down while the dollar goes up.

The GBP/DEM weekly "coiling" pattern is one chart to watch quite carefully to see how this all sets into motion.

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