Currencies the key to market's next move

Various currencies
Image caption Follow the money if you want to know which equity markets will perform best

After a month of angst and torpor on the equity markets September came in like lion (to misapply the metaphor) and after having done its job reinvigorating investors, is going out like a lamb.

Much of what was lost in August has been regained over these last five weeks. September has a reputation for being a rotten months for stocks, but the gains have made it the best September since 1939 - which, bearing in mind the five years that followed, might not be the most reassuring of statistics.

This last week has been less spectacular as investors took their profits. No one though is very sure of where we go from here.

The currencies though might provide some hints.

The term "currency war" has been flung about over the last month along with the more familiar expression "trade war", all of which hark back to the protectionism of the Depression era.

The first shots were fired by Japan two weeks ago when it intervened to weaken the yen.

There was tough talking between the US President and his Chinese and Japanese counterparts in the White House, and then this Wednesday the House of Representatives approved a bill allowing the American government to treat undervalued currencies as an improper trade subsidy.

The Chinese, at whom the legislation was primarily aimed, reacted angrily saying it "will only seriously damage Sino-US trade and economic relations".

In the midst of all this the Brazilian government floated Petrobras on the stock exchange - the world's biggest ever IPO at $68bn (£43bn), causing the Brazilian Real to surge as foreign investors bought into the country's offshore oil ambitions.

The central bank tried in vain to buy dollars and bring the currency back into line.

Brazil's finance minister, Guido Mantega, was quoted as saying: "We're in the midst of an international currency war, a general weakening of currency."

One blogger estimated that there had been 12 interventions by central banks in a single week in September.

The problem is that everyone wants a weak currency, and, to point out the obvious, that's simply not possible.

Instead it seems likely that the biggest kid on the block, the US, is probably going to get to win this particular race to the bottom.

The most obvious tool is QE2, or, as we might call it, quantitative easing, Mark II, whereby the Federal Reserve buys up debt and pushes money into the economy for the second time since the crisis.

Jeremy Stretch, market strategist at CIBC points out the Federal Reserve's has already dropped heavy hints it may do this and that's helping weaken the currency.

Fighting against this will be hard.

In the case of Japan, Stretch says: "I think inevitably the yen was always likely to drift back up. The prevailing wind is for a weaker dollar. In the absence of coordinated action they were pushing against the market on their own, and that seldom works."

The only currency that seems, for now, to be happy to allow some strength is the euro.

Stretch explains: "I think this to some extent is part of the Bundesbank's influence within the European Central Bank, and which says that a hard currency is a good currency.

"But when the pain threshold is reached, probably around 1.40 euros to the dollar, then we will see the politicians beginning to demand action - the French are usually the first to break ranks - and put a cap on the currency rising further."

The 8.4% rise in the Dow last month can be seen in this context.

Certainly there were other factors - better economic and corporate news - but it neatly coincides with the waning fortunes of the dollar (a 3.8% fall in September against a trade-weighted currency index) and a 4.6% rise in the gold price beyond the $1,300 level to new record highs and a spike in oil prices of around 10%.

Stretch says: "if we are going to get more monetary easing there could well be a wall of money looking for a home, and that will benefit a number of asset classes, including equities."

The loser in all this appears to be US Treasuries, which have long been the asset of choice for safe haven seekers.

If they really have lost their allure, along with the dollar, you can have some sympathy with the Chinese, the largest holders of US debt in the world, who are reacting with a certain justified pique at seeing them devalued - it is not, then, just about the competitiveness of their exports.

The falling dollar will have consequences, both intended and unintended for all investors.