INSIGHTS

On November 24, 2010

U.S. Dollar May Rally Against Korea Conflicts and European Debt

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Today’s global events have been long forewarned by politicians and financial leaders. The attack on South Korea by North Korea, though a bit surprising, seems to be a calculated effort to drive a further rift between the South Koreans and their supporters, namely the United States. Recall what happened in the last two weeks following the G20 meeting with the rebuttal of the United States’ call for a change to the free trade agreement with South Korea and China’s continued refusal of calls for a currency unpegging from the United States Dollar.

Could it be that North Korea saw a chance to pounce on a perceived weakened status of the United States? By revealing the further steps it has made toward nuclear weapons in the last week and attacking the island of Yeonpyeong early this morning, one should question the timing of said events. The attack is the most intense seen in many years and clearly raises the specter of military escalation. Some might say it was a response to the world discovering how advanced North Korea has become with regard to arming weapons with nuclear warheads and their fear of being attacked or at minimum, trade restrictions. Further trade restrictions at this point may only increase the chances of a military conflict as North Korea is already a very impoverished country. Since former President George W. Bush called North Korea one of the three “axis of evil” nations, it seems the confrontation would only be a matter of time.

Though this should not be confused with other military conflicts of higher magnitude, it should not be ignored. The result has been a flight away from the Asian emerging markets and towards the U.S. Dollar in a typical flight to quality move. With the Thanksgiving holiday already pushing volume towards the light side, any significant news may overwhelm what few buyers exist.

We also saw that Ireland formally announced its agreement to a $100 billion bailout. We have long been stating that there could be a domino impact of further political and economic fallouts in the European region. Ever since the acronym PIIGS (Portugal, Ireland, Italy, Greece and Spain) has been popularized, the only surprising shock is the rally in the Euro vs. the Dollar from 1.19 to 1.40. It has corrected down to 1.33 currently, and we would expect further drops as the markets begin to realize that the situation could become worse.

PIIGS: Debt and GDP Metrics

Source: CIA World Fact Book. See Charts/Graphs Disclosure.

With Greece and Ireland beginning their shift to more stringent austerity measures, one may erroneously assume that their worst days are behind them. Though we wouldn’t necessarily agree with that assumption, at least the size of the pain seems to be gauged. What is more pronounced is that with Ireland and Greece only accounting for 3.40% of the European Unions GDP, what happens when the next domino (Italy, Portugal and Spain) begins to quiver from the dominos falling around it? Portugal would be similar to Ireland in our estimation, however, the fact that Italy and Spain account for 4 to 6 times the amount of GDP, one begins extrapolate the potential impact to well beyond the European Central Bank’s ability to stabilize the situation.

Consider the 10-Year Benchmarks as a sign of the strife infecting the European Union:

Germany 10 Year	2.55%
Greek 10 Year	11.85%
Italy 10 Year	4.25%
Spain 10 Year	4.89%
Ireland	8.24%
Portugal	6.08%

Our call for the dollar to continue to rally against the Euro is only more affirmed as the methodical approach to financial crisis’ that have been witnessed by the ECB and the European Union as a whole appears to only elongate the problems.

Overall, the negative global news is overwhelming the good 3rd quarter print of GDP in the United States. This move back into the Dollar may have the same impact as witnessed earlier this year. We expect bond prices to stabilize and rally as U.S. Treasuries rally on behalf of the Dollar and risk aversion. The recent sell off in the corporate and municipal markets, we believe, presents some intriguing value for those willing to do a little leg work on the credit side.

At some point, the markets and investors become a little desensitized to the shocks and proceed on their continued route. In time the instability becomes the norm and investors block out the “end is near” signs on their way to work and back home again. Though the recent moves politically and economically are large in the historical sense, they pale in comparison to the events over the last three years. As Saul Bellow once stated, “Myself is thus and so, and will continue thus and so. And why fight it? My balance comes from instability.”

At some point, the rocky and choppy investment seas allow investors to gain their sea legs.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.