Behind the market frenzy

Traders were in frenzy last night because they could smell major trouble ahead. Australia is, unfortunately, in the eye of the storm.

My charting friends tell me that we need to fasten our seat belts for the market fall that is ahead and they will be right if the current trends continue.

Last month, I explained why the cost of capital was likely to rise and that this threatens share markets. What is suddenly triggering those danger signals is the crisis in Europe (see Europe at a crossroads, February 4 and Greece's crisis is contagious, February 4).

Yesterday I set out some of the forces that are building and today Karen Maley explains some of the reasons for the fear that has sent the northern hemisphere markets into a minor panic (Inching towards a trade war, February 5).

One could argue that the strong European countries such as Germany have to decide whether they will keep the EU together with a common currency or let it split up. What Germany are currently saying is that they will only help the weak countries like Greece, Spain and Portugal if they undertake massive cuts in government expenditure. Politically, those governments are unlikely to be able to manage those cuts even though Greece has undertaken to comply with the German demands.

If Greece, Spain and Portugal were not part of Europe there would be debt defaults and a massive fall the value of their assets and their currency. But these countries currently have the euro as their currency, which means that their currency is much higher than it otherwise would have been, making debt repayment harder and likely asset price falls steeper.

In the process, the euro itself falls because there is real danger that the eurozone will be broken up. But even if it stays together, the looming severe recessions in the problem countries make the outlook grim.

That means the US dollar and the Chinese yuan are rising. The last thing the US needs at this point is a higher currency because it could snuff out a weak recovery. As the American currency rises, Wall Street's fears of tougher times ahead multiply and US shares fall. All this has nasty effects on mineral prices including copper, gold and oil.

Mineral prices are falling first in adjustment to the higher US dollar and then because of fears that the total crisis, including the looming higher cost of money, will lower demand. Copper has fallen 17 per cent since its peak of January 5. Oil and gold are suffering similar falls.

And with the commodity price falls, down comes the Australian dollar, which means that those traders in our currency who had been betting on parity with the US dollar are selling fast. The sharp fall in the Australian currency will frighten overseas investors here and will crimp retail margins where big imports are involved.

And the bottom line is the Australian share market. Share markets usually swing too far either way. Back in January I saw fear in the eyes of the day trader as he liquidated his holdings. Unless he went back in the days that followed, today he is relaxed. But there are a whole lot of others who did not take that action and that are very concerned.

The long term bottom line for Australia is whether China demand can hold. The Chinese are slowing their economy which was very necessary. But they have their own set of problems.

It's important for Australia and the world that these problems in China be contained as we play through this European/US crisis.