Posts from — August 2007

I will be going on vacation for two weeks. I will be back on September 10. Hopefully, you will be able to find some other place where you can get my kind of cutting-edge commentary until then.

Calm seems to be returning to international financial markets.  US economic data released today surprised to the upside.  The US dollar is even losing its safe-haven bid with fear not as dominant in the market as in days past.  We could even see conditions set up for a normalization of credit and liquidity in the last quarter of the year.

Asian and European markets have done well for the past couple of days.  US markets have not been as resilient, but we haven’t seen major losses either (which is almost as good).  We talked about the carry yesterday, and it should continue to rebound as long as the Dow does well.  The only major negative report that we have heard regarding financial institutions is the discovery of $10 billion worth of asset-backed securities on the books of China’s national bank.  But that’s a bank that doesn’t have to worry about liquidity, so it is not something that should worry investors.

US economic data should also prove reassuring to traders at all levels.  New Home Sales came in with a dramatic 2.8% increase, registering a pace of 870,000 new purchases compared to expectations of only 820,000.  Durable Goods printed even better, rising 5.9% last month after a revised 1.9% growth the month before (check out dailyfx.com for an explanation of how you can make money trading currency on the back of the durable goods report).  Economists at Bloomberg only expected 1.0% growth in July.  What these reports mean is that the US economy was doing really well before the credit crunch this month, and if we can get passed the liquidity issue, the overall economy is on a good track.  As good news dominates the market, fewer investors feel compelled to park their assets in US dollars, and one place you can go right now is Canadian dollars.

The best case scenario in this situation is for world financial markets to settle down before the Fed’s meeting in September.  The ECB has reaffirmed its commitment to raising the overnight lending rate on the continent.  Bank of Japan Governor Fukui is determined to normalize Japan’s interest rates before too long because extremely low rates result in a misallocation of resources.  Time Magazine has a profile defining Fed Chairman Ben Bernanke as a man walking a “fine line” between inflationary pressures and threats to growth.  But Main Street looks like it may survive, and the Fed (hopefully) will be able to keep the Funds rate constant on September 18 without too much trouble.

Financial markets look to be rebounding after their huge drops in the last couple of weeks. Markets have seen an uptick in value and, and recent news only seems to support that trend. The primary effects of this movement on the foreign exchange market have been twofold: providing the Fed with justification to slow down the easing process and giving Mrs. Watananbe the ability to resume the carry trade.

Let’s look first at how the financial markets have returned to a relative state of calm. The four biggest US banks borrowed $500 million each from the Fed’s discount window yesterday. None of the four actually need the money, but the act is a symbol of trust in and acceptance of the Fed’s recent decision to lower the discount rate. Bank of America also took a new $2 billion stake in Countrywide Financial, the nation’s biggest lender of home loans, a catalyst that drove down corporate bond risk and drove up stocks. Once thought to be on the verge of bankruptcy, Countrywide appears to have survived the crisis, signaling hope for the larger economy. Looking at the broader equities market, the VIX index feel even more yesterday, now sitting more than 40% lower than the highs hit last week.

All this good news might indicate that the Fed doesn’t have to ease rates to the extent that futures traders have priced in. And indications from US central bankers point to the Fed not really wanting to lower rates just now (the moral hazard problem). The Fed has a number of different options as to what it could do in September and October, but it has to realize that the credit problems are still far from over. Commercial paper is still being ignored to a ridiculous degree, and if a wide scale easing program is not implemented, then we could see the problems of Wall Street spread to Main Street.

A spread to the wider economy is not out of the realm of possibility. Layoffs in mortgage companies are coming, and the big banks are already shutting down their subprime units. More troubling is what happens to mortgage rates if the Fed keeps rates steady. Adjustable rate mortgages are set to be re-priced next month, and with credit conditions as they are now, we will see consumers swamped with enormous debt service bills. Consumers are the engine of the US economy, and any slowdown in that sector because of higher bills could be disastrous. That said, if the Fed keeps rates steady, it would also be bullish for the US dollar in the short-term. As corporate profits shrink and equities markets decline, we would see a strengthening of the dollar’s safe-have bid, and USD/JPY, especially, would see the bottom fall out.

But with the stock market reasonably strong and most market participants sure of a Fed funds interest rate cut, the US dollar is seeing some capital outflow and so is the Japanese yen. The dollar-yen hit 117 last night, and the carry trade seems to be returning. Mrs. Watanabe saw in the recent drops the same buying opportunity that hedge funds proclaimed (and quantitative funds have made back most of their losses this week). We should see at least two rate cuts this year in the United States and that should generally prove bullish for the carry trade. But as always, be careful.

Yesterday, we wrote that when the US sneezes, the rest of the world still gets a cold.  Now there are reports from DailFX.com comparing the Asian financial crisis of 1997-98 to the US subprime fiasco.  But while the starting points may be similar, there is reason to believe the reactions by international central banks will be different.

In 1997, traders and investors were highly leveraged in risky investments in emerging markets in Southeast Asia.  When the Thai government floated the baht, all hell broke loose.  In the current situation, traders and investors were highly leveraged into complex debt instruments backed by risky mortgages.  When foreclosures reached record highs, the credit market went into a state of panic.  If the parallels continue, then we should be looking at multiple interest rate cuts by the end of this year.

But the major difference in this case is that Fed Chairman Ben Bernanke has proven different than his predecessor Alan Greenspan.  Bernanke seems to be less inclined to bail out investors suffering in times of falling markets, especially if that bailout would include an interest rate cut.  Recent reports on Bloomberg indicate that the Fed has not decided on a course of action with regard to interest rates, instead hoping to give the increased liquidity time to work and the market time to digest the effects of the discount rate cut.  Senator Chris Dodd, Chairman of the Banking Committee, even pressed last night for more banks to take advantage of that rate cut.

That comment took place after a meeting with Secretary of the Treasury Henry Paulson and Chairman Bernanke.  The meeting was important on a number of different levels.  It occurred amid a backdrop of hawkish comments by a couple of Fed officials.  Futures traders, who had priced in a 100% chance of an interest rate cut in September, dropped their projections after the meeting to a 50% chance of a rate cut.  But one analyst for DailyFX.com still regards it as almost a certainty that the Fed will lower rates by at least 25 basis points (and maybe even 50) during their meeting on September 18.

The interesting thing about this scenario is that even in the midst of all these problems in the credit markets, the broader economy is still doing well.  Fundamentally, US growth remains on track, above the standard 2.0% level.  Unemployment remains low, and inflation seems to be relatively contained.  Even the debt market appears to be balancing itself out, as yields have begun to bounce back (the Fed is even considering accepting commercial paper a collateral for its discount loans).  Volatility is retreating, with the VIX down 30% off its 4-year highs last week.  Equities trades might cry foul, but the best decision right now might be to leave the Fed Funds rate unchanged.  And at least with regard to the foreign exchange market, that is good news for dollar bulls.

Yesterday, we stated that there would be little empirical effect of the discount rate cut on the international credit crunch.  Until the Fed actually cuts the Fed Funds rate (and that will not happen until September at the earliest), markets around the world are going to continue to be wary.  The equities markets are sending mixed signals about the health of the financial economy.  But the real signal is the credit markets because that is the epicenter of the crisis.  And it is there that we see the negligible effect of the Fed’s decision: yields on one-month and three-month bills are skyrocketing.

Asian stocks, led by the Nikkei, rebounded from their horrendous fall last week.  But European traders have been more cautious, and the net result on the Continent is a downward trend on equities.  The German ZEW survey of analyst sentiment did not help, printing at -6.0 vs. -1.0 expected.  Investors have been more accepting of risk than in recent days, as signs of a carry trade rebound have shown up in the market.  As evidence of that phenomenon, the yen crosses have begun to edge higher.

But looking at the credit market, there is still reason to remain bearish on international prospects.  Commercial paper is being avoided like the plague, not only in the United States but in Europe and Asia as well.  As an alternative, investors are rushing to US Treasuries, as they are really the only completely safe investment left.  Yields are being driven to multi-year highs.  Even the Bank of England, which stood on the sideline all of last week, is beginning to get involved in easing the credit crunch.

Forex sentiment on the US dollar is mixed.  The run of Treasuries should provide a strong support for bids at the moment.  But the housing recession and credit problems started here, and their final effects are likely to manifest themselves most strongly here.  Although that probably means bad news for the entire world, as when the US sneezes, the rest of the world still gets a cold.  Foreign exchange traders should remain bearish on the USD/CAD and bullish on EUR/USD and GBP/USD, especially considering the coming Fed Funds rate cut.

But there might be a problem with that scenario as well.  Recent reports show inflation in developing countries to be as strong as ever.  In China, the only real solution to that is to let their currency appreciate, something the government is still loath to do.  In India and Brazil, global demand has prices skyrocketing.  Developed economies may be experiencing a credit crunch, but emerging markets around the world may actually be confronted with excess liquidity.  A loosening of credit conditions in the United States could lead to an exporting of inflation internationally, and the primary job of a central bank (no matter what Bernanke or any politician might say) is still price stability.  Which means we might not see that rate cut in September after all.  And then we should prepare for all hell to break loose in the financial markets.

The Fed cut the discount rate from 6.25% to 5.75% before trading opened Friday morning, and US stocks responded.  Green numbers showed up for the first time in weeks.  The Nikkei rebounded from its shocking fall on Friday.  But it is impossible to tell right now if the cut will provide a lasting calm to financial markets worldwide.

There is a possibility for the Fed’s decision to have a big, positive effect on the credit market.  Much of the liquidity crisis has been a result of the inability of securities firms to obtain loans based on their assets.  The Fed has announced that it will take asset-backed securities and mortgages as collateral for the thirty-day (maximum) loans.  Securities firms cannot go to the Fed directly, but they can go to banks with their goods and the banks can go to the Fed.  In theory, this should solve the problems of the credit crunch.

But if you check out how the discount rate is used in practice, you see that the effect of Friday’s decision may be pretty small.  Only $11 million dollars changed hands last week through use of the discount window, a laughably small number.  A rate decision cannot really affect the market if no one borrows at that rate.

The real effect of the discount rate cut is probably psychological.  The decision signals that the bank is ready to do something to ameliorate the liquidity crisis.  The FOMC statement on August 7 was hawkish and preoccupied with inflationary risks.  The Bernanke Fed has prided itself on transparency, and in order to leave itself the room to lower rates in September or October, the bank needed to alter that statement.  Ignoring the effect of the financial crisis was a rookie mistake, but the Fed fixed that problem without indiscriminately bailing out the idiots of the subprime crisis.

The effect this will have on the credit market depends on the Fed’s willingness to lower rates.  If they do not cut the Fed Funds rate in September, we will see a resumption of instability and dollar-bullishness.  But the effect on the equities market is a little more complex.  Risk aversion should trend downwards, allowing for greed to surpass fear as a market mover.  But the fundamentals of the global economy are still troublesome, as the housing problems haven’t exactly gone away.  So investors should be wary of volatility; the VIX index registered its highest level even after the discount rate announcement.

For the US dollar, the Fed’s concern with economic growth over price stability is bad news.  Traders will now value the greenback’s safe haven status less highly.  An easing of the monetary policy should promote growth in the United States over the longer term; we are already seeing American growth outpace European growth for the first time in years.  And that phenomenon should continue.  But with investors hungry for yield and with the forex market as competitive as it is now, we are looking at a bearish outlook for the US dollar.

The discount rate in the United States was lowered today from 6.25% to 5.75%.  The 50 basis point reduction was a necessary move to stave off credit market gridlock (at the very least, it will satisfy Jim Cramer).  With regard to the foreign exchange markets, volatility is approaching the crazy days of October 1998.  The liquidity injections by the major central banks have obviously not been doing the job in easing the credit crunch, and the lowering of the discount rate sends a major message to the international financial markets.

The discount rate is the interest rate at which the Federal Reserve lends money to major banks, as opposed to the Federal Funds rate which is the overnight lending rate between banks (check out dailyfx.com for a more detailed look at the difference between the discount rate and the Fed Funds rate).  By not touching the benchmark interest rate, the Fed is trying to avoid the moral hazard problems.  Central banks around the world are loath to bail out completely the financial institutions that lent out money so irresponsibly.  But the economic impact on the borrowers and on the “real economy” has become so profound, that the Fed needs to do something.

When it comes to trading currencies, the primary effect of this morning’s decision is a removal of support for the US dollar.  Accompanying the discount rate announcement was a dovish statement by the Fed stressing economic growth and deemphasizing the fight against inflation.  A September 18 rate cut is as close to a certainty as is possible.  But that weakness is compounded when you realize the psychological effects of the Fed’s decision.  Now we know that the US central bank stands at the ready to ensure proper credit movement, and with removal of some risk, more daring investments come into play.  And there’s less of an incentive to hold cash (or T-bonds, which are just about the same thing).  People do not care anymore about the US dollar’s safe haven status, and that is reflected by the fact that the currency fell against 14 or the 16 most highly traded currencies.  Dollar bulls are going to eat some losses now, but today’s news is good news for the global economy as a whole.  And ultimately, that’s good news for the dollar.

The yen crosses are all taking a beating. After more than a year of weakness (mostly through carry trade borrowing) the Japanese yen is cleaning up. Even the US dollar, up against all the other major currencies, is not safe from the yen’s resurgence.

The yen is now at its highest level since July 2006. The high-yielding currencies have suffered the most, with NZD/JPY and AUD/JPY both falling over 5% yesterday. EUR/JPY has acted the proxy for carry trade sentiment in the foreign exchange market, and the currency pair fell 2.3%. And just as we predicted yesterday, USD/JPY blew past the stops at 116.50, and reached 113.60 in early New York trading. Even against the pound, which looks to be the most fundamentally-backed of the major currencies has fallen against the yen, as GBP/JPY dropped 700 pips yesterday. The carry trade unwind is on, folks, and this is just the beginning. If the market has its way, the Japanese yen will appreciate even more.

But that’s just the thing. There’s a chance the foreign exchange market will not be allowed to have its way. The Bank of Japan has a well-deserved reputation for aggressive intervention, and it will be looking at the recent yen gains with some dismay. Japan’s domestic economy basically sucks, and the country’s production is being kept afloat by its world-beating export industry. A stronger yen is bad for business. That’s the reason that Toyota’s share price fell 3% last night. The BoJ could look at the yen crosses and say the Japanese currency is overbought. If that happens, we will see the yen give back a lot of its gains.

The Dow sold off below 13K yesterday, foreign purchases of US securities were mixed and the market has already priced in an interest rate cut in the United States at the Fed’s next meeting on September 18.  But the US dollar has shrugged off that data and continued to remain strong, at least against every major currency except the Japanese yen.  I am particularly bullish on US Treasuries as most of the rest of the bond market is particularly illiquid and difficult to price.  Treasuries are the surest bet for investors.

The gains against the commodity currencies are especially striking.  Commodities continue to fetch high prices in the futures markets, but the currencies themselves are feeling the effects of the recent appreciation.  Canadian production has fallen as a result of the strong Loonie, and investors are becoming more wary about bets placed in New Zealand and Australia.  Fundamentally, long positions in NZD/USD appear to be the most at risk.  With traders paring back on riskier strategies and sticking to the US dollar, look for the commodity currencies to continue their falls.

The interesting thing about the strength of the dollar is the lack of good economic data to support that strength.  The CPI report was flat, and the subprime problem seems to be contagious, rather than contained.  The New York Fed was hot, buy Housing Starts fell to a 10-year low in July.  The housing sector is mired in an 18-month recession.  If the Fed needs an excuse to lower interest rates, there’s plenty of poor data it can point to.

Speaking of interest rates, I will be very surprised if we do not see one on September 18, but just as surprised if we see one before then.  Bill Poole has come out and said that it would take a calamity for the Fed to introduce an emergency rate cut.  Mark Gilbert of Bloomberg brings up an interesting point though: the liquidity injections into the market by the Fed have already brought the 4-week Treasury bill below the target rate of 5.25%.  A temporary easing has already occurred which leaves the September 18 meeting to just make it official.  And when that happens, look for the dollar to lose its support.  But not until then.

“Mrs. Watanabe” is the designation used to describe the typical Japanese woman, and she is killing the professional forex market right now.  Currency analysts at places like Deutsche Bank and Goldman Sachs predicted USD/JPY to end this year around 115, or even lower.  But until the catastrophic events of this past week or so, the yen has not been able to do much better 120/dollar.  And much of the reason for that is Mrs. Watanabe.

Fundamentally, the yen should be rebounding.  The Japanese economy is starting to emerge from its decade-long slump, and the currency should rise with it.  But the overnight lending rate in Japan is still only 0.5%, making the currency an attractive borrowing option for the carry trade.  And retail investors are (or at least have been, before this week) in love with the carry trade.

The Japanese retail forex market is especially important because it is bigger than the retail markets in the rest of the world combined.  You can even get savings accounts in Japan denominated in something other than yen.  And in Japan, the investment decisions of the household are made by the wives.  Those wives are as enamored with the carry trade as anyone else.

In July, Bank of Japan board member Kiyohiko Nishimura made a speech praising these Japanese housewives for steadying the forex market.  Historically, the carry trade has always ended disastrously (although it has always rebounded from that crash) with investors across the board rushing to get out of the trade all at once.  Mrs. Watanabe does not act that way, however.  Every dip in USD/JPY is a buying opportunity, and as such, she reduces currency swings.  It looks like the carry trade is near its end.  But it was a good ride while it lasted, thanks to Mrs. Watanabe.  A gnome of Zurich, she is not.