Posts from — August 2007

Should the US Fed lower its overnight lending rate, and what will its decision mean for the US dollar?  The short-term strength of the greenback would surely disappear if rates were indeed lowered in September.  But just as certain is that financial markets would recover faster, and the economy might be stronger going into the end of 2007.  the danger of cutting interest rates (besides the inflationary risks) is the idea that a market bailout by the Federal Reserve would create a moral hazard in the financial industry.

Short-term support for the dollar remains strong.  The dollar is on a steady upward path against the euro and the pound.  It is absolutely killing against commodity currencies.  With risk aversion still dominating the forex market (and the carry trade likely to fall even further), the yen remains the only currency to show strength against the US dollar.  If USD/JPY touches 116.50, we will see all hell break loose; that’s the level at which many retail traders started shorting the yen and their stops will come into play.  Economic data for the greenback has been mixed.  Industrial production and producer prices surprised to the upside.  But the CPI report this morning came in particularly low, as many economists were predicting.

The last development would provide cover for the Fed if Bernanke decided to bail the financial market out with an interest rate cut.  Monetary policy makers could argue that the upside risk of inflation is abating, thereby preserving their inflation-fighting credibility.  But one thing to note is that the liquidity that has been injected into the market in recent days has not exactly been a “helicopter drop.”  The money has gone through the big banks, and there are still reports of smaller companies and mortgage lenders being mired in a liquidity crunch.  The signs of the intervention working are mixed, at best.

But then that points to an interesting question.  Should we bail out lending companies that made foolish decisions resulting in bad loans?  If the financial companies are not held accountable for their poor actions, then we could see even riskier investments and loans flourish in the new environment.  The ideal scenario would be to find some way to help those families stuck paying off impossible mortgages and keep them from losing their homes, but do that without assuming the risk of the larger corporations.  An actual helicopter drop, distributing money to those at the bottom-end of the operation, would be best.  The government would need to get involved.  However, the integrity of the Fed and the US dollar would be maintained, and US consumers would be saved.

Financial markets have stabilized in the last couple of days, but support for the US dollar has refused to wane.  Believe it or not, there are actually legitimate economic reasons to continue to bid up the ugly duckling of the foreign exchange market.  Especially with relation to the pound and the euro, the US dollar is connected to better recent data.  But if the subprime problem is contained (if the international interventions prove successful) then that will signal bad news for dollar bulls; financially, the US economy is in worse shape than its global counterparts.

Producer prices is the United States rose 0.6% last month versus an expected gain of only 0.2%.  That is a strong reversal of May’s 0.2% decline in producer prices.  Core prices registered a jump of 0.1%, bringing the yearly inflation index to 2.3%, higher than then 1-2% comfort zone.  The US trade deficit also fell in June to $58.1 billion from a revised $59.2 billion in May.  Providing further support for the health of the US dollar, the Fed funds rate opened this morning at 5.1875%, lower than the target rate of 5.25%.  The Fed is likely to see this situation and remain hawkish on inflation, with the recovering growth providing some cover for keeping interest rates steady.

Across the pond, the ECB and the Bank of England are faced with more negative immediate conditions.  UK CPI printed last night at 1.9% versus an expected gain of 2.3%.  The latest rounds of monetary tightening look to have had their effect on prices, and English monetary authorities may have to check their hawkish stances somewhat.  As for the continent, GDP data has been extremely disappointing, with US growth outpacing growth in the Eurozone for the first time since 2006 Q1.  But futures markets are still pricing in the probability of a rate hike in Great Britain and the EU and the likelihood of a rate cut in the United States all by the end of this year.  So while the dollar might be gaining now, the gains are likely to be short-term.

Even the short-term gains are dependent on how the international financial markets evaluate risk.  If risk aversion maintains its stranglehold, then the US dollar will continue to benefit from its status as a safe haven.  But economic data in the US, as a whole, is still pretty underwhelming.  So if traders can get past the housing mess (and the doldrums of August), we should see the dollar go back to being what it has been for some time now: safe, steady…and a terrible investment.

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.

The Japanese currency made a 5^th weekly advance today against the U.S. dollar as investor appetite for risky assets has plummeted. Fear of the credit market crisis has sent the yen to its longest winning streak against the dollar since December 2004. Traders have stopped investing in risky assets with loans using cheap yen, thereby unwinding their carry trades. The Japanese currency rose .4 percent to 117.67 per dollar this morning in New York. The yen also made gains against other currencies across the board.

The biggest driver of this yen increase has of course been the U.S. subprime meltdown. Major central banks have finally taken action to alleviate the credit crunch. The European Central Bank made an unprecedented move yesterday of pumping loans into the banking system as the U.S. subprime crisis hit Europe. Yesterday, France’s largest bank, BNP Paribas SA, announced the halting of withdrawals from 3 funds. Today the ECB made loans of 61.05 billion ($83.5 billion) and the U.S. Federal Reserve pumped $19 billion into the banking system to meet increased demand for cash in the fixed-income crisis. The Bank of Japan has taken similar actions by providing loans of 1 trillion yen ($85 million).

Outlook and Strategy:

Central banks have finally felt the need to take action as U.S. subprime mortgage losses have been rippling through the credit markets. Stephen Malyon, co-head of currency strategies at Scotia Capital Inc., comments: “Subprime is clearly not contained. Concerns over the turmoil in global equity and fixed-income markets keep the pressure on the carry trade.” He does not advise betting against the yen right now.

At almost a quarter of GDP, we have finally seen the broader consequences of the U.S. housing slump affecting the U.S. economy. Paul Kasriel, chief economist at Northern Trust Corp., states: “Housing created a lot of ancillary economic activity and jobs, and now we are in the reverse process.” The problem seems to be contagious, not contained as Fed Chairman Ben Bernanke believed on March 28^th. Corporations spread as far as countertop makers, railroads, and some fast-food chains have been blaming subprime for lower than expected earnings. If anybody was watching Jim Cramer’s interview on CNBC last week, his frustration with the subprime crisis could not have been more evident.

The subprime mess has spread into the major international banks, especially in Europe where many investments were made in collateralized debt markets. Shares of top 12 U.S. Banks have fallen 17 percent since June 1^st. The problem began when mortgage firms, who had packaged loans into securities and sold them to investors, have hit trouble as loans defaulted diminishing investor demand. In addition, these firms had borrowed heavily from banks to buy more loans. But as the defaults increased, banks have been demanding their money back. The credit market is in a very tight spot finally receiving some liquidity from central banks.

But what does this mean for the U.S. dollar? As the Fed continues to make loans, investors will continue to turn away from risky assets. The yen may make more gains against the dollar, especially if the likelihood of a raised interest rate by Japan’s central bank increases.

The European Central Bank and the United States Federal Reserve are bailing out the financial markets right now.   BNP Paribas declared that they are suspending withdrawals from three of their investment funds, and the market reacted pretty poorly.  The overnight lending rate for euros shot up to 4.7%, leading the ECB to distribute over 155 billion euros over the past two days.  The Fed, which has seen two straight days with the LIBOR rate above the benchmark rate of 5.25%, has added $43 billion in temporary cash.  The Bank of Japan and the Reserve Bank of Australia, this morning, added $8.5 billion and $4.2 billion, respectively.

Risk aversion has been on a steady climb recently, and naturally, the demand for liquidity has skyrocketed.  Central banks around the world have used their tools to ameliorate the crisis.  The real problem is what message this sends to participants in the financial markets, whether it be equities or foreign exchange.  The last time there was a bailout this large was right after September 11, 2001.  Earlier this week, both the ECB and the Fed were talking about how credit conditions were manageable.  The Reserve Bank of Australia raised its interest rate to 6.5%.  The Bank of England basically came out and said that they were ready to keep raising interest rates for the near future.  What do the central banks know now that has caused them to change their positions?  And what do the commercial banks in Europe and America know that led them to accept the loans?  Is the US subprime crisis a worldwide issue now? Bear Sterns Chief Financial Officer Samuel Molinaro came out and called this the worst fixed income market that he has ever seen.  And the primary driver for investors is fear, fear of what the answers to those three questions are.

It would be a different scenario if it was only firms on Wall Street losing money.  It would hurt the US economy, but the influence would be limited.  But what a liquidity crisis means is higher interest rates.  For everyone.  Analysts across the spectrum have been chirping about how the era of easy money is over.  There are billions of dollars worth of adjustable rate mortgages that still need to be re-priced according to current interest rates in the coming months.  The housing situation is on track to get worse, with foreclosures even higher than before.  About seven million Americans are slated to lose their homes.  And with homes so important to personal equity and wealth, the problems will stifle individual growth and consumer spending.

In the short-term, the US dollar actually benefits from market uncertainty.  Risk aversion and volatility (Chicago Board of Option VIX survey is at a 4-year high) lead traders to park their assets in US dollars.  Counterintuitively, the US subprime crisis puts support under the US dollar.  But it’s time for the Fed to ease credit.  What has been done so far is not enough, and interest rates have to be lowered; money has to be thrown in to the financial markets.  The lower interest rates will counteract the safe haven status of the US dollar for now, but it is what is needed for the US economy to get through this situation.  Lower interest rates and greater liquidity will hurt dollar bulls in the short-term, but they will benefit the US economy (and therefore the US dollar) in the long-term.

The People’s Bank of China may be in a position to use its $1.33 trillion currency reserves as a bargaining tool against U.S. lawmaker demands. Xia Bin, director of financial research at the State Council Development Center, believes China can use its holdings of U.S. government debt to its advantage. As the world’s second-largest holder of U.S. Treasuries of $407 billion, the selling of U.S. asset holdings would significantly lower their value. U.S. Treasuries fell yesterday after traders cited in a U.K. Daily Telegraph report that China may threaten to sell its holdings in U.S government debt if the U.S. imposed trade sanctions (see more in an article by Kathy Lien).

On July 26^th, the U.S. Senate Finance Committee approved legislation that would place higher duties on Chinese imports. These higher duties should compensate for the undervalued yuan. U.S. lawmakers since the beginning of the year have expressed concerns that an undervalued yuan is hurting U.S. companies. The People’s Bank of China has bought huge sums of U.S. government debt in order to keep its yuan artificially low.

With a high foreign currency reserve, a central bank is able to issue more than sufficient amounts of its domestic currency to stifle demand. If demand decreases when the economy bottoms out, the central bank would have plenty of foreign reserves to buy back the domestic currency. The enormous influx of capital from its incredible trade surplus is what has allowed China to maintain the world’s largest foreign currency reserve.

Despite numbers for April and May this year showing cuts in PCB U.S. Treasury holdings after 17-months of purchases, the central bank has indicated it would cut holdings anytime soon. President Bush and Henry Paulson agree it would be “foolhardy” for China to cut holdings in U.S. debt. Selling off these assets would strengthen the yuan significantly and thereby lower export value. Both have indicated that a mutual trade flow without penalties on imports should persist. Yet, with its true actions always a secret to the public, it remains to be seen what the PCB will decide if U.S. import duties do come into play. The PCB could use its huge foreign reserves to put a dent into the U.S. economy. The situation has turned from a question of economic policy into a potential political showdown.  

The carry trade is not back. At all. Stay away for right now. The Dow rallied to close 150 points higher yesterday, and yen crosses followed that stock market rally. The high-yielding currencies, especially, made back a lot of their losses. But the upward movement is likely to be temporary because the current market is not conducive to the carry trade.

Volatility is still significant (the stock market may have ended in positive territory, but it wavered back and forth throughout the day). Risk aversion in the market is at a high level. This is the reason that US Treasuries continue to do well; the bonds gained 1.6% last month, second-best performance of all major international government bonds. And then there are the comments yesterday out of China threatening to dump dollars in response to protectionist legislation in the United States. No rational observer of the market actually thinks this is a likely possibility, but the chance is there. If nothing else, the proclamation by the government researcher reminded investors (in the forex market and elsewhere) of the potential power that China holds to disrupt international financial markets. And the fact remains that we do not have a long-term record to rely on of responsible financial administration out of China. The more people are afraid of risk, the worse the carry trade does.

The carry trade is a complicated proposition for anyone participating in the FX market. That’s why so many people get it wrong all the time, including those who make their living trading the currency. There’s so much information bouncing around the market, and traders are relying on fundamentals and technical analysis and have trouble deciding when different signals suggest different actions. As sacrilegious as it might sound, traders might actually be relying on too much information.

The great thing about the internet is it brings real-time news about everything right to our fingertips. But too many choices (for a trader) can actually be a bad thing. There’s a book out right now called The Paradox of Choice, and it’s about how, at a certain point, more options actually reduce the amount of choices available for an individual. We are paralyzed by the sheer number of things that we look at, and so we are unable to focus (or choose) the most valuable information. Bringing it back to the carry trade, the important observation to keep in mind is the following: carry trade thrive on three market conditions: (1) low volatility in international financial markets, (2) cheap money (or credit) and (3) a strong risk appetite among investors. The carry trade will not rebound because none of those three conditions are met in the current market climate.

The FX trading last night is evidence of this point. EUR/JPY, which has acted as a proxy for carry trade popularity, lost 200 points. The Swiss franc gained support through both a run away from the carry trade and a run toward safe havens. The high yielding currencies will continue to lose ground as both phenomena continue. USD/JPY will be the one of the few yen crosses to buck the trend because of the US dollar’s status as a store of value and a safe haven. But that is an abnormality and should not fool traders into thinking the carry trade is back.

The actual interest rate decision yesterday afternoon did not surprise anyone in the forex market. The Fed kept rates the same which, despite the bank’s famous lack of transparency, was predicted by everyone. The announcement accompanying the FOMC decision did provide some short-term support for dollar bulls. But of greater concern for most forex analysts, the longer-term problems afflicting the US dollar are not likely to go away anytime soon.

According to the announcement, the primary concern for the Fed is still trying to control inflation, which is certainly reassuring for those still long US dollar. There are two primary reasons for this track. The first is that the bank looks to be providing a calming voice to the international financial markets. While accepting that the housing crisis is troublesome (and could get worse), the situation is not as bad as it might seem.

Analysts all over the United States are screaming their heads off about the problems in the subprime sector and how they are going to sink the market and how the central bank needs to cut interest rates. But the fact remains that the broader economy continues to do well. And despite the Fed’s dual mandate (of controlling inflation and ensuring economic growth), the fact remains that the bank’s primary job is price stability. While core inflation may be within the target range (1-2%) espoused by Bernanke’s Fed, commodity prices are skyrocketing. Oil is still above $70/barrel and food prices are growing at a 6% annualized rate. The upside risks to inflation remain high, informing much of the bank’s decision to keep interest rates the same.

The second major reason that the FOMC kept interest rates steady is the need to keep returns competitive with the rest of the world. Interest rates are on the rise all over the world, and if the United States lowers its rate, investors realize they can better return to equity elsewhere; US bonds would be inherently less attractive than bonds offered by countries with lower rates. The market still expects interest rate cuts by the beginning of next year, which leaves the US yield curve inverted.

Traders, before anything else, are obsessed with higher returns, and if they cannot find them in the United States, we will see a capital flight away from this country, torpedoing the US dollar. Deterioration in our current account surplus would leave American consumers unable to pay for imports in the short-term, setting the stage for a massive devaluation of the US dollar. The greenback is buoyed by its status as a store of value and by the dollar’s preeminence in international trade, but that’s not going to matter to investors hungry for yield. The Fed’s caught between two problems: the slowing down of the US economy and the need to keep US bonds attractive to international investors. It is this situation that will keep US interest rates the same for some time, keeping a cut at bay for longer than most forex analysts seem to think.

While the euro has been beating up on the US dollar recently, the British pound has not seen fit to join in.  Rather than rallying, the pound sterling has been hit by a variety of crises, including the weak global equities market and the US housing problems.  The resurgence of Foot and Mouth disease in the English countryside points to a further deterioration in the pound’s standing.

The weak stock market has proved especially damaging to the financial services-driven British economy.  And as credit continues to get more expensive, demand will dry up for whatever the City has to offer.  New reports have also surfaced from British banks that the subprime problems in the US are starting to have a negative effect across the pond as well.

Recent economic reports from Great Britain paint a mixed picture.  Retail Sales growth printed at 1.2%, the lowest level since November.  Currency traders drove the pound to a two-month low against the euro and to its second straight day of losses against the US dollar.  The concern in the FX market centered around worries that five consecutive interest rate hikes may be putting a brake on the British economy.  But GDP growth came in at 0.8% versus 0.7% expected, suggesting that monetary policy is still accommodative to further expansion.  But the market moving data out of London is the reemergence of Foot and Mouth disease, and it is this news that should strike fear into all currency traders long on the British pound.

If the disease is not contained, FMD is almost guaranteed to sink the British pound.  The first reported outbreak was on August 3, and a second case was found last night.  The area has already been quarantined, and a voluntary export ban has been established for England, Wales and Scotland.  The last FMD outbreak cost the British economy 10 billion pounds.  Meat prices rose 5% and inflation was estimated to be 0.1% higher. For the forex market, an analysis of the past is even worse.  In the summer of 2001, after the first reports of contamination in the livestock, GBPUSD fell from 1.4750 to 1.3680, a drop of over 1000 pips.  GBPCHF has already begun it breakdown.  All those with an exposure to the British currency should be wary of the current market and keep an eye out for future developments with FMD because the disease, and what happens with it, will be the major driver of action on the pound for the time being.

The state of the US economy is not dire, but it certainly does not bode well for the US dollar.  Job creation was at its lowest level since February, with the NFP printing at an abysmal 92K.  But even worse for the dollar is the fact that job numbers are not the cause of growth or decline in the economy.  Payrolls are a reflection of demand; as house prices depreciate and take personal income down with them, that creates less of an incentive for businesses to grow.  In recessionary times, businesses are always slow to cut jobs, as the fall in labor always lags behind the fall in production.  The chance of a US recession will lead the greenback to fall against all the other major currencies.

As of right now, however, the idea of a recession is a little overstated.  But even if the economy is only stumbling (and will pick up later in the year), the US dollar is still going to take a hit.  That is because in this current market, equities are on line to fall even further.  US stocks have already been underperforming for years now compared to foreign equities markets.  And with fixed income in the United States more and more attractive because of the rising risk aversion among traders, that phenomenon is only going to continue.

Even the Fed policy meeting on Thursday is not likely to improve the mood of traders or dollar bulls.  That interest rates will stay the same is a market consensus, and Bernanke seems less inclined than his predecessor to act as a stock market savior.  The “Greenspan Put” should be pronounced dead, and forex observers can expect the announcement on Thursday to remain hawkish on inflation.  The futures market is pricing in a 100% chance of an interest rate cut in early 2008, but I believe the Fed funds rate will remain at 5.25% through the end of 2008.

The problems in the US housing market are a concern, however.  American Home Mortgage declared bankruptcy this morning, becoming the second-biggest lender to do so amid the subprime fallout.  Bear Sterns continues to take hits, with S&P announcing a negative on its debt rating.  The primary beneficiary of the weakness in US assets is the euro.  Ever since its inception, the euro has acted as the anti-dollar, providing an alternative for currency traders soured on the US market.  That is certainly the case right now, as euro bulls are having a field day.  Look for EURUSD to test 1.3900, and if it can overcome the resistance there, then the pair should see clear sailing through 1.4000.

After the euro, the other major currency to benefit in this forex climate is the Swiss franc.  Look for the Swissie to be the biggest gainer against the US dollar this week.  The low-yielding currency has found support as the carry trade has unwound.  As painful as carry trade unwind has been for those shorting the franc, history tells us that we are not even close to done yet.  The franc already hit a two-year high against the US dollar early this morning, with USDCHF reaching 1.1868.  The Swiss franc is both a growth story and a safe haven in a time of risk aversion, making it extremely attractive to currency investors.