Posts from — June 2008

With this week’s ECB’s decision all but official, a more important question looms: what’s next? The ECB is a bank whose primary focus – witnessed in both its charter and its past actions – is price stability. Despite poor economic performance in recent months, the ECB essentially has to raise rates this week, as the Euro-Zone’s current inflation level is double the target of 2%. While President Trichet and his peers may pray that a single, small hike will be enough to curb rising inflation, the more likely scenario is that the policy move will not have a huge effect. So, the question remains: what’s next?

What’s next is a big decision. The age old debate (or as old as central banks have existed) between pursuing policies that facilitate growth or inflation is front and center in many prominent economies around the globe, and Europe is no exception. Rising energy costs have not helped the problem, leading some analysts to publically worry about stagflation rearing its ugly head. In a perfect world, high growth rates allow central banks to raise rates in the never-ending war on inflation (e.g. Australia). However, growth is unquestionably slowing all throughout Europe, and many fear that a rate hike could severely impact many of the smaller economies in the Euro-Zone.

In the long-run, Trichet (or whoever is in charge of the ECB in the future) has no choice; the ECB must focus on price stability first and foremost. However, in the next six months, what the ECB will do is anybody’s guess. One popular school of thought is that the ECB will employ a wait-and-see attitude; they will raise rates now and then observe the resulting economic data for a few months. Others feel that the ECB’s mandated focus on inflation will lead to a series of hikes, regardless of the costs. For many years, West Germany’s Bundesbank produced astounding economic prosperity, a result that many attributed to the Bank’s dedication to price stability. The ECB is a descendent of the Bundesbank, and so in my mind, I think that the ECB will not be done raising rates for the year after this week.

Of course, they could shock the world and not raise rates. You never know what will happen in the world of foreign exchange…

Upcoming Figures
AUD Reserve Bank of Australia Rate Decision
USD ISM Manufacturing (Jun)
USD ISM Prices Paid (Jun)

Whether you focus on fundamental or technical analysis when trading currency, you should have a healthy grasp of both.  Fundamentally the current account of the US is unsustainable and depreciation was expected.  After experiencing such a large depreciation over six years all traders should ask themselves, have we overshot?  When I say overshot I reference the Dornbusch model, which can be even more volatile if you believe in the J-curve.  Volatility is synonymous with the foreign exchange market, which is part of the allure.  The volatility enables range traders and technical traders an opportunity to profit.  As a trader you need to know that at times trends are overcompensated, and fundamentals are temporarily ignored. 

            In the short term it seems inevitable that the EURUSD will break 1.60, even though traders know this is an unsustainable level.  The EZ can not sustain such a high exchange rate without seriously damaging international competitiveness.  Why will the currency pair reach 1.60 if traders know it is unsustainable?  Answer because in the currency market we overcompensate, in terms of exchange rates.  Exchange rates adjust instantaneously while goods markets adjust slowly.  Prior to investing in the EURUSD you should think whether or not this exchange rate reflects fundamentals or sentiment.  In the case of the EURUSD the moment it hits 1.60 look for individuals taking profit and the pair moving back toward 1.50.  The ball is in Bernenke’s court because he has the power to dictate the sentiment regarding the pair.  The ECB will raise, who knows what the Fed will do? 

The markets are closed, Wall-E is opening in theatres, and by now most people have at least a foot out the door for the weekend. After writing all week about the USD, the Fed, and about how I am a better forecaster of market movements than my colleague John, I have decided to do the second piece in the Random Country Report Series. Excluding Antarctica and its rather inactive central bank (please see below), the continent with the least amount of coverage in the world of foreign exchange is Africa. So today let’s examine a country known for its history, architecture, and lamb kabobs: Egypt.

Egypt has come a long way from the time of the pharos and the pyramids, being one of the first – and longest lasting – republics in the Muslim world. Its currency is the Egyptian Pound (EGP), which is currently trading at 5.35 EGP to 1 US Dollar and 8.4479 EGP to 1 GBP. Today the Central Bank of Egypt raised interest rates to 10.5%, and unlike many of the major banks around the world, promised to actively combat inflation. If necessary, the CBE promised to bring rates even higher in the future should price stability (inflation) continue to be a problem.

The US Federal Reserve, along with other prominent central banks, is confronting the problem of simultaneously rising costs and slowing growth. As a result, it left rates unchanged the other day. Fortunately for Egypt, however, growth has not been a problem. In fact, the Egyptian economy is expected to expand more in this year than in 2008. As a result, the CBE has what would be seen as a gift by many other central banks: the chance to fight inflation without worrying about growth.

There are, of course, some problems in the Egyptian economy. Inflation is right under 20%, yet this problem is at the forefront of the CBE’s conscience. Many Egyptians also live with a low standard of living – a problem that the government has not yet been able to fully remedy despite recent moves such as wage increases. Another area of worry is rising food costs, as Egypt is the worlds’ second leading wheat importer due to their inability to grow the crop in the bleak Sahara Desert. As commodity prices continue to rise, Egypt should become concerned about their need to import so much wheat.

Still, in all, the outlook seems solid for Egypt. The International Monetary Fund (IMF) has rated the country as being one of the top countries in the world undertaking economic reforms, as they have taken steps in the past decade to become more transparent and liberalized economically. Politically, despite having the largest population of any Muslim country, Egypt is a voice of moderation in an ever-volatile region. By avoiding political turmoil and pursuing sound monetary policy, Egypt has produced consistent growth, and should be seen as a model for nearby economies that also don’t have access to enormous natural oil resources.

Antarctica’s Central Bank’s most recent meeting:

Irrational exuberance was a term Greenspan used to demonstrate the speculative bubbles that occurred throughout the economy.  Robert Schiller used this phrase as the title to his very influential book Irrational Exuberance.  The term was invented by Greenspan while he addressed the AEI in Washington DC. 

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” 

                                                            -Alan Greenspan

The term addresses a fascinating discipline named behavioral economics.  Unfortunately it is a field in embryonic stages, and it is complicated interdisciplinary field that encompasses many schools of thought.  Economists and psychologists use models developed in this field to attempt to understand why irrational and rational decisions are made.  In Schiller’s work he examines why bubbles persist throughout markets.  His work focused on the stock market bubble that was the tech boom.  However his work can be applied to the housing bubble that is deflating as I write, more importantly can identify the recent commodity bubble.  Individuals will site supply and demand as the reason that oil is now at 140 dollars a barrel.  That is part of the equation yet such a large increase in price can be attributed to numerous factors.  One of the reasons for oil’s price is speculators, who are manifesting irrational exuberance.  Don’t expect any one to cry for them when the bubble pops.  Why does it happen, why are we continually drawn into irrational decisions in search of profits?  Want the answer read Schiller’s book, it will only help you as a trader.

On the other hand we seem to have a pattern of shifting bubbles.  Why do assets seem to leap from one bubble to the next in search of profits?  We started with the tech bubble then the housing bubble then the commodity bubble.  Where the next bubble will occur?  FX, perhaps.  Just look at the dollars decent over the past five years.  Could this be defined a bubble?  Absolutely the exchange rate is an asset price, so why not.  Bubbles are natural they occur, just try to be prudent and avoid them.  Accept that the Euro is at 1.60 and this level is unsustainable in the long run.  Understand however that in the short run irrational exuberance may overrule rationale prudence.   

Ever since the Medici started banking, the industry has been very simple, long term loans from short term liabilities.  This system is sound, it’s boring but it works and smart people make a lot of money doing it.  However big banks in 2004 began to feel a squeeze in Net Interest Margins, the cost of consumers borrowing went down and the cost of bank financing went up.  Banks decided to part from the boring model of loans, and pursue non interest income.  In other words bankers are great at being bankers but not at managing hedge funds.  Hence the billions of write downs that all the big banks have undergone.  

            Structured Investment Vehicles were the method of choice for non interest income.  SIV’s have become toxic to big banks balance sheets.  The big banks decided to branch out into a new revenue sources, and right now it’s punching them in the mouth.  This occurred because the yield curve was relatively flat in mid 2004 because inflation was so well contained.  The flat yield curve hurt the profit margins of big banks, while it did not affect small banks to the same extent.  As a consequence the small banks seem to have better balance sheets and the recent turmoil has affected the share price of small banks as well.  Perhaps a buying opportunity is a foot.  Small banks did not have a decrease in Net Interest Margins because they didn’t rely on overnight loans like the big banks.  CD’s and money market accounts tend to be a large part of small bank liabilities and they change mush slower than over night rates.   The NIM of the small banks was not squeezed, so they did not branch into non interest income.  All the while big banks had to succumb to a decrease in NIM, and pursued exotic forms of revenue.  Today the mom and pop bank on the corner seems to be much healthier than Citibank.  How to trade this phenomenon, understand that the Fed is terrified that of a big bank going bust.  Since over 25 percent of their income came from assets that are now virtually worthless, be skeptical of any Hawkish comments.  The question is not whether the Fed will raise rates but can they raise rates?

          The FOMC had its meeting today and they fulfilled expectations.  This is evidenced in the 100 pip move shortly following the decision.  The market then stabilized and has been flat ever since.  What does this reflect?  Indecision, it reflects the fact that traders feel the Fed is still ambiguous as to whether they will fight inflation or try to avoid recession.  Funny, that one of if not the most important market moving event, barely moved the market.  

            Bernanke is focused on averting recession.  He’s trying to save a sinking ship with a pail and it’s not working.  Long term yields have not moved and they are not decreasing in the near future.  The 325 basis point cut pumped a lot of liquidity into the banking system.  These emergency measures taken in August, did there job.  Bank runs were averted and Bear Sterns was the only calamity.  So far Banks have rushed to fortify their balance sheet by liquidity injections; UBS is now the United Bank of Singapore.  If banks are perceived to be safe then the Fed would have increased interest rates in order to fight inflation.  The fact of the matter is by not fighting inflation the Fed has signaled that the banks are not safe.  Another shot gun wedding between banks is out of the picture, augmenting the probability that a bank failure could occur.  All bank stocks have been crushed due to the uncertainty of the market.  No one knows how toxic or how exposed the big banks are to the Sub-prime crisis.  The market for Structures Investment Vehicles has dried up and banks are stuck with billions if not trillions of worthless assets.  This scares the Fed because bank runs exacerbated the pain of the Great Depression.  By the Fed not raising they forced me to sell every bank stock I own.  The inflationary pressures are not going away and the Fed will address the problem soon.  Hopefully the banks will miraculously strengthen their balance sheets.  However that outcome does not seem likely.  The near term is going to be very range bound evidencing the fact that no one knows the direction of the market or the depth of the crisis.

10:16 AM PST – I am writing right now about an hour before the US Federal Reserve announces what it will do regarding interest rates, along with a hopefully detailed forecast of what is to come. Some of my colleagues (cough… John… cough), have come to the conclusion that the Fed will shock the markets and raise rates. When considering if perhaps I should also predict that an upset is in the making, I think back to a boxing match a little over a year ago. In the days before the match between Floyd Mayweather Jr. and Oscar De La Hoya, the public actually began to favor De La Hoya, despite the fact that Mayweather was younger, faster, and quite simply, better. However, everyone loves an upset, and as a result, my next door neighbor took advantage of the incorrectly skewed betting odds. My neighbor made several thousand dollars that day, and because of that story, I’m ignoring the suddenly numerous voices who are now saying that the Fed will surprise the world.

10:33 AM PST – With about forty minutes to go, I just can’t believe that anything will happen… I still think that the Fed will hold rates while trying to deliver hawkish commentary at the same time. Advice of the day: bet on the event that’s more likely, not the event that you want to happen. As much as the Fed would love to raise rates right now (which would likely be the best thing for US inflation), virtually all of the economic data released in the past few weeks have one thing in common: disappointed results. I just can’t see how the Fed can justify chasing after inflation when the economy seems so weak.

11:31 AM PST – To quote Alec Baldwin in 30 Rock, “Oh happy day!” Sure, I’m currently happy mostly because of my bank account, but let me put that aside. The Fed did what it had to do, and something which Bernanke is not accustomed to – restraint. I applaud the Fed for abstaining from putting additional strain on the economy.

12:02 PM PST – The rally has definitely slowed, but it’s likely that it will pick up at a slower pace within the next hour or two.

2:16 PM PST – So now that the market has stabilized, we can asses the damage done to the USD. The EUR gained about 100 pips thus far today against the greenback, the GBP is up about 40 pips and the JPY up only 10 (don’t get me started on the yen). All in all, the effect of the announcement was short-lived, and didn’t provide as much of hit to the USD as might have been expected. This more muted effect is likely due to the majority of the market having correctly anticipated the Fed’s stance. In the upcoming weeks, we have similar announcements from the ECB and the BOE. Hopefully this will liven up the market and provide for interesting debate and speculation. So, looking back on today, we arrive back at the lesson I discussed several hours ago: If you’ve got a sure thing, stick with it until the end, as there will always be people who flip at the last moment. Don’t be one of them!

Upcoming Figures
USD Gross Domestic Product (Annualized) (Q1)
NZD Gross Domestic Product (Q1)
NZD Trade Balance (May)
JPY National Consumer Price Index (May)
JPY Household Spending (May)

As I have explained before, there are some days when there is little of note in the FOREX world, so I get the chance to research a random economy somewhere in the world. Today (and I’m sure tomorrow) is not such a day. Everyone’s favorite superpower, the United States of America, came out with important economic data today, and will have even more important data tomorrow. US Consumer Confidence was lower then expected, and the lowest it has been since 1992. While some analysts are often critical of the fickle nature of this statistic, it nevertheless measures an important aspect of the market: what consumers are thinking about the economy. Partially as a result of this data, but mostly because investors are really waiting for tomorrow’s events, the US Dollar did little today.

A day after bad news came out of Europe’s largest economy, the second largest released better then expected data. Yesterday Germany announced that a measure of business confidence was lower than expected, but today Consumer Spending results in France surprised many by showing solid results. The Euro, like the USD, moved little today relative to the other major currencies. It is very likely that the news coming out of the US tomorrow (see below) will send currency pairs flying even if the USD is not in the pair. If the announcements fall into line as expected, the EUR should enjoy a good day as investors move away from the USD.

If you have an opinion about what the FOMC will say, tonight is a great time to get in before the market moves tomorrow. If you are unsure, I encourage you to try to find out what has been announced as soon as you can, and then look to jump on board if the market seems to be moving. Good luck!

Upcoming Figures
EUR German Consumer Price Index (Jun)
EUR Italian Retail Sales (Apr)
USD Durable Goods Orders (May)
USD New Home Sales (May)
USD Federal Open Market Committee Decision @ 2:15PM EST
NZD Current Account Balance (Q1)
NZD Current Account Deficit – Gross Domestic Product Ratio (Q1)

    Prior to Wednesday’s meeting the Fed has little room to wiggle.  The inflation readings of CPI and PPI are extremely high, while other economic indicators are signaling recession.  Let us overview the news that evidences a recession bound economy.  The Richmond manufacturing index is down a lot, home price index is down, and consumer confidence is down.  There is no light at the end of the tunnel and the Fed is backed into a corner.  Two weeks ago on June 9 Bernanke said, “The risk that the economy has entered a substantial downturn appears to have … diminished over the past month or so.”  Does this signal that the FOMC will raise rates; not likely.  I analyzed this question in a prior post, the Fed will take a prudent course and talk hawkish while hoping inflationary pressures subside.  The fact that the economy is tipping into a recession juxtaposed with high inflation puts the Fed in a precarious position.

    Why is the economy tipping into recession?  Well the above listed reasons, unemployment at 5.5 percent, and stagnant growth among numerous sectors.  How does the Fed fight inflation?  Hike interest rates, and how does the Fed fight recession?  They lower interest rates.  Do you see the conundrum?  With the above statement the Fed is perceived as changing their concerns from growth to inflation.  To reiterate my last post the Fed will do nothing and talk tough, which is expected.  The indecision that has plagued the market for two weeks will persist, unless the Fed makes a commitment.  If they do then the dollar will rally, if not look for steep losses.  If the Fed even acknowledges growth as a concern then the dollar will slide.  This market is based on expectations and sentiment, and right now Fed is an enigma.  Clarity of the issue is needed and the Fed better step up to the plate and clarify their position.  The market will eventually decide for them if they remain ambiguous.  The indecision could last until June 7^th when Trichet & Co. and the BOE meet.  There actions could shed light on the situation which will result in traders taking a position.  For dollar bulls it could be a long week if the Fed remains neutral. 

    Poor FOMC because of today’s numbers, the trough of the housing bubble is far from reached, and a depreciated currency hasn’t lead to increased manufacturing, and consumer confidence has fallen again.  Best of luck trading the most watched event in Forex if you’re like me you’ll be glued to the television tomorrow at 14:15 EST, trying to gauge Bernanke’s thoughts.  He might be thinking, “Darn I miss my cushy position at Princeton.”

My assignment for the day: write 200 times “Next time I will not get too excited when I write about India’s short term economic situation.” For those who have been following India in the past few days, the developments seem anything but the rosy picture I painted last time around. Sure, in the long run, India is still poised to have solid and sustainable growth. However, their current battle with inflation may be more than just a bump in the road.

The rupee has been slammed in the past few days, as many see the Reserve Bank of India (RBI) having made insufficient actions, and being too slow to respond. The rupee’s fall is testament to the economy needing more rate hikes in order to limit its rapidly rising inflation. Limiting inflation is seen as being one of the keys to fixing the myriad of problems in India’s economy: a rising budget deficit, a current account deficit, a weak rupee, rising import costs (including energy), and diminishing spending power. However, concerns exist for the RBI (similar to the worries of the U.S. Federal Reserve) when considering rate hikes: the role of energy costs and the related adverse effects of rates that are too high.

So, let me revise my earlier statements. In order to correct the problems that their country is facing, the RBI should (and most likely will) continue to raise rates. As they are very dependent on oil imports, it would be a very worthwhile long-term goal to try to utilize alternative energy sources. As the country is still becoming industrialized, by pursuing these alternative energy methods while the country is still growing, the new energy sectors could grow along with the country. Finally, most analysts are saying that India is not in the same position as it was in 1991, when it suffered another economic downturn (and rupee devaluation). In other words, though the Indian economy may suffer a downturn or even a recession, India is still well situated – as long as they utilize smarter monetary policy – to stabilize and expand in the future.