Posts from — June 2008

The FOMC meets on Wednesday and most analysts are predicting nothing, in other words they don’t have a clue as to what Bernanke and Co will do. Most are playing the waters safe and saying that the Fed will hold and analyze whether supply side pressures have increased inflationary expectations. In English they want to know whether high oil and food prices have spilled over into consumer goods. Since oils increase companies have become very efficient and been able to absorb the cost increases. The cost cutting efforts have reached a limit and more capital accumulation, job cuts, or just in time manufacturing won’t improve the profit margin. The only recourse is to pass input price increases onto consumers. What does the Fed do, they raise interest rates in order to curb inflationary expectations. Now the longer the Fed waits the more prolonged the resulting recession will be. The last supply side shock resulted in three years of 10-15 percent interest rates. If the FOMC doesn’t get on the ball then the long run affects could be disastrous.

When constructing policy the Fed may use the Taylor rule. It has guided policy makers for the past two decades and is credited with keeping inflation in check. Now with inflation being the first subject of any Central Bankers speech we may be playing a game of chicken. In this arena game theorists abound and if you use game theory 101 a rationale decision maker would expect the Fed to talk hard and secretly hope for prices to fall by divine intervention. The likely hood of this happening is very low; sooner or later an interest rate hike will occur. Raising interest rates is the only solution to inflation. The increase of the Fed funds rates can influences long term rates and as a consequence investment decisions. Businesses borrow at long term rates and the difference between the Fed funds rate and the long term rate reflects the credibility of the Fed. For these reasons investors, psychologists, and random economists take time to analyze the speech that follows the FOMC meetings. If the sentence begins with inflationary pressures the dollar will rally because the FOMC is viewed as Hawkish. If Bernanke addresses the affects of the credit crunch on the economy look for the dollar to tank, because the FOMC is perceived to be Dovish.

Denial is one of those psychological blocks that can ruin a trader, like changing a stop because the trend will reverse. A cardinal rule of traders is don’t do it. This applies to Central bankers as well. Divine intervention will not occur; the Fed should stop hoping and step to the plate and increase interest rates. Yes the decision will make the Dow and the Nasdaq lose 2 percent in one day. However this is the consequence of our twenty year economic boom. A correction is needed and the Fed will be seen as the catalyst when any game theorist could have predicted the outcome. Either this meeting or the next the Fed will raise rates. In my opinion the sooner the better because procrastination makes the hangover last a lot longer.

In some weeks, the news highlight in the FOREX world is an Italian report on car sales. Other weeks, the major headline is that Nigerian workers are striking against the oil companies. However, this week, there’s plenty to be excited about, especially the most important gathering since the meeting of the Five Families: the U.S. Federal Reserve Open Market Committee Meeting.

Ladies and Gentlemen, start your engines.

Ok, perhaps this is not quite as important as Don Corleone and Co., but in the FOREX world, there are few planned events that can have as much impact as this one. Ever since Fed Chairman Bernanke announced an end to rate cuts a few weeks ago, anyone and everyone has circled this week on the calendar. Most analysts, traders, and “people in the know” are not anticipating a rate change, which would be the first time that FOMC has met and not done so in some time. However, despite a general sense of confidence that rates will be held constant, everyone connected to the market will be reading between the lines to try and get a glimpse of the Fed’s future moves.

With energy costs going nowhere but up, it has been argued that the Fed’s main concern might be that issue instead of their stated focus: inflation. Should the meeting’s outcome go as forecasted (no rate change), that would be a signal that inflation is not the only problem that the Fed is attempting to solve. If inflation is rearing its ugly head, the standard call out of the Central Bank’s Playbook has been to raise rates. However, there is a general worry that such a hike would only aid energy prices in their climb. As a result, most are predicting that the Fed will stand pat for now.

Though not this week, the ECB will be meeting soon, and will face a tough decision of their own. While the Fed only said that they are done cutting rates, the ECB has stated that they plan on raising rates. The problem with President Trichet’s plan, however, is that the economic data reported since that announcement has indicated that a rate cut might not be the smart move. Growth in the Euro-zone is slowing, and unless Trichet wants to play chicken with the economy and see who backs down first, a rate cut is being seen as less and less likely. However, Trichet is considered one of the most hawkish heads of a central bank in the world, so anything is possible.

Oil is what is driving the currency market; because of its rise commodity currencies such as the dollar have been pummeled. The dollars small appreciation yesterday was attributed to the PRC raising gas prices 18%. Now that traders slept on the news they have began to think simple supply demand analysis the situation has changed. Sinopec and other Chinese oil companies are forced to sell gasoline at a loss. The current increase will give the companies an incentive to produce more gasoline. Whether you like it or not demand from China will continue unabated in the near future. Not price increases or oil’s rise will even dent the rise of the Chinese consumer. China may go from the world’s manufacturer to the world’s consumer. It is expected they contain 20% of the Earth’s human population, only natural that they should spend at least equal to 300 million Americans. Has oil hit its peak NO, has the dollar reversed its slide, NO.

As a currency trader this information should net you profits, because when you saw the dollars short appreciation you hopefully went long on EURUSD. If not there’s still time it’s still below 1.58 resistance and might break through next time it tests those waters. The slow down in America has not reined in the unthinkable $140 a barrel price. Don’t expect it to either because America is already very oil efficient as a ratio to GDP. On the other hand those Mao era monstrosities in the Tianjin province burn ridiculous amounts of oil per ton of steel produced. Do the Chinese care, not really they still have over 300 million people living on a dollar a day. China needs jobs, jobs, and more jobs they care little in regards to the price of commodities. In short the recent gas price increase will free state run companies to produce more at a smaller loss perhaps even a profit. So Oil at $150 definitely a possibly even if the Fed funds rate hits 5%. The demand for Oil has another facet the Chinese consumer.

On June 28, 1914, Gavrilo Princip assassinated the heir to the Austro-Hungarian throne, leading to the onset of the Great War. Indirectly, Princip’s actions led not only to WWI, but also to WWII and as the Cold War. In other words, Princip inadvertently became one of the most important figures of the 20th century.

Fast forward to today, June 19, 2008, when two former hedge fund managers for Bear Stearns were arrested in New York on charges of securities fraud and conspiracy. These men allegedly mislead investors regarding the outlook for their funds, claiming that the funds presented excellent opportunities for investors despite poor actual results. It is doubtful, however, that these former managers truly believed their optimistic talk; one manager added no new deposits of his own to the account, and the other actually withdrew $2 million from his fund. Beyond the details of the case, however, is the more important point: these men are being arrested for having played a part in the onset of the current credit crunch.

What’s not as important here (for this article) is their guilt or innocence, but what is significant is the theme. Unlike Princip, these managers’ actions are highly unlikely to lead to any war or a worldwide struggle between communism and capitalism. Similarly to Princip, however, the managers’ actions (allegedly) helped lead to a worldwide problem far beyond what they could have foreseen. As their actions show, they were concerned with two localized thoughts: guarding their personal assets and protecting their companies’ stability. The collapse of these large hedge funds helped facilitate the demise of Bear Stearns, which had been the fifth largest financial services company in the United States.

The fall of Bear Stearns is one story involved in the worldwide credit crunch, which has influenced economies all around the globe. As the trials for these men go forward, it is important to remember that we must think about all of the potential consequences of our actions. Their dishonesty and deceitfulness helped lead, in some small way, to worse economic conditions internationally. Now, the judicial system will decide if the roll they played was significant enough to merit punishment.

Upcoming Figures
EUR Italian Trade Balance Non-EU (Euros)
CAD Retail Sales (Apr)
CAD Retail Sales Less Autos (Apr)

            Lately there has been a lot of chest pounding and brow beating regarding China’s emergence on the World stage.  There economy is booming at a 12% clip that is unsustainable and they have become the manufacturing center of the world.  Now the Politburo knows this, they were educated at America’s top Universities, and they are taking action to fight inflation.  For years the PRC has artificially depressed the Yuan in order increase exports.  Now this has hurt because to do so and maintain the peg they have sterilized open market operations which has cost the PRC dearly.  In order to maintain the peg China buys Treasury bonds which give a 4% return.  They must sell domestic bonds at 12%, (that is sterilization) do you see the black hole forming. 

            Apart from this disastrous policy we owe the PRC a debt of gratitude.  Now I know the rise in oil has a lot to due from gargantuan demand from the Chinese.  Today the command economy announced an 18% increase on gas prices.  Hopefully this will curb demand for gas and therefore its input oil.  The reaction has been a $3 drop in the price of oil at the NYMEX.  This is not the pop of the commodity bubble that has formed but it is good news in a sea of chaos.  If this decision can put a dent in the inflated price of oil, then traders and businesses around will cheer.  It is one of the few times I have applauded the Politburo of the PRC, but desperate times call for desperate measures.  So if your wondering why the Forex market is flat today or why the dollar is making a small come back thank President Hu and the rest of the Politburo for there inflation fighting gasoline hike.

Some days, I know exactly what I’m going to write about. On days that I don’t, I usually peruse through the news, trying to find something that piques my interest. Today’s top headlines in the currency sector centering on the US Dollar not doing anything as there’s little to trade on… thanks for the help world. So, I have decided that on days such as this, a day with little of note on the economic calendar, I would focus on a country (and its currency) that rarely gets much discussion in the world of FOREX. Today, that country is India.

For those of you who were unaware, the currency in India is called the rupee. Should you be traveling to India soon, it would be in your best interest to know that the USD is currently worth about 43 rupees. The country is dealing with high inflation, rising energy costs (who isn’t?), and a weakened rupee. As a response to all three, the Reserve Bank of India recently increased its benchmark repurchase rate and raised interest rates. As a result of this responsible policy move, many analysts now expect the rupee to strengthen against the USD to around 41:1 by the end of the year.

Like many other countries around the world, India has suffered from crude oil prices. As they import about 70% of their oil, their rupee has suffered in kind. Still, not all is bad, as India has produced very impressive growth over the past decade. While that growth is crucial to India’s long term development, the Reserve Bank of India has sent a message that it is willing to sacrifice some of that growth today for improved economic indicators tomorrow. Unlike its neighbor, China, whose policies have led to – and sustained – very high inflation, India has decided to confront the problem.

As for the long term, most analysts remain optimistic. With its enormous population, the economic potential for India is still very strong. The country does sustain a sizeable current account deficit, but much of this could likely be attributed to energy costs. Personally, I applaud India’s commitment to keeping its inflation and rupee at acceptable levels. Instead of just continuing to focus on growth regardless of the long term consequences (ex. China), India is positioning itself to experience excellent growth for a long time by fixing its economic problems now.

Upcoming Figures
CHF Trade Balance (May)
CHF Swiss National Bank Rate Decision
GBP Retail Sales (May)
CAD Consumer Price Index (May)
USD Phildelphia Fed Business Survey (Jun)

The European Monetary Union is by no doubt the largest and most radical economic experiment that has ever taken place. How the Europeans established the political cooperation necessary to incorporate a Monetary Union is a mystery. The Euro Zone never came close to Mundell’s optimal currency area and Economist’s on both side of the pond have been predicting its demise. After ten years the critics are silenced but the question as to whether intra European trade has increased still remains. Theoretically it should increase in order to decrease variance and hedge against risks. However home bias in Europe is a political reality, Endesa and Alitalia are good examples. Has Euro become an optimal currency zone, and if so has intra European trade will increased? Europe has distinct differences, for a highlight ask someone from France about Italy’s victory in 2006. To argue for an increase in intra European trade know that all these countries indeed specialize. Swiss chocolates produced in Sweden don’t taste the same, nor does a Ferrari assembled in England look so magnificent. By specializing in what Europeans do best this should increase intra European trade which is true and can been examined. Definitely something to keep in mind when analyzing the Euro’s amazing appreciation and a persuasive explanation for European GDP growth.
As a trader I look at the GDP of the Euro Zone and see that growth is substantial. The hypothesis I have formed is just that a hypothesis but with a little bit of internet fishing you can confirm my suspicions. Better yet you can surmise that the Euro’s inception has cushioned Europe from the global slowdown. The European’s have increased trade with each other. With intra European trade far below intra U.S. state trade levels you can safely assume a further increase in intra European trade. Which increase the Euro Zone’s prospects for growth and makes Trichet’s rate decision a little more palpable for the French palate. An increase in interest rates when the Economy is not contracting is easy; it’s stagflation that’s the problem. With a little homework you can prove whether or not the intra European trade has ticked up and supported the Euro Zone’s growth. You will have an insight based on empirical evidence not some hunch based on a doji or two. My suspicion tells me that you’ll buy the Euro after finding that intra European trade has increased. You’ll conclude that this type of trade will become the engine of European growth for the coming years. As a consequence the EURUSD has only one direction to take.

Last month was an economic roller coaster and the market see sawed on the news. Anyone who thought the dollar would appreciate 300 pips is a liar, but it did and the move shocked us all. While most traders where glued to the Fed and the ECB podcasts, I was analyzing the economic calendar. The BOJ confirmed my expectation with and a specific number that received little fanfare. The BOJ bought 404 billion worth of foreign bonds compared with 85.9 billion the previous month. So those tricky little guys are intervening in the foreign exchange market again. Why? We all know Japan is an export lead economy and when the Yen appreciates the big boys at Fujitsu, Toyota, and Mitsubishi start calling Governor Shirakawa complaining about profit margins and loss of market share. All those funny business terms that, crafty MBA types use to describe losing money.
Governor Shirakawa will forget those lessons he learned at the University of Chicago on letting the market decide comparative advantage. He starts depressing the Yen, by buying U.S. Treasuries, which truth be told he’s buying a time bomb to placate big business. Why because the opportunity cost of holding Uncle Sam Treasury bonds can be very high in such a volatile market. He could potentially lose billions when the dollar devalues. Another problem comes when the BOJ in a sense subsidizes the export industry they run the risk of over allocation within that particular sector of the economy. Coincidentally Japan has no need to build a War chest to defend its currency, like China or the Asian tigers. Intervention is a dirty game that Shirakawa should avoid, but we in the fx market know he will not. Look for more intervention and watch the dollar climb against the Yen. This dollar rally will not be supported by fundamentals, current account readjustments, or a rogue Fed governor. No it will be brought about by the BOJ, so buy the dollar and send a thank you card to Shirakawa & co.

The world loves the idea of a superhero. The thought of a superhuman force that comes in and saves the day is a concept that has been around as far back as ancient Greece. The tales of superheroes have come a long way since Hercules, with today’s most notable ones being green, wearing iron suits, or having a thing for spider webs and Kirsten Dunst. However, in the real world, the world is still waiting for something incredible to happen about rising energy costs… and the wait continues.

The G-8 had an excellent opportunity to push the US dollar higher (and perhaps crude oil prices lower) last week, and what did they do? Not a thing. Instead of addressing what my colleague John labeled “the 800 lb. gorilla,” they focused on inflation. The problem that I see here is that the world has witnessed and dealt with rising inflation before. A $150 barrel of oil is a new concept, and the G8 sidestepped the issue that is the driving force behind global inflation.

So, if they G8 won’t swoop in and save the world, who is next up at the plate? The central banks would likely be the next candidates to become superheroes, but they cannot solve this problem on their own. While they can influence exchange rates, most are restricted in that they can only change monetary policy. Chairman Bernanke, for example, has been previously unwilling to even comment about Bush’s tax cuts. It seems unreasonable to expect that he would come out and advocate his opinions about what others must do to deflate energy costs.

Other possible players are the oil-producing nations, who to their credit, have stepped up to the plate in the past few days. Saudi Arabia announced that it will be increasing daily output, and the OPEC nations will be meeting this weekend about their admittedly overpriced oil. Still, it is unreasonable to expect these countries to solve the problem on their own. In the long run, their focus is on their own interests, not the chance for each American man, woman, and child to have an SUV fueled by cheap gas.

One more option is the oil companies… no just kidding.

So, the wait for that superhero continues. The demand is there; the everyday person in the industrialized parts of the world has demonstrated that they are going to keep refueling. The question is who will be the first to say, “I’ll sacrifice some of my wellbeing to help the entire world”?

We’re still waiting.

Upcoming Figures

JPY Leading Economic Index (Apr)

GBP Bank of England Minutes (Jun 18)

CHF ZEW Survey (Expectations) (Jun)

CAD Leading Indicators (May)

The currency market has a lull in astounding economic news, so today we will address the 800 pound Gorilla everyone tries to forget. $140 a barrel oil is unprecedented and well above the inflation adjusted price of $101.70 in the 70’s. Here is where the conspiracy theories start, the Rockefeller’s have a depot under there house, maybe the Kennedy’s, no no it’s really the Bushes who created a reservoir under the White House. Probably not so, why is oil rising? There is really no one aspect rather a slew jumbled together that give no relief at the pump. The fall of the dollar has a strong correlation with the rise in the price of oil, simply because it’s a dollar denominated commodity. OPEC is the cartel we all love to hate, because they restrict production to augment the price. With control of over two thirds of the proven reserves in the world they are a force to be reckoned with. Oil nationalization, countries with little or no engineering experience does not allow the seven sisters to come drill in their backyard. Kindergarten politics that has lead eastern bloc countries to stagnated oil production, not to mention Latin America, and the Middle East. Engineers are a plenty in the West but not to valuable if there is nowhere new to drill. The ever so popular demand argument from China and India has some credence yet it is definitely over played. These two countries are about as efficient as Afghan steel mill, so for every 1% increase in GDP oil consumption ticks up by a ridiculous amount. Subsides in developing countries have lead over consumption; it is not a coincidence that the oil boom in Venezuela has been accompanied by a large increase in the sale of Hummer’s in Caracas. Finally refinery bottle necks, the Saudi’s could open up the spigot as much as they want it doesn’t change the fact that a refinery hasn’t been built in America for decades. A barrel of oil isn’t aesthetically pleasing, and it’s pretty useless unless some Texan refines the thing.
Let’s face the music oil is going to be very sticky at the current price. OPEC loves the profit margins, and if the price retreats so will the amount supplied. Oil nationalization is definitely in vogue and the swagger of Russia highlights the liquid courage these nations are drinking. Fact of the matter is these countries all suffer from the Dutch disease and once the price of oil falls so does the Russian economy. As for demand from India and China they can’t wait to play baseball, drink Johnny Walker, and burn oil like those funny Americans. China has officially retired the bicycle and has converted to the gas guzzler. As for subsides they are not going anywhere because politicians are in politics for themselves not the good of world. Now how can you make money, know this Canada exports more oil to America than any other country. Norway is another stable oil producer that will likely see some appreciation in the future as oil prices increase. As for any OPEC country forget about investing in there currency because I’ve seen mud that is more transparent than Venezuela’s monetary authority. The Gulf States that peg to the dollar are only going to experience more inflation as the U.S. continues expansionary monetary policy. In the meantime expect a negative correlation between the dollar and the price of oil. This correlation could be used as a hedge, ie buy oil and the dollar in order to decrease your investment variance. What ever you choose to do know oil is going nowhere but up, so get used to it.