Posts from — July 2008

Tomorrow is the one for all the marbles. The single most important economic announcement for the USD takes place tomorrow: Non-Farm Payrolls (NFPs). Despite today’s very important announcement of US GDP for Q2, the EUR/USD essentially stood pat around 1.56. What is special about NFPs is that, unlike announcements such as rate decisions or GDP results, predicting the outcome is often like finding a needle in a haystack. The unpredictability of this announcement, coupled with its importance, generally make it the largest “market-moving” announcement for the USD.

Given the hazy future of both the USD and the US economy, tomorrow’s results take on added importance. Good results could potentially enable the Federal Reserve to make market movements in the coming months. If, however, the news mirrors the tone of today’s disappointing results, then the Fed is likely to be stuck for the near future. The last time NFPs were announced, Bernanke pushed the results aside, as employment was not his paramount concern. However, should the numbers approach dangerously high levels, actions will likely need to be taken to curb rising unemployment.

The current expectations are around 75,000 new lost jobs. Should that number turn up around 100,000, there could be a rapid reaction by the government. If unemployment starts creeping towards 6% and beyond, we could witness a further crunch in the credit market, as the unemployed usually have more difficulties in repaying their debts. That problem would reverberate through the financial sector, weakening an already fragile industry. And as Bernanke has declared that the strength of that sector is his top priority, it would be in his best interests to do what he can to combat rising unemployment numbers in the coming months.

Upcoming Figures
USD Total Vehicle Sales (Jul)
JPY Vehicle Sales (Jul)
AUD RBA Commodity Index SDR (JUL)
EUR French Purchasing Manager Index Manufacturing (Jul)
USD Change in Nonfarm Payrolls (Jul)
USD Unemployment Rate (Jul)
USD ISM Manufacturing (Jul)
EUR Italian Budget Balance (Jul)

           Guns are dangerous so are pools, but which one is more dangerous?  Steve Levitt a Professor from the University of Chicago analyzed this question through economic analysis.  His results overwhelmingly supported the conclusion that pools killed 1000 times more children; yet pool control laws are not on the agenda for Congress.  In short expectations are every thing in terms of risk.  A gun is perceived to be dangerous and many are terrified by their existence.  Pools are more dangerous but no one runs for cover from a pool.  Rationale decisions are a major part of risk analysis apart from justifying banker’s salaries; it leads investors to prudent investments.  In order to judge whether the risk premium associated with an investment is worth the reward; models are employed.  The list of models is endless some of the simple familiar models are CAPM, MAR, VAR.  Almost all the models are constructed from data that uses correlations to construct portfolios with low variance returns.  Recently these models have failed to measure risk and the financial sector is suffering because of this failure.

Risk applied to the currency market can justify the Euro’s appreciation.  Central banks have decreased their exposure to the dollar by diversifying to the Euro and other major currencies.  This is theoretically in their best interest because by reducing their exposure to the dollar they are lowering the variance of their portfolio.  However by reducing their exposure they have flooded the market with dollars, thus a depreciation of the dollar has been occurring for the past seven years.  The question remains when will the diversification stop, and whether countries will start buying the dollar again.  We are no where close to the monthly simple moving average of the EURUSD, which suggests that we have a long way to go until equilibrium is reached.  I am not suggesting that a reversal is afoot, however I am hinting that the depreciation of the dollar has reached a peak, and the resistance at 1.60 may not been broken in the near term.  The risk of an undervalued dollar is beginning to outweigh the risk associated with dollar heavy portfolio.  Inflation has risen to alarming rates and the correlation between a 33 percent depreciation of the dollar and the rise in commodities is evident.  By acknowledging that risk influences Central Bank decisions a trader stands to gain.  The market for the EURUSD is range bound until it crosses 1.53, if it does then sell and hold on for the ride.

    “Human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve” 

                                                                                    -Alan Greenspan

           All major markets plunged on Monday, because of renewed fears of the credit crunch.  The Nikkei actually rose until the tsunami went across the world and crashed on the Nikkei on Tuesday morning.  Merrill Lynch just wrote off another 5 billion in mortgage related assets, which sparked fears that more are to come.  Expectations within all stock markets are shaky.  Investors see a global slowdown approaching juxtaposed with the fastest increase in prices in twenty years, which equals stagflation.  Currency markets reflect the uncertainty in the market place because they have been range bound for the last four months.  The only currency that is not range bound in the AUD which is still appreciating against all major currencies.  However Australia’s growth is correlated with the rise of Chinese GDP.  Australia is a commodity rich country that has provided the raw materials for China’s economic boom.  Iron ore mined in Australia costs 1/3 less than ore produced in Brazil, mainly due to transportation costs.  This has provided Australian mining companies with record profits, and an unemployment rate that is below natural unemployment. 

Once China slows down, which is not a certainty but highly correlated with the health of the U.S. consumer then Australia will slow down.  However due to the fact that most Chinese goods are inelastic trinkets the relation may not be as strong as expected.  The country that will lose the most in regards to a global slow down is Japan, because articles manufactured in Japan are elastic.  China produces GI Joes and Barbie’s which believe it or not are very inelastic.  They are inelastic because the purchase represents a small percentage of consumer spending, thus consumers don’t change their spending patterns dramatically.  Exporters such as Canon, Toyota, and Sony stand to lose the most because these big ticket items are not consumed when a recession hits.  The prediction of China’s demise does not apply unless a correlation is found between US consumer spending and Chinese exports. 

The Politburo wrote in the five year plan that they wish to augment domestic consumer spending.  This could be accomplished by allowing the Yuan to appreciate because the Chinese could afford international goods not found in China.  However this solution is highly unlikely because the PRC focuses on export lead growth.  The other option is to single handedly prop up the USD.  In order to do this the PRC must buy more US bonds, which would strengthen the dollar, but puts the Chinese in a bad situation.  The risk premium associated with U.S. bonds has risen, the U.S. will not default but the value of the dollar may be outside of China’s power.  If the dollar depreciates then the PRC stands to lose billions, from there 1.8 trillion dollar position in dollars.  Expect this to happen because it is a tricky way of augmenting exports.  It is not the prudent path but the PRC is known for the Great Leap forward and the Cultural Revolution.  By augmenting their dollar positions they are helping exporters at the expense of Chinese tax payers.  In short the global tsunami will first fall on Japan then on the Chinese tax payer.

One of the popular predictions of the past few years has been to declare China as the next world superpower. The most populated country in the world has experienced tremendous growth for some time, and given their size, growth, and stability, many view China as the United States’ next competitor for worldwide dominance. While I am not speculating as to China’s social or political future, I strongly believe that their growth-oriented policies will eventually – and inevitably – bring about economic consequences.

As children we all learned the saying “don’t put all your eggs in one basket.” By pursuing policies aimed at maintaining their meteoric growth, China has consistently cast inflation aside. With rates currently hovering around 8%, China will eventually have to work harder to contain this figure. Their growth of over 10% per quarter has been able to overshadow most other economic problems. However, in response to those numbers I’ll put forth another saying from childhood, “nothing lasts forever.”

China’s astronomical growth will slow, with some – including myself – believing that this slowdown will take place after the Olympics this summer. At that time, the following question will take center stage: will the Chinese economy be able to grow rapidly enough to make up for high inflation, an appreciating Yuan, and a swiftly rising standard of living? I predict no, and hence foresee and economic slowdown occurring in China by the onset of 2009.

Upcoming Figures
EUR German Consumer Price Index (Jul)
EUR German IFO Business Climate Survey by Industry (Jul)
USD Consumer Confidence (Jul)

With mixed news coming out of the world’s remaining superpower in recent weeks, the recent US dollar rally induced widespread befuddlement. With Europe suddenly looking economically worse-off than America, it is easy to understand why the USD has rallied against the EUR. However, the USD has rallied against many of the major currencies, including the JPY and the CHF. In other words, it is not only bad news coming out of the Euro-Zone that is fueling this USD rally. So, the important question is what exactly is causing this rally?

One obvious corollary is oil prices. Having fallen about $20 (or about 15%) in the past week or so, relaxed oil tensions have allowed the USD to achieve solid gains. However, the Forex market is rarely so simple in its explanations of cause and effect, so it would be unwise to solely attribute this USD rally to oil prices. However, the main theory that I am proposing is related very closely to oil prices, whose unprecedented levels are causing rising inflation all throughout the globe.

The hidden culprit, I believe, is foreign government entities. As the bulk of the commodity world – including oil – is priced in US dollars, the weakened state of the USD has been a primary component of the widespread inflation. The issue of permanently lowering oil costs (or oil demand) has not dissipated by any stretch. In lieu of a radical shift in the energy industry, however, is a simpler, temporary solution: a stronger USD. As countries have come to witness the terrible effects that the oil situation is wreaking on their economies, I believe that they are beginning to act in a manner to try to build up the USD.

It is unclear if the past few days are indication of any real changes or if they are just testament to the EURUSD being in a range-bound market. However, if the USD continues to rally and oil continues to fall, then perhaps we could be witnessing a long-overdue correction. Should that occur, inflation concerns could begin to lessen, and then central banks might be able to focus more on fixing other problems. As always, only time will tell.

Upcoming Figures
EUR German IFO Current Assessment (Jul)
EUR Euro-Zone Current Account (May)
GBP Retail Sales (Jun)
JPY Consumer Price Index (Jul)

          Congress is proposing legislation to restrict speculation on the oil market.  Is this beneficial to the American consumer, will it decrease the price of oil?  No, a recent paper written by Phil Abbott and Economics Professor from Purdue discusses in detail that speculation has not contributed to the recent surge in oil prices.  The paper underlines the correlation between the weakness of the dollar and the price of commodities.  Commodities are valued in dollars and a depreciation of the dollar makes commodities more affordable on the international market, thus increasing the demand for commodities.  Increased global consumption has increased the price of all commodities pork bellies and wheat included.  In short the decreased value of the dollar has contributed toward global inflation because it has fostered excess growth which has increased the price of commodities. 

            Over the past week oil has decreased by 15 percent, I doubt that Congress will blame speculators for shorting oil and forcing the price of oil down.  The dollar has consequently appreciated across the board.  The correlation between the price of oil and the strength of the dollar is undeniable, which gives the Fed another reason to raise rates.  By raising rates the Fed could actually help the economy, because the price of oil would fall dramatically.  The Fed’s current Dovish bias has done as much as supply and demand to raise the price of oil.  If the Fed could decrease both the price of oil and inflation, what is stopping them from raising rates?  Equities, unemployment, and the health of the financial sector are the only justifications for not raising rates.  The stock market seems to have stabilized and financial stocks have appreciated 30% across the board.  Banks are still fragile even though the FDIC claimed that Indy Mac would be the largest fatality of the credit crunch.  The question now becomes whether baby sitting banks is worth the weak dollar.  In the short run yes, but in the long run the Fed needs to take a more Hawkish tone towards inflation.  Will the Fed raise I doubt it, but the benefits could soon outweigh the risks.

The growth recession that is taking place has affected millions of Americans.  It was brought about by high commodity prices and the credit crunch.  Should the Government intervene?  Sometimes they should, but their intervention should be prudent and they should not waste borrowed money for political gain.  The fiscal stimulus that occurred seemed nice but at what cost, it was a three month shot in the arm that Americans will have to pay back in the future.  Now another round of stimulus is being planned and what will the Government do?  The Congress should not pan handle to voters, which is what politicians do, but it is not beneficial to the people.  If a stimulus should pass then it should be in the form of infrastructure spending.  This would put people to work and increase productivity.  However in doing so, the government borrows money from the private sector and corporations find it hard to find capital.  This is known as crowding out, which raises the interest rate.  This would be beneficial because it would slow down inflation.  Spending on infrastructure would not be reflected on Wal-Mart’s balance sheet, it would increase the productivity of the American worker, and decrease unemployment.

            It is estimated that traffic alone costs the American economy 25 billion in lost productivity.  Los Angeles was designed for 2 million people and the over crowding has forced Angelites to lose 3 hours of their day on the road.  This is disastrous to business and could easily be addressed by a 21^st century infrastructure plan.  I will not propose a solution, I’m not an engineer.  However as an economist I need to point out that productivity is being lost by out dated infrastructure.  This is an election year and the economy is in the doldrums, so another stimulus in imminent.  The responsible thing for Congress to do would be to increase government spending for infrastructure not stimulus checks.  The increase in interest rates would make American deposits desirable to foreigners and influx of foreign capital would drive up the dollar’s value.  Congress does not get many things right, however by funneling the stimulus to infrastructure instead of rebates they would kill two birds with one stone.  By increasing government spending on infrastructure, the Government would be able to decrease unemployment and decrease inflation.  The dollar would appreciate and oil would fall as a result.  These projects would take a long time and keep citizens employed for years.  In todays supply-side inflationary environment it is the only government intervention that I condone.  On the other hand they could do nothing but in an election year don’t count on it.

Upcoming Figures

EUR French Consumer Spending (JUN)

GBP Bank of England Minutes

CAD Consumer Price Index (JUN)

USD Fed’s Beige Book

NZD Reserve Bank of New Zealand Rate Decision

JPY Merchandise Trade Balance Total (JUN)

The goal of monetary policy is “to promote effectively the goals of maxi¬mum employment, stable prices, and moderate long-term interest rates.” Stable prices in the long run foster growth and stability, however in the short run there can be some friction between employment and price stability. The Feds reaction can become very difficult when there are supply side shocks, namely a rise in the price of oil or energy. Decisions can lead to a pro cyclical business cycle making troughs deeper in order to rectify the system. With CPI at 5 percent we are entering a stagflation environment where inflation and unemployment will rise together. This is an anomaly in economics that does not occur often. It occurs when the price of commodity with inelastic demand increases substantially over a short period of time. This is shown in PPI which is at 9.2 percent, alarmingly high for financial stability. The Dollar rose this past week because traders decided that the Fed acknowledged this was unacceptable and may raise rates in the future. Highly unlikely and a quarter point rate hike would not reign in inflation.
Inflation has been relatively mild for the past 20 years, so few understand the pain of paying 14 percent yearly for a mortgage. This is what Volker did to rectify inflation sparked by the oil shocks of the seventies. The Fed Chairman Miller did not raise rates because he was concerned with growth; luckily he stepped down after a year at the helm of the Fed. Volker was forced to overshoot inflation to convince the market that the Fed was serious about extinguishing inflation. Bernanke is walking a thin line and will be forced to deal with inflation soon. With PPI at 9.2 percent the consumer will begin to feel the spill over affects of business raising prices. Greenspan hinted that the inflation fighting benefits of globalization have run their course. In short Globalization in the future will not contribute to decreased inflationary expectations.
The U.S. with their high current account may be forced to import China’s inflation. Many on Capitol Hill are protesting China’s undervalued currency; however would an appreciated Yuan decrease the U.S. current account deficit. At first glance yes, however remember that China exports Barbie’s which tend to be inelastic because they are a small percentage of our budget. In short an appreciation of the Yuan would make the inflation worse, while narrowly rectifying the current account. What could the Fed do to fight inflation; first priority is to keep a lid on inflationary expectations. This is done by having a Hawkish reputation, which the Fed does not have. The dollars value reflects this dovish bias and imported goods have become more expensive as a result. Basically in order for inflation to recede domestically and internationally the Fed must raise rates, and the cure needs to be much more severe the longer we let inflation fester.

Many in recent years have pointed to a “global market” that has emerged in the past few decades. While this term is typically a reference to increased global trade and international economic cooperation, the expression is also becoming applicable to the status of the world’s economy. After several years of widespread economic boon, it is becoming clear that the status has shifted. This has occurred not solely in economic powerhouses such as the U.S., the Euro-Zone, and Great Britain, but in many of the emerging markets throughout the world. As I reported here, India’s rupee has been slammed recently, and many other up-and-coming economies’ currencies are sharing the rupee’s fate of late.

Until recently, one of the “hotter” currencies in the world was the Brazilian real. However, it is expected to experience significant losses in the coming months, along with the currencies from many other emerging markets. From this trend, it is clear that the effects of a “global market” are not all positive. Similarly to how they import goods, so too it seems that these growing economies import the economic health of the major economies. Despite having vastly different economies, many are suffering from the familiar problems of rising inflation, high commodities prices, and rising unemployment. In other words, problems that seemed so close to home for many Americans and Europeans are nonetheless beginning to afflict peoples halfway around the world.

Still, unlike the U.S., the Euro-Zone, and Great Britain, growth is not as severe of a problem for many of these emerging economies. Hence the central banks do not have the complex task currently facing the Federal Reserve and the ECB: rising inflation and decreasing growth. This will allow them to just focus on combating inflation, yet the obstacle of high unemployment may limit any potential effectiveness of their actions. With investors starting to exhibit a preference for investing in U.S. markets in lieu of emerging markets, these growing economies must figure out a way to solve their economic problems soon. Otherwise, it could take some time to entice foreign investors to return, which could make any recovery of currencies such as the rupee or the real a long, arduous process.

Upcoming Figures
CHF Trade Balance (Jun)
CAD Retail Sales (May)

The Dollar rallied yesterday during Bernanke’s speech, because he acknowledged that inflation posses a long term liability to the health of the US financial system. As a trader I would be skeptical of Bernanke’s resolve to raise rates to fight inflation. The U.S. financial system is hanging on by a tread and the FOMC is perceived to be Dovish. The dollars rally will be short lived, and there is severe support at 1.58. The market has been range bound for months due to the indecision surrounding the world economy. Will a recession in Europe force the Euro to retreat, or will a recession in the U.S. spark a dollar crisis? Let me reiterate that as a trader never trade against the trend. The U.S. will have a more severe recession for several reasons. The U.S. economy is more dependent on consumer spending, the price of oil has increased inflation in the U.S., the ECB is containing inflation, and they are no where near a liquidity trap like the U.S. Governments in Europe have many more social welfare programs that will lengthen the recession, but make it less harsh. The Europeans have traded productivity for supposed security. The recession will be shorter and the U.S. will return to growth faster than our European counterparts.
This is a short term outline on why the USD has depreciated against the EUR. The major reason being the U.S. current account was unsustainable, and depreciation was eminent. The current account is still large, yet it does not drag on GDP like the previous gapping trade deficit. The rally seems to suggest that some traders believe the Euro to be over valued. Perhaps, the EZ has a negative current account which is at 4.6 billion for the month of May about 2 days of the U.S. current account deficit. The U.S. current account deficit is still around 15 times larger than the European current account deficit. Not a bullish sign for the USD. In the long run the market is guided by interest rates and risk premium’s which are more favorable in Europe for the time being.