Category — Americas

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)

Many people involved with the market are adamantly opposed to any actions justified by the term “too big to let fail.” In capitalism, a company should be able to experience without interference both the profits and the losses that come with business. In theory, if a company has placed itself in a position where there is a possibility of failure, so be it; the company will have to deal with the consequences of their mistakes. The notion that the government – posing as a white knight – will ride in and rescue the company from danger is a thought that repulses many market followers. However, while existing in the theoretical world is nice, reality is far more complex. I applaud the federal government stepping in to help embattled companies Freddie Mac and Fannie Mae, as the extended consequences of their potential failures outweigh the theoretically sweet idea of a non-interfering government. Furthermore, I encourage the Federal Government to continue to utilize the “too big to let fail” mentality in order to stave off a severe recession.

If a house a few blocks down is on fire, should you do nothing? The chance the fire will destroy your house is slim, yet you might still feel the effects of that house burning down. For example, the smoke might linger in your neighborhood for several days, or in the longer-term, nearby property values may fall. In other words, though an entity seemingly unconnected to you is in danger, you still might feel the ramifications should the “fire” not be extinguished in time. No one is an island, and were Freddie Mac and Fannie Mae allowed to fail, people throughout America (and hence, the globe) would have been subjected to a worsened recession. Had the federal government done nothing to help the two companies, it is likely that they eventually would have had to use more taxpayer funds in the long run to help heal the economy. The domestic housing market is already in enough trouble, and though I do believe that discretion should be used when deciding how big is “too big to let fail,” I think the Federal Government was right in its actions.

Upcoming Figures
AUD Reserve Bank of Australia’s Board Meeting Minutes (Jul)
JPY Bank of Japan Monthly Report
EUR Italian Consumer Price Index – EU Harmonized (Jun)
GBP Consumer Price Index (Jun)
USD Advance Retail Sales (Jun)
CAD Bank of Canada Rate Decision

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)

Last week I mentioned that though the G8 conference would impact the US dollar in the short term, the ultimate fate of the USD will ultimately be determined more by Bernanke than by anyone else. The Group of Eight’s meeting has come and gone, offering little good news for the USD. In the FOREX market, that “little good news” led to bad news for the USD, as the greenback surrendered some of the territory it had gained last week. So with the conference in the rear-view mirror… let’s look ahead.

In his most recent column, Robert Novak wrote that despite his publically hawkish stance, Bernanke is more concerned with growth rates. Furthermore, Bernanke feels that oil and gasoline prices, if they continue to rise, could lead to the dreaded state of halted growth in addition to rising inflation. Assuming that what Novak is reporting is accurate, it would seem that Bernanke’s pronouncements last week were a charade. In other words, Bernanke isn’t likely to walk the walk. However, this might not be a bad thing. Many see the economy as not yet ready for a rate hike, and so perhaps holding rates constant for the next several months would be the best thing for the US economy.

The USD has ended the rally it began last week, and while the short term prospects are dimmer than they were several days ago, the jury is still out regarding the long term. On the one hand, disappointing economic data that keeps coming out (most recently in the US: poor manufacturing results) would indicate that the USD is in for more stormy seas. However, analysts are noting that it has been years since people have held such bullish opinions about the USD. Many feel that the dollar is “due,” meaning that after taking its lumps for years, it is poised to finally recover. With the Saudis agreeing to pump more oil, perhaps the stars are aligning for a USD recovery. However, it’s hard to know the future for certain. As it is written in one of the Harry Potter books, we humans are not very good at reading the stars.

Upcoming Figures

AUD Reserve Bank of Australia’s Board Minutes (Jun)

EUR Italian Trade Balance (Euros) (Apr)

GBP Consumer Price Index (May)

EUR Euro-Zone Trade Balance (Euros) (Apr)

USD Current Account Balance (Q1)

USD Housing Starts (May)

JPY BoJ to Publish Minutes of Board Meetings

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 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.

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.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

The GDP release for the second quarter came out strong this morning, printing at 6.4% annualized growth versus 3.2% expected. This was on top of a revised 0.6% pace for the first quarter of 2007. The dollar was already trading upwards early this morning and in European trading in anticipation of a positive release. EUR/USD had fallen as low as 1.3650, and it is hovering at about 10 pips over that right now. For a good primer on how you should trade an event risk like the US GDP report, try the GDP analysis on DailyFX.

US GDP rebounded for a variety of reasons. Rising exports, aided by the weak dollar, made up for the high input costs of $70 oil. There was a gain in commercial construction, balancing out the slump in the housing market. And finally, there was a significant rise in government spending last quarter, which probably cannot be sustained and certainly should not be counted on for future growth.

But the engine of the US economy is consumer spending, with consumption comprising 70% of GDP. And this sector only rose 1.3% the past three months, a troubling amount considering the 3.7% rise in the first quarter of this year. If the American consumer is tapped out, and that looks to be the case, then that does not bode well for growth the rest of the year.

The report this morning did beat expectations. And it probably fooled the traders in the Fed Futures market that have priced in a 90% chance of an interest rate cut by the end of the year. But economic prospects in the United States are not aligned for expansion either. Risk aversion seems to be killing the market (and the carry trade) as well. It is in times like these that it seems the best that individual traders can do is tread water. And that’s why managed funds seem so attractive. Most forex managed funds will not offer returns much different than mutual funds, but they do provide extra diversification important in market downturns. And one of the best that you might want to check out is called the Sentiment Fund by FXCM. Trading has been up and down in the forex market recently, and it’s hard for even the professionals to stay on top of things. And so it’s helpful to have an experienced hand at the top.