Category — Money

For several months, one of the hottest debates in the currency world has been “1.50 or 1.60?” Those who follow the Euro-US Dollar currency pair have been debating its future for several months. Since around the end of February, the price has been locked within a range of 1.50 and 1.60. Only on three days has the price ventured outside that area during the past few months, yet each of those days, the price closed back within the range. In other words, despite minor breaks, the tight range between 1.50 and 1.60 is still in play, signaling more uncertainty and likely more range-bound movements in the coming months.

Given that the EURUSD is the most liquid global financial instrument, the importance of the pair is unparalleled in the currency world (and it’s not even close). The EURUSD is involved in 27% of the trades in the FX market.¹ The next most commonly traded pair, the USDJPY, is involved less than half as frequently. Movements in the EURUSD ripple throughout the entire market, and looking back over several years, it is clear that many other currency pairs have mimicked the trends of this predominant instrument.

As there is presently a firmly established range, trading has become more tedious for many. Some traders thrive in range-bound markets, yet most do not. Many of the more well-known traders are not range-traders, but carry-traders. They thrive on trends and rollover, and while the rollover is still present in a range-bound market, the trends go out the window. The strategy of simply buying a currency and letting it sit for some time becomes more dangerous, as it is unclear which direction the price will move after breaking out of the range. While the trend for much of the decade in the EURUSD has been upwards, many analysts believe that the current range will eventually lead to an end of that overall trend. While I personally feel the opposite, the important point here is that range trade has certainly thrown a wrench into the trend. As a result of being in such a tight range, it has become much more difficult to predict future movements for the EURUSD.

The next few months promise intrigue for the pair. Now that each central bank, the US Federal Reserve and the European Central Bank, seem to be done moving rates for the time being, the pair should be allowed to fluctuate without fundamental interruptions. We will be able to see if the USD is ready to make a resurgence, or if this range is merely a bump in the road for the rise of the EUR.

Upcoming Figures
EUR Euro-Zone Trade Balance (May)
CAD Leading Indicators (Jun)

¹ I based my statistics off of the Bank for International Settlements’ “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007”.

Take your emotions out of the picture, that’s what they say. While some investors are able to treat securities in an indifferent manner, few are able to ignore the feelings of greed or fear that come with profits and losses. For people involved in financial markets, finding ways to trade without emotion is one of the toughest and most important tasks that an investor will attempt. The border between human psychology and investing is a shady one, filled with perilous lessons as well as the figurative corpses of an immeasurable amount of investors who have tried – and failed – to ascertain the balance.

The ugly truth of investing? Not everyone is a winner. This is true in almost any market, including the FX market. Even while attempting to strategize without emotion, we cannot avoid our own psyches; we are not machines, no matter how much caffeine we digest on a daily basis. As a result, things that should be certain are often unclear, and things that should be unclear are often certain. Today, Henry Paulson and Ben Bernanke spoke to Congress and presented a mixed bag of information. However, despite the overall optimistic tone of their talks, the US Dollar got slammed across the board, losing about 100 pips against the Euro. So what to do?

The best suggestion that I have learned from dealing in the FX market is to utilize whatever tools possible that push your emotions out of the equation. Personally, I utilize ‘Stop Losses’ and ‘Take Profits’ whenever trading, and perhaps more importantly, I avoid altering them at all costs. Our minds play tricks on us, fostering greed when we’re up, and inducing fear when we’re down. Even for incredibly successful individuals in the business and finance world (i.e. Jerry Yang), removing emotion can be a difficult proposition. However, there is something else to keep in mind: many traders do win. And as long as you are responsible and mature in your approach to investing, there is no reason why you can’t be one of those people who learns to balance psychology and investing.

Upcoming Figures
CAD Net Change in Employment (June)
CAD International Merchandise Change (May)
USD Trade Balance (May)
USD U of Michigan Confidence (Jul)

Today we have the last part in the three-part series focusing on oil. Again, we hope that you have enjoyed our debate, and look forward to possibly having more debate-style discussions in the future.

Question #5: How will the current energy situation impact America’s relationship with oil?

BB: More than anything, this recession has forced the general public to look in a mirror and see that there is a severe problem. Our addiction to oil has been justified or excused in the past, but no longer. The public– I believe – is ready to admit the problem and look for solutions. One interesting plan was proposed just the other day by billionaire oilman T. Boone Pickens, who is advocating a shift away from foreign oil towards wind power and natural gas (from within the US). It is one of many potential plans being put forth as a way to wean America off of its dependency on foreign oil. Another thing to point out is the timing of this recession. 2008 is an election year where either candidate is more likely to push a more progressive energy agenda than the former president. As a result, many are hopeful that between a more forward-thinking government and a more concerned public will lead to dramatic change in the next decade or so. Despite the best efforts of the current presidential administration, the problems of climate change and high energy costs are now front and center in the public’s conscience, and the next administration will likely pursue “greener” energy policies. I expect that with the next twenty years, America will cut its foreign oil imports by at least 15%. Through the development of more efficient cars and an overall dedication towards cleaner energy sources, I think that the current energy situation will successfully help the US become less dependent on oil, though it may take some time to see pronounced effects.

JK: Americans addiction to oil will continue until the price rises to a point that eliminates demand. The public is not serious about eliminating their carbon footprint. If they were, then lawns would be brown and a victory garden would grace every house. This leads to the conclusion that Americans will not change their way of life until forced too. Americans can not continue their way of life on wind, solar, or wave power. The amount of electricity generated by these sources is minimal and our entire energy infrastructure is not designed for it. If greener technology is to be undertaken then the entire infrastructure needs to be changed, which will happen as a result of sky high oil not a moral imperative. Boone Pickens made the wind power investment to generate stable revenue; he is looking to turn a profit not save the world. Profits are the American way, hope and change is nice but useless without employment. If America’s addiction to oil is too be cured nuclear energy, car pooling, and public transit will play a much larger role. Oil imports will not decrease until cold fusion is invented, or the price is too high. No matter what happens in the long run the short run will continue to be painful. Our relationship with oil will continue to be an expensive love hate relationship. The current price increase will cure the disease but it is a chemo therapy cure for the cancer of oil addiction.

Question #6: Is there any way that oil prices will fall dramatically in the near future?

JK: The price of oil has fallen $9 in two days; however don’t expect this to persist. The price of oil will continue to go up for the simple fact that oil’s rise is demand based. The current dip is a hiccup within the market, the trend has not changed. One of the rules of FX is don’t trade against the trend, this applies to commodities as well. The only way for the price to fall is for demand to diminish, which happens when the price rises. OPEC producers are concerned with the price of oil because they know that the farther it goes up the more alternative sources become profitable. Hence the Saudi output increase because if demand diminishes then so do Saudi coffers. Some will blame speculators whose profit is based on positions based on the direction of oil. No oil changes hand only cash, they are not hoarding oil just taking a position. Blaming speculators is like saying that gamblers affect the direction of a baseball game. Speculators do not influence the price of oil; they profit from it, and lose from it. All commodities have doubled over the last couple of years, and their rise has been demand driven. The transparency of expectations that futures contracts create help airlines and chemical companies secure lower financing to expand production. The price of Oil will not fall in the future until demand diminishes, or supply increases. With all producers at almost full capacity, the demand side of the equation is the only adjustable factor. The only solution is a fall in demand which will not happen at the current price. There is no easy solution, but a bad solution is more regulation. A popular policy that would hurt individuals because clarity would diminish and financing costs for transportation and airlines would increase. Speculation is a hedge used by these industries for future price increases and taking it away would cripple them.

BB: It’s very unlikely… but stranger things have happened. One man quite familiar with global markets, George Soros, has expressed his belief that the current oil prices are a bubble, which would imply that a large fall in price will eventually come. However, I find this hard to imagine happening anytime soon. If the demand for oil persists at or near current levels, why would the price dramatically drop? John is right about this… the price won’t fall until demand does. Unless there is some sort of shock (a new invention, new legislation, etc.), the price is not likely to fall back down. Eventually, however, there will be a point when the price of oil has reached an unsustainable high. At that time, enough people will have finally been “priced out” of using oil in their everyday lives, and as a result, the demand will slowly start to go down. However, this scenario is only likely to play out if we continue today’s trends of increasing supply, demand, and prices. Should we find a way to buck those trends, perhaps by utilizing alternative energy sources, then the process of falling price of oil could happen sooner. I ultimately view oil falling in price as inevitable; one day, we will wake up and there will be none left. However, in the short run, I do not foresee any reprieve for energy costs.

Today is the second part of the series regarding oil. We hope you enjoy our debate, and again, if there are any questions that you would like to see debated relating to oil, please post a comment for us.

Question #3: Can oil prices lead to stagflation? Will they?

BB: Let me put it simply: they can, and they will. Unless something occurs which halts the rise of oil prices, it is very likely for the dreaded situation of simultaneous high inflation and stagnant growth to occur. Of all the terms in economics, there are few as feared as ‘stagflation.’ The last time that stagflation was prominent was in the 1970’s, which also just so happened to have been a time of sky-high oil prices (see where I’m going with this?). Those oil shocks were widely blamed for the stagflation’s onset, and though silly policies by the Federal Government and the Federal Reserve played their part in making the situation worse, it was oil prices that created the situation. That historical lesson does not leave me with an optimistic outlook. In theory, we should learn from the mistakes of our predecessors, yet in this case, that may not be enough. Unless something is done to stop the rise of oil prices, the trends that have already been establish (rising inflation, decreasing growth) are likely to continue until we enter a period of stagflation. Uh-oh.

JK: It depends; the fact oil contributed to stagflation is undeniable. However the assumption that oil shocks bring about stagflation is false. Stagflation is simply rising unemployment and inflation, an oxymoron but possible. The stagflation of the 1970’s was brought about by a variety of factors namely, because central bankers didn’t do their jobs correctly. Inflationary expectations rose, because the initial response to the rise in oil prices was to cut interest rates (sound familiar). Almost all Central banks pursued this pro-growth, pro-cyclical policy, which lead inflationary expectations to rise. If you listen to the press conference from ECB President Trichet one thing you can conclude is that he is terrified about inflation. He highlights the dangers of short-term policies that can alter long term inflationary expectations. When they set in then the domino effect of a wage price spiral can be initiated which will only make a bad situation worse. Oil can be considered a necessary but not a sufficient condition for stagflation. However the given the current situation stagflation will most likely occur, due to the prolonged period of time that oil has been at its current price. The spill over effect can be seen in every countries PPI. The wage increase can be observed in China and India. As for the OECD, a lot of pain awaits because imports which that have contained inflation will become very costly. Let us only hope that Central Bankers choose the prudent course of containing long term inflationary expectations, not promoting short term growth.

Question #4: Will the price of oil lead to the USD losing its premier status in the FOREX world?

JK: No, these types of responses are typical from Mahmoud Ahmadinejad and Hugo Chavez. Both stand up individuals, but both with little or no trade ties to the United States besides oil. Yes, Chavez does export millions of barrels to the U.S. but these countries need to export just as much if not more than U.S. needs to import. One of the reasons that oil is above $140 is because the U.S. dollar has depreciated. The reason for this depreciation is our current account deficit, excess government spending, etc. The rise of oil did not crush the dollar; the depreciation of the dollar gave the price of oil a shot of steroids. The dollar is king because the domestic economy creates 13 trillion dollars annually. As long as the risk premium associated with U.S. investments continues to be low and the U.S. stays on the forefront of technological innovation the premier status will not change. The dollar will lose its premier status when China can build a 747 or provide financial consulting. Currently China fills container ships with of knick-knacks, not very inelastic, and definitely not reserve currency export.

BB: As much as I hate to do this, I agree with John. The critics of the USD have been howling for decades, and I don’t expect this current recession to alter much. The only way that the USD could be knocked off its pedestal is if it becomes so weak that it can no longer function in its many roles, such as the reserve currency for the world, the currency for commodities, or the currency involved in the bulk of FX trades. In the end, it would be too monumental of a project to shift away from the USD, and even if the “powers that be” decided to, which currency would take its place? The only truly viable candidate would be the EUR, yet that has only been around for about a decade, so it lacks the historical track record of the greenback. So while it is possible that the USD might eventually lose its spot as top dog, that time is many years down the road. Even if the price of oil is shifted to another currency in the next few years (also unlikely), I do not anticipate the USD losing much prominence.

Despite last week’s small gains against the euro, the U.S. dollar fell against the European currency on speculation of further weak U.S. growth. It may seem like old news, but investors fear further losses on securities backed by subprime mortgages to weaken the U.S. economy. Today, Germany’s IKB Deutsche Industriebank AG reported losses directly linked to the U.S. subprime mortgage crisis. Along with last week’s Deutsche Bank report, this indicates corporate debt to be at risk from the weak housing market. The dollar fell to 1.3678 against the euro this morning, a 0.3 percent drop from last week.

The risk of owning corporate debt has sky-rocketed, also a factor in the euro gain. Bond buyers have been demanding higher risk premiums on corporate debt as risk-aversion has increased. According to index data by Merril Lynch, the spread that investors demand on corporate debt instead of holding U.S. Treasuries has widened 20 basis points this week to 128 basis points. Investors fear corporate debt will be taking hits from the subprime meltdown.

Currency Outlook and Strategy:
Tomorrow at 8:30 a.m. the U.S. Commerce department is due to release a report on U.S. consumer spending. Economists from a Bloomberg news survey speculate personal spending rose 0.1 percent in June, the least since September. Ever since U.S. personal spending has slowed from a 5-month high in December, the dollar has fallen 3.5 percent against the euro. Even though a weak spending forecast is already factored in the EUR/USD price, there is room for a further fall if the U.S. Federal Reserve decides to lower interest rates. Kenta Inoue, economist and currency analyst at Mitsubishi UFJ Securities in Tokyo, states: “I expect the U.S. economy to slow and the Fed to lower rates in the 4^th quarter. There is still room for rates to rise in Europe, so investors will start to favor European currencies over the dollar.”

And this brings up another question: Will the European Central Bank raise their federal funds rate above the current benchmark of 4.00 percent? There is much speculation the ECB will hold onto the current rate after its next meeting on August 4^th, but is likely to raise rates later in September. This increase may mean further appreciation in the euro, a main worry of French President Nicolas Sarkozy. But recent data has shown an appreciating euro has not hurt the euro-region as a whole. Exports from the EU rose 9 percent in 5 months through May from a year earlier, the second fastest pace in 6 years. This begs the question why an appreciating euro has not hurt exports. The reason is that against the currencies of the EU’s 25 trading partners, the euro has increased less than half as a much as against the U.S. dollar. Exports to the U.S. may have been hurting, but with Germany as the world’s largest exporter, exports to other countries have more than made up for losses.

Another benefit from a rising euro has been lowered costs of oil, which is priced in U.S. dollars. The price of oil has risen 26 percent this year to $76.73 a barrel today. Despite hurting some European corporations like Airbus and Peugeot (charts), the overall euro-region seems to be withstanding the euro impact. The ECB is forecasting economic growth at 2.6 percent for 2007.

As the U.S. dollar fell to record lows against the euro last week, technical analysis may indicate an earlier than expected rebound in the short run. Last week traders speculated long-run rebounds due to the U.S. economy benefiting from a weak dollar and from pressure on the ECB by Nicolas Sarkozy to cool a strengthening euro. But as traders have been eyeing the Relative Strength Index (RSI) on the EUR/USD pair, there is a possibility of a short-run rebound.

The RSI measures the strength of a currency pair price movement typically within the past 14 days. When the RSI is over 70 there is a good chance the price movement will fall. At over 70 most sellers who have been looking to sell perceive the current price to be the best price. On the other hand, buyers will likely wait for the price to fall when the RSI is in fact over 70.

Thus, in the context of the current EUR/USD pair, the RSI is at 76.34 today hinting at a future fall in favor of the dollar. The U.S. currency did in fact make a small gain to $1.3817 per euro this morning. This level is up from last week’s record low of $1.3845, but not enough to indicate an actual rebound. Nevertheless, the high RSI value may indicate a rebound sooner than expected.

Currency Outlook and Strategy:
On July 25^th, the National Association of Realtors is due to report figures on last month’s existing U.S. home sales. It is expected that U.S. existing-home sales have fallen the lowest in 4 years. This could further hurt investor confidence in the dollar. Looking across the Atlantic, European Central Bank Executive Board member Lorenzo Bini Smaghi states he is not worried about euro appreciation. But Nicolar Sarkozy, newly elected French President, thinks otherwise.

Tim Shea, currency analyst at FXCM, concludes: “This week in the Euro looks very quiet news-wise. We’ve got next to nothing on the European calendar, and pretty much just housing data and GDP in the USA. So, watch the housing numbers and the Dow for some direction, and don’t forget about $75 per barrel oil.”  

The Chinese economy has grown at its fastest rate in 12 years during the second quarter. China’s GDP growth has increased to 11.9 percent from a year ago. This figure has exceeded all expectations from 23 economists at Bloomberg. Inflation has risen to 4.4 percent in June, the fastest rate since September 2004. The Chinese economy is on fire and needs cooling. The most obvious is a change in monetary policy. There is much speculation the Chinese central bank will increase interest rates and in turn this will strengthen the yuan. But is revaluation by direct policy of the yuan needed?

According to Glen Maguire, chief Asia economist at Societe Generale SA, a strict revaluation by the central bank is needed in order to quell the surge. He indicates the yuan may even need to appreciate as much as 3.5 percent in a single day. A stronger yuan would slow down the economy by making exports more expensive and thereby reducing China’s enormous trade surplus. U.S. lawmakers have been very keen on a strengthened yuan, claiming that U.S. companies have been taking hits by its artificially low value. Senator Charles Grassly has spoken on the issue extensively stating the Chinese currency has not risen fast enough.

Despite U.S. and Chinese economists having met and agreeing on the same direction for the yuan, the Chinese central bank does not want a fast acceleration. Bank of China Governor Zhou Xiaochuan has stated he does not want the yuan to accelerate nearly as fast as the U.S. would prefer. Other currency analysts do not see the yuan appreciating to unprecedented levels anytime soon. According to Tim Shea, a currency analyst in the Sales and Trading Department at FXCM, “China has shown since the initial dropping of the peg in 2005 that the strengthening of the yuan would happen gradually and at their own pace.” He points out, “…that a 3 percent change in one day would be a move of 2200 pips, the equivalent of all the movement made since January. This would not be in line with past policy.”

We have also seen changes in Chinese fiscal policy to help the cooling process. Inflation has actually outpaced the return on bank deposits spurring investments in the equities market. The benchmark CSI 300 stock index for the Chinese market has gained 87 percent this year. In response, fiscal measures have included legislation allowing the 20 percent tax on interest income to be reduced or even taken away. As a result, fixed-income investments have increased to 26.7 percent in the first half of the year from a year ago. Even though this increase in savings is modest in comparison to the spurring equity run, a future meltdown of the Chinese economy is unlikely. With the right fiscal and monetary policy the Chinese economy will continue to grow at a controllable pace. The yuan will strengthen, but most likely at a pace unsuitable to U.S. lawmakers.

In the highly volatile forex market the dollar rebounded slightly from a previous falling trend. A government report today unexpectedly showed a record level of U.S. securities bought by foreign investors in May. Holdings in U.S. stocks, bonds, and notes rose to a net $126.1 billion in May, up from a net $80.3 billion in April. This surge is an indication that confidence in the U.S. economy has not diminished. Economic data in May suggested that the housing slump did not necessarily spill into other sectors as had been feared. Economists had predicted that international investors would buy a net $72.5 billion in U.S. long-term securities for June, but in fact a net $105.9 billion was bought.

The dollar traded at 122.30 yen at 9:42 a.m. in New York up from 121.89 yen yesterday. Against the euro the U.S. currency traded at $1.3783, a significant increase from the July 13^th record low level of $1.3814. Earlier gains in the dollar were due to a report showing an increase core prices for May. Core prices, which exclude energy and food, rose 0.3 percent giving investors reason to speculate that the Fed will not be cutting interest rates. However, it remains to be seen what Fed Chairman Ben Bernanke will report during tomorrow’s testimony before Congress.

The gains made by the dollar are only short term. Investors should be careful and not overly optimistic as both the European and England Central Banks are about to raise interest rates. European Central Bank Council Member Nicholas Garganas is wary of inflation pressures from stronger than expected economic growth. This would prompt the ECB to raise the interest rate above the six-year benchmark of 4 percent. Likewise, inflation in England exceeded the central bank’s 2 percent target level for a 14^th month in June. Interest rates will likely be increased to cool the economy.  

The recent report on U.S. jobs growth came in stronger than expected. The forecast for new jobs in June was 125,000, but instead the report showed 132,000 new workers being added. This is below the 190,000 workers added in May, but it beat expectations nevertheless. Wages also increased as reports showed average hourly earnings to have increased by 3.9 percent in June. Further reports showed the unemployment rate to be held steady at 4.5 percent for the third month.

In response to this news of strong economic performance treasury yields have increased as investors are worried about inflation. During this week, the rate on the 10-year note climbed 15 basis points. This has been the biggest increase since the 16 point increase in the week of June 16, 2006. The economy has been doing better than expected amid the subprime mortgage crisis. This has given bond holders reason to believe that there is potential for increases in inflation, and thereby, have increased demand for higher yields. If inflation does go higher than the target level, then the Fed is likely to increase interest rates to cool to economy.

On the other hand, Janet Yellen, President of the San Francisco Federal Reserve Bank, has indicated that the Fed should not change interest rates. According to Yellen, the best way to achieve faster growth while maintaining a low level of inflation in the current state of the economy is by keeping interest rates steady. Despite a very robust economy, Yellen indicates that inflationary pressures are not strong enough to hurt the goods and labor markets. She is more worried about future problems that are yet to come from the subprime mortgage defaults.

It is difficult to say where the value of the U.S. dollar will stand in the next two months. There are mixed opinions among investors and policymakers as to where interest rates will be held. The next FOMC meeting is not until early August.

As U.S. interest rates remain unchanged at 5.25% for the 8^th straight Federal Reserve meeting, and as terrorist arrests in London spur worldwide concern, the U.S. dollar has dropped against major currencies. The dollar fell 0.5% to 1.3605 per euro and 0.6% to 122.44 yen. Investors have become more risk-averse with the recent geopolitical events. As a result, demand for the yen and the swiss franc, a haven for security, has increased. According to Derek Halpenny, senior currency strategist at the Bank of Tokyo-Mitsubishi UFJ in London, interest-rate differentials will continue to move against the U.S. dollar as a result of the unchanged U.S. monetary policy.  

This trend may continue in the long run. Despite recent positive reports of increased retail sales and job growth, investors are worried that losses from hedge funds owning subprime mortgage bonds will slow economic growth. This increase in risk aversion has caused an increase in holdings of risk free debt. Treasury holdings are at 35% of funds overseeing $315 billion in bonds. This is 1% higher than holdings in corporate and sovereign debt for the second consecutive week. In the previous month for the first time in a year, U.S. treasuries have outperformed corporate and emerging-market bonds.

Investors like Bill Gross of Pacific Investment Management Co. are speculating that the housing slump will restrain the economy for the rest of the year. The subprime mortgage crisis is the worst since 1991, and the effects may even be felt next year as well. Investors are speculating that the Federal Reserve will be forced to lower interest rates in the long run in order to induce consumption.

What will lower interest rates mean for the value of the U.S. dollar? Lower interest rates will cause a drop in the value for the U.S. currency. If the Fed does in fact decide to lower interest rates, in the attempt to avert further dampening effects on the economy by the housing meltdown, currency traders will decrease demand for the U.S. dollar. A decrease in demand in will bring down the value of the currency.