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By Mike Conlon | February 25, 2011

With recent turmoil in world markets, one of the “surefire” things we would normally assume under such risk aversion did not take place. In the past, when world economic markets have been faced with adversity and risk, the US dollar was one of the most sought after investments.Because the US dollar is the world’s de facto reserve currency, people want to own Dollars when risk increases, as many times those Dollars will be moved into US Treasury bonds.

This has not occurred this week, as the Dollar has been primarily lower despite higher oil prices and stock market losses. In fact, as I mentioned yesterday, the primary beneficiaries of the flight to safety trade this week were the Swiss franc, the Japanese yen, and gold.

Meanwhile, oil has pulled back from trading a 100 handle as Saudi Arabia is going to raise the supply of oil they send to market to make up the losses from Libya, but again, I think $100 oil is here to stay for a while. The story with oil is not really about supply shocks, but rather with the weak US dollar.

In the UK, GDP figures came in slightly lower than expected, showing a 4th quarter decline of .6% vs. the expectation of a decline of .5%, pushing the YoY figure down to 1.5% vs. an expectation of 1.7%. The Pound is weaker across the board as a result.

Here in the US, revised GDP figures showed an increase of 2.8% vs. the expectation of 3.2%, and personal consumption figures came in slightly higher than expected at .5%. While this still shows good growth, the lower figure has to change assumptions about budget deficits, which means that deficit is actually higher than is being reported. Oops.

So lower oil prices today have encouraged some early risk-taking, as stock markets and commodity currencies are higher.

In the forex market:

Aussie (AUD): The Aussie is higher following the MSCI Pac Index higher as yield differentials and general Dollar weakness have increased demand.

Kiwi (NZD): The Kiwi is also higher in the wake of the earthquake despite the market pricing in a rate reduction at the next rate policy meeting. This would normally be a negative, but the positive interest carry and weak US dollar make it still more attractive.

Loonie (CAD): The Loonie is mixed this morning, as lower oil prices and lower US GDP figures highlight the difference among the commodity currencies.

Euro (EUR): The Euro is lower as it has actually been trading more closely linked to oil prices than the Loonie. In addition, German CPI data showed an increase in prices which combined with hawkish rhetoric from the ECB could mean rate hikes will happen soon. (Click chart to enlarge)

Pound (GBP): The Pound is lower across the board as GDP figures came in lower than expectations. In addition, business investment was also lower, as was a consumer confidence survey. How the BOE will react is anyone’s guess at this point. (Click chart to enlarge)

Dollar (USD): GDP revisions came in lower than expected, and later this morning consumer confidence figures are due. In addition, there is a lot of Fed speak on the docket, with policy-makers trying to justify current policy as weak dollars are driving inflation.

Yen (JPY): The yen is mixed as the demand for safe haven assets has decreased, though it is trading higher vs. USD, EUR, GBP, and CAD. Stocks in Asia were higher overnight, as oil prices began to reverse.

It is amazing to see the confluence of events that is taking place around the globe in the form of protests. Libya, Egypt, Tunisia, Wisconsin….

Whoa, Wisconsin? I’m not trying to put on my tin-foil hat just yet and claim conspiracy, but these events can be linked to a common sourceâ€"weak US fundamentals and the need for loose monetary policy to accommodate it.

While I have been harping on inflation all week and will probably continue to do so until the Fed does something to change policy, it will be interesting to see the reactions both here and abroad. While the Fed may be able to manage core inflation, they may not be able to manage the inflation expectations that in turn could become a self-fulfilling prophesy.

This is exactly the type of build-up that could lead to over-reactions that the textbook that the Fed uses doesn’t account for. So while getting a respite from higher oil prices is nice today, it does not mean that risk has left the market.

In fact, going into the weekend I am very concerned about risk, as who knows what might occur. I would not be surprised to see some flight to safety by the end of the day, though nothing surprises me any longer!

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here! Don’t miss out on the world’s fastest growing market!

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Rising Inflation to Force Bank of China to Hike Rates Further

On February 8th, the People’s Bank of China raised the one-year lending rate twenty-five basis points to 6.06 percent. This marked the third rate increase in four months and most observers believe more interest rates hikes will be necessary for China to keep a lid on inflation.

The latest figures from China’s Statistics Bureau indicate that consumer prices jumped 4.9 percent in January compared to the same month one year ago. The actual result was less than the expected 5.3 percent but January’s outcome keeps intact a long string of monthly price increases underscoring the risk of inflation in the Chinese economy.

In addition to raising rates further in the coming months, China’s monetary authority will likely continue the trend of forcing lending institutions to increase the percentage of funds to be held in reserve. This effectively removes liquidity from the money supply leaving financial institutions with a smaller pool from which to lend to businesses and consumers. Rampant property speculation for instance has helped fuel a property bubble and in light of the Japanese and more recent American experience with property bubbles, authorities in China have good reason for concern.

As well as surging property values, a dramatic jump in food prices is forcing the government to take more decisive action. Authorities have even resorted to selling food reserves to augment supplies in an attempt to stem the pace of price increases. Officials are also taking sterner actions to target hoarding and other actions artificially boosting the cost to purchase these basic essentials.

Naturally, as prices continue to climb, pressure is building for salaries to also rise to help consumers bridge the growing inflation gap. The potential spillover effect could have serious implications for China’s all-important export sector.
China was able to position itself as one of the planet’s leading exporters by taking advantage of its abundant and â€" compared to most other countries â€" inexpensive workforce to produce goods at a lower cost than the traditional manufacturing centers. However, this advantage could be diminished if salaries are pushed higher to offset rising domestic prices.

Does China’s Inflation pose a threat to Global Recovery?

One thing lost in this discussion perhaps is how China’s inflation struggles could impact the global recovery. With the Eurozone lurching from one crisis to the next and the US economy recovering at a much slower pace than following previous recessions, China is being heralded as the driving force to lead the greater global recovery.

But what if China’s internal problems worsen and it falls short of these expectations?

China’s central bank recently warned of the potential for this very scenario. As major economies in the West (read, the markets for China’s exports) abandon spending programs originally implemented to combat the recession, demand for imports from China could decline. Should China also be forced at the same time to tighten monetary policy to hold the inflationary tide, the combined impact could seriously impede China’s adopted role of the “engine” of the recovery.

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Untangling the Puzzle of Risk Appetite

When analyzing forex, nothing is more satisfying than establishing a strong correlation between a particular currency pair and another quantifiable investment vehicle. You see â€" we fundamental analysts love to kid ourselves that we can actually explain what’s going in the forex markets, but it’s only when you can visually observe (and statistically confirm) a correlation can you actually pretend that this self-assuredness is justified.

On that note, I found myself looking at in interesting chart today: the EUR/USD vs. CHF/USD vs. S&P 500 Index. My purpose in drawing this particular chart was to ascertain how risk appetite (represented by the S&P) is being reflected in forex markets. As you can see, two observations can immediately be made. CHF/USD very closely tracks the S&P (or vice versa), while the EUR/USD similarly mirrored the S&P for most of the last 12 months, before suddenly diverging in November 2010.

By extension, this raises two questions. First, why should a rising S&P be accompanied by the Swiss Franc? After all, the former is a proxy for risk appetite, while the latter is a symbol of risk aversion. That means that tither the S&P is a weak indicator of risk appetite, or the Swiss France is not being driven by risk aversion. In a way, I think both notions are true. Specifically, US equity prices are are primarily a sign of US economic recovery and strong corporate profits. It’s probably equally accurate to say that the S&P promotes risk appetite, as saying it reflects risk appetite.

Moreover, as US stocks and investor risk appetite have increased, interest in the US Dollar has (somewhat ironically) decreased. One would think that this would spur a depreciation in the Swiss Franc, but I guess this was superseded by the falling Dollar. [For that reason, I actually added the MSCI Emerging Markets Stock Index after I started writing this post, because I realized it was a better proxy for global investor risk appetite. Sure enough, the recent continuation in the Franc's rise has coincided with a correction in emerging market stocks].

While this explains why the Euro should also appreciate for five consecutive months, it doesn’t offer any insight into why the EUR/USD correlation with the S&P should suddenly breakdown. [Question #2]. Recall from my earlier posts that there was a sudden flareup in the Eurozone sovereign debt crisis in November 2010. Around that time, there were a handful of debt downgrades, Ireland received an EU bailout, and there was heightened concern that the crisis would soon spread from Greece to the rest of the PIGS.

This caused a bout of intense Euro instability, against both the US Dollar and Swiss Franc. While the S&P continued rising, interest in emerging market stocks began to flag. It’s extremely tempting to posit a connection between these two trends, especially since it would seem to be implied by the chart. However, I think the correction in emerging markets is due more to Central Bank intervention and a recognition that a bubble was forming, than to the EU sovereign debt crisis. That the Euro has rallied in 2011 even as emerging market stocks have begun to decline, supports this interpretation.

Trying to draw meaningful conclusions from these correlations is frustrating at best, and dangerous at worst. Namely,  that’s because it’s impossible to completely distinguish cause from effect. The two stock market indexes are probably the least dependent of the four items. For instance, the Euro is derived in part from the Dollar, which is derived in part from the S&P. You could say that the Franc takes its cues from the S&P (as a proxy for risk appetite) and the Euro. Second of all, the strongest correlation on the chart (CHF/USD and S&P) is also the most unexpected.

In the end, I think only one solid conclusion can be drawn: uncertainty surrounding the Euro will continue to boost the Franc. While I probably could have told you that without the use of this chart, at the very least, it reinforces the interconnectedness of all financial markets and that even if poorly understood, all trends are ultimately related.

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EU Ponders Tobin Tax

Only two years after the worst financial crisis in decades, the DJIA is now back above 12,000. Yield-hungry investors are pouring record amounts of cash into emerging markets. Commodities and food prices are rising into bubble territory. In fact, not a single meaningful reform has yet to be passed that would prevent such an event from erupting again. The EU, however, is trying to change that, with the proposed introduction of the first-ever Tobin tax on foreign exchange trades.

The campaign is being led by French President Nicolas Sarokozy, who happens to be the current Chairman of both the G8 and G20. Recently, he has used his podium for populist rants against the international financial system. To his credit, Sarkozy has done more than bluster. He is fighting to advance the idea for a minute tax on all financial transactions, with the aim of reducing volatility and raising money for cash-strapped governments.

The so-called Tobin tax was first proposed in 1971 by Nobel Laureate James Tobin. While it has always enjoyed support from a handful of leftist economists, it has never been seriously considered by any western country. In the wake of the financial crisis, however, anger towards speculation seems to be peaking, and some governments might finally have enough political capital to push forward the idea. In fact, France has already obtained the tepid support of other EU members, notably Austria. In addition, the Economic and Monetary Affairs Committee of the European Parliament has backed the idea. The EU is fighting to keep the Euro alive and its member states solvent, and it clearly resents the (perceived) role of speculators in betting on default and breakup.

Proponents of the Tobin tax generally cite the amount of revenue it could raise as its chief benefit. For example, it has been estimated that a .005% on forex transactions could raise $26 Billion worldwide, while a .05% tax on all financial transactions could generate as much as $700 Billion in revenue. Even though studies suggest that it wouldn’t do much to reduce volatility (and perhaps speculation), the fact that it shouldn’t destabilize markets is enough to satisfy some of its naysayers.

Not surprisingly, the US remains opposed to such a policy, on the grounds that it could “send misleading signals that could hamper investment to end extraction and cause production bottlenecks.” This kind of incantation rings hollow, however, and it’s clear that the biggest obstacle to its being implemented is almost certainly the bank lobby, which has insisted that a Tobin tax would “cause serious damage to this highly efficient [forex] market.”

Personally, I’m a cautious advocate of the Tobin tax. At .005%, it would levy $10 on every round-trip lot ($100,000) forex transaction. This would punish those that engage in leveraged account-churning and computerized, rapid-fire trading, without impacting those that take a longer-term approach to forex. In addition, it would impact institutional traders and investment banks (which currently monopolize all financial markets) much more than retail traders. Then again, they would probably just shift more of their trading into unregulated, private markets.

At this point, the Tobin tax is still probably a long-shot. The fact that it’s being seriously considered, however, is nothing short of remarkable.

Presidents Day And More!

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By Mike Conlon | February 21, 2011

Today is President’s Day here in the US so it is a bank holiday and most financial markets are closed for the dayâ€"yet the forex market is open for trading! However, volume in the US session will be noticeably lighter as the bank holiday will reduce participation.

So today’s blog article will be an abridged versionâ€"as I still need to make my way to the trader’s expo here in NY where I will be giving a presentation at 3:30. And I also have a minor snowstorm to navigate, though this winter has left me indifferent to the fluffy white stuff as it has become less of a surprise and more of an expectation.

Some “surprises� coming from the Arab nations have heightened risk in the region and threaten stability as protests in different nations are met with different responses. Just days after protests in Egypt forced change in the government, it is not going as well in Libya as it is already been reported that over 200 people have died. This situation could explode into Civil War, as warned by the son of leader Quaddafi.

This situation is far from over and represents a major risk to global stability. As such, the forex market is in risk aversion mode.

Overnight, German business confidence figures were higher but the Euro is trading lower on risk themes. There will be GDP and CPI data figures released later this week.

One anomaly taking place this morning is a higher Kiwi, as expectations of tomorrow’s inflation expectation report has traders postioning accordingly.

At the end of the week, both US and UK GDP figures will be released.

So this week is busy with news, while heightened risk from Arab countries will keep the markets on edge. It is not quite smooth sailing this week which like the snow in NY is not surprising but more of an expectation.

If we are able to run this economic gauntlet this week without too much damage, then I may be surprised! So the only trading I’ll be doing this week will be demonstrations at the Expo, and if you are nearby come stop in and say ‘hi’.

For the rest of you on the internet:

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here! Don’t miss out on the world’s fastest growing market!

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NY Traders Expo!

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By Mike Conlon | February 18, 2011

It’s that time of the year again folks! 

Join FX EDU at booth # 5613 for The New York Traders Expo on February 20-23, 2011 at the Marriott Marquis Hotel. This is the ultimate opportunity to meet face-to-face with industry leaders.  FXEDU will be conducting numerous tutorials on trading and trade strategies throughout the expo and will be offering unbelievable discounts on our courses, in addition to giving away thousands of dollars worth of prizes to those who stop by.  Test out the hottest products and software, and learn techniques you can use now that will minimize your risk and increase your profits. Every speaker at The Traders Expo is carefully selected because of his or her proven ability to teach trading techniques that can lead to a lifetime of success. Register now and prepare for four days that will get you on track for a profitable future! Call 800/970-4355 and mention priority code 021879 or register online. 

In addition, come see me give a talk on the reasons that you need to be in the forex market and how you can become a better trader in under 30 minutes/day. My workshop, “Trade Forex Like a Professional in 30 Minutes or Less a Day”, will be given on Monday, February 21st at 3:30PM.  You can view the event details here. 

So I hope to see you all at this amazing event, which will feature some of the best minds in the business and show you the cutting-edge in trading today. I hope to see you there!!! 

For those of you who can’t attend, please check out our currency trading courses! 

If you wish to get started in the forex market, click here.  Don’t miss out on the world’s fastest growing market!

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Week in Review-Feb 18th

Risk-sensitive currencies are surviving despite a China reserve requirement ratio hike and confirmation from Egyptian authorities that Iran had formally requested permission to transit the Suez Canal. ECB board member Bini Smaghi comments that the Central Bank will have to watch inflation closely has the ‘bullish hawks’ squeezing the weak EUR bears positions. Investors, in these thin markets are again adding some geopolitical and G20 risk premium to their portfolios. The most logical reason for not wanting the dollar, despite the US inflation components edging higher this week, is the belief that an ambivalent Fed is falling behind the curve. The lack of confidence in the US administration’s ability to deal with its issues has investors questioning owning the reserve currency. Below, we have some of the highlights of the week.

EUROPE

• Euro-zone Industrial production fell -0.1%, m/m, in Dec. after rising a revised +1.4% in November. The market was seeking a flat reading. IP was flat in Germany and up +3.8% in Portugal, but weaker in Spain (-0.8%) and Ireland (-1.7%). Analysts believe the weather suppressed production in Germany. However, the softness in Spanish and Irish numbers again promotes further EUR negative sentiment.

• The Euro-group finance ministers met to discuss peripheral financing issues and again did not agree on specific measures. The principal innovation from the meeting was agreement of the size of a future (post-2013) backup facility at EUR 500bn, supplemented by an IMF contribution. No specifics on the mechanics or financing of this facility or clarification on measures to enhance the pre-2013 EFSF. These details will need to wait until March summits, creating risk for peripheral sentiment.

• News of complications in the restructuring plans of German’s West Lb again heightened Europe’s financial sector concerns.

• Euro flash GDP came in weaker than expected, rising just +0.3%, q/q vs. a +0.4% consensus. National releases so far across Europe showed a still weak recovery in the periphery, as Portuguese GDP contracted in 4th Q, while the Greek economy showed little sign of improvement. In core Europe, German and French GDP growth was softer in the 4th Q due to adverse weather. However, y/y, German GDP still grew a robust 4%.

• The ZEW survey in Germany showed strength in the current economic assessment but weaker than expected forward sentiment in February. Next week’s Ifo will give the market a clearer picture of German momentum into March.

• UK January inflation was +4.0%, y/y, softer than market fears of +4.3%. However, Governor King’s letter to Chancellor Osborne explaining the inflation overshoot of target contained two surprisingly hawkish twists. Inflation will be ‘as likely to be above the target as below it two to three years ahead’ based on market assumptions for the Bank Rate to rise. King also noted that the split in the committee and said that ‘every member of the Committee is determined to act to adjust policy in order to bring the (inflation) risks into balance’. Market is trying to price in a rate hike by May or if not sooner. The inflation report is making it difficult.

• Surprisingly in the inflation report, BOE pushed its GDP trajectory a bit lower, kept the central projection for inflation in two years’ time under the 2% target, assuming market rates at just 2%, and also assuming that the Bank Rate remains unchanged. This would suggest that King would need to see a significant tightening in the UK labor market and signs of labor regaining pricing power over wages before turning ‘hawkish’.

• UK Jobless claims unexpectedly climbed +2.4k last month vs. an expected -3k decline. Growth in average weekly earnings also slowed to +1.8% in Dec. from +2.1% previously.

• UK CBI export orders rose to the highest level since July 1995. The CBI headline improved to -8 in February from -16 last month. The forward looking output expectations component strengthened to 23, the third consecutive monthly gain. This should point to another strong PMI release in February, as our economist noted, and supports the notion that the benefits from a weak GBP are starting to kick in.

• UK retail sales rebounded sharply last month and although Dec. saw a big downward revision. UK core sales advanced +1.6%, m/m (the biggest in a year), however, Dec. sales was revised lower from -0.3% to -1%, m/m. In nominal terms, sales are up +5.3%, y/y (highest rate since May 2008). This will support the hawks on the MPC.

• Chancellor Merkel nominated her economic advisor Jens Weidmann for President of the German Bundesbank

• ECB board member Bini Smaghi said that the Central Bank will have to watch inflation closely to keep rising costs in check. The market has interpreted the comments to signal that the ECB is again looking towards a possible interest rate hike to combat inflation in the coming months.

• Today and tomorrow will see France hosts the finance ministers and heads of the central banks of the G20 bloc. The ministers will follow up on the pledges made by the leaders at in Seoul in November, particularly regarding exchange rates. The market can expect a communiqué on Saturday. The meeting will discuss global imbalances. There may be agreement on the need for better monitoring of current-account deficits and surpluses.

Americas

• Headline (+0.3% vs. +0.5%) and core-US retail sales (+0.3% +0.5%) continue to rise but disappointed the aggressive upbeat expectations. Analysts are questioning the price versus volume effects in calculating the market disappointment. There is talk about a downward revision to 4th Q GDP. The backward revisions certainly took some of the steam out of the Jan report. Both the headline and core were revised lower in December and it was just the core print adjusted for the November release.

• US import prices accelerated higher last month, doubling to +1.5%, higher than market expectations. This is the fourth consecutive month of price increases (4-month annualized rate more than +15%). These numbers will have the Fed being challenged on its price stability policy. Year-over-year, import prices are up +5.3%, while export prices are +6.8% higher. Obviously, export prices got a boost from the Fed’s QE2 stance.

• Manufacturing in the NY region grew at its fastest pace in eight-months (+11.92 to +15.43). Analysts note that with capacity utilization at historical lows, there remains plenty of room for manufacturing to aid consumer consumption in the economic recovery. It’s worth noting that the Empire index has been relatively consistent over the past year. Analysts are optimistic that business will begin open their coffers and spend more of their cash hoards on capital goods.

• The FOMC minutes did not sway from recent market opinion. The improved economic views were not enough to change the outlook very much. Near term growth, unemployment and prices all improved, but this strength does not seem to be carried through to the longer term view. We have witnessed the split on the speakers circuit of late, however, consensus does not need to change policy just yet. Some members felt that ‘if more data showed stronger evidence of recovery it could justify changing the pace and size of current asset purchases’.

• US Jan. housing starts advanced +14.6% to +596k. The aggressive rise easily offset the softer permits surprise of -10.4% declines to +562k. Analysts note that even with the abnormal weather variable and regulatory changes, the print looks ‘consistent with a moderate underlying improvement’. Noting that mortgage rates continue to tick higher, the overall picture though somewhat upbeat will definitely not be leading US economic recovery any time soon.

• US producer prices advanced for a seventh consecutive month in January (+0.8%). It’s not surprising to see that most of the support came from energy prices (+1.8%). The stronger than expected core-PPI reading (+0.5% vs. +0.2%), coupled with stronger data of late, is expected to eventually put pressure on the Fed’s doves to abandon any plans of further monetary accommodation, like QE3. The market is beginning to expect the debate over monetary policy to ‘return to more normal lines’ in the second half of this year.

• US industrial production disappointed, declining -0.1% vs. a market expected rise of +0.5%. The surprise is palatable because of December’s upward revision from +0.4% to +1.2%.

• Canadian December manufacturing data recorded a big miss (+0.4% vs. +2.3%), however the impact was eased by the modest positive prints on capital inflow (+9.63b) and leading indicator data (+0.3%).

• US inflation (headline CPI +0.4%) is still being bullied by gas prices. Strip transportation (+0.23%) and the gas component out of the report, and we have inflation going nowhere in the US economy (core-CPI +0.2%). It’s not generalized inflation, but, price shock being expressed mostly by commodities.

• The US jobless claims headline (+410k) happened to give back some of the previous week’s gains. Initial jobless claims increased by +25k. Apart from last week’s +385k print, it is the second lowest level seen this year. The less volatile four-week moving average moved a touch higher to +417.8k and remains supportive of a firmer NFP report for this month.

• The Philly Fed print blew everyone out of the water (35.9 vs. 19.3). This is strong proof that ISM may not have peaked. The strength can be attributed to a surge in shipments and higher prices. The gain in shipments is on the back of a solid quarter of new-orders.

• Canadian Wholesale trade (+0.8%) is expected to add to December’s GDP print, while housing starts, hours worked and manufacturing sales will act as a drag. It is the fifth-consecutive month of gains and came with a significant price effect.

• Canadian inflation disappointed the medium term hawks. In non-seasonally adjusted m/m terms, headline CPI advanced +0.3%, while core remained flat. In a seasonally adjusted m/m terms, headline CPI was up a more modest +0.2%, and +0.1% at the core level. The absence of inflation pressures combined with a mixed growth picture should keep the BoC on hold until late this year.

ASIA

• Japanese GDP contracted only -0.3% in the 4th Q vs. market expectations of -0.5%. This was largely due to 3rd Q revision to +0.8% from +1.1%, q/q. With yields so low, the JPY will remain vulnerable as other G10 countries begin to tighten.

• Value of loans in Australian managed to advance +2.5% in Dec. Home loans increased +2.1%, m/m, doubling the +1.0% forecasted. Investment lending was up +3.0%, offsetting the revised -2.0% contraction in Nov.

• Chinese Jan. trade surplus was +$6.5b (smallest surplus in nine-months). The 12-month rolling surplus fell back to $177b from $185b in Dec. The narrowing surplus was due to record high imports of $144b, up +51.4%, y/y. Exports were up +38%, y/y, to $151b. Strong proof that Chinese demand remains solid.

• The recalibration of the Chinese inflation release (+4.9% vs. +5.3%) is having only a modest affect on risk and Asian currencies. The lower than expected, but elevated print is proof that rising food, housing inflation, will keep headline inflation elevated and require Chinese policy tightening to be front-loaded. This is obviously a risk to domestic growth, handcuffing the PBOC in being more hawkish on their exchange rate policy.

• RBA minutes stated that a ‘slightly restrictive’ policy stance was appropriate as a resources boom boosts incomes. The minutes offered no new real news, but stated clearly that the medium-term outlook for the Australian economy remains robust.

• The NZ PMI rose +0.6% to +53.7 in Jan. Input prices rose +0.9%, q/q, while output prices only rose +0.2%, with producers not passing on costs in full. The ANZ consumer confidence fell -9% to 108.1 in Feb.

• China raised reserve requirements by 50bp, accelerating its pace of tightening (+19.5%). The markets appear to be getting more comfortable with the notion that the PBOC can achieve a soft landing without disrupting global markets.

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The Obama Budget and the Dollar

Last week, the Obama Administration released its fiscal 2012 budget to much fanfare. Unfortunately, the budget makes only a token effort to address the rising National debt, and forecasts a budget deficit of $1.1 Trillion. While the release of the budget failed to make a splash in currency markets, traders would be wise to understand its implications for the future.

The budget proposes spending of $3.7 Trillion in 2012, and forecasts receipts of only $2.6 Trillion. As usual, entitlements (Social Security, Medicare, and Medicaid: $2 Trillion+), Defense ($760 Billion), and net interest on debt ($250 Billion) are projected to consume the brunt of spending. The Departments of State, Education, Energy, and Veterans Fairs will receive an increased allocation, while almost all other Departments face drastic cuts. (For more comprehensive breakdowns, the WSJ and NY Times offer excellent graphical representations of how the federal budget is funded and disbursed).

The proposed budget allows for a deficit of $1.1 Trillion (7% of GDP), which unbelievably represents a significant decrease from the $1.6 Trillion (11% of GDP) that is projected for fiscal 2011. The Congressional Budget Office (CBO) forecasts the deficit to return to a more “sustainable” level of 3% of GDP beginning in 2014, which should allow the national debt to remain constant in relative terms for the following decade. Beginning in 2021, however, entitlement spending is projected to skyrocket, which would cause debt to rise similarly.

CBO projections are based on a handful of rosy assumptions. First of all, it assumes that the US economy will grow at 3%+ for the indefinite future. Second, it assumes that deficit spending can be financed at reasonable interest rates. Third, it assumes that tax receipts will rise from current lows and revert back to historical levels. Given the ongoing economic uncertainty, high unemployment rates, tax cuts, rising interest rates, the difficulty of cutting spending, etc., there is reason to believe that actual deficits will be even higher.

In fact, net interest payments on national debt will rise 33% over the next year even as Treasury rates remain at record lows. If the economic recovery gathers momentum (something that the budget is counting on), risk appetite and interest rates must rise. In addition, given that the national debt will probably double from 2009 to 2012, it seems likely that investors will demand an increased risk premium for lending to the US. On the other hand, demand for Treasury Securities continues to remain strong: “Net long-term securities transactions showed total buying of $65.9 billion in long-term U.S. securities in December, after purchases of $85.1 billion the month before.” Many Central Banks continue to be net buyers.

In addition, there are some commentators that think the Fed will abet the US government in deflating the real value of its debt. Since the majority of US Treasury Securities are not inflation-protected, 15 years of high inflation (~5%) would be enough to decrease the real debt burden by half. Especially when you account for “contingent obligations,” this might be the only feasible way for the government to deal with its debt burden over the long-term. Then again, higher inflation would probably drive proportional increases in yield, such that the Treasury Department would have a tough time rolling over existing debt (let alone in issuing new debt) at reasonable interest rates.

The main variable in all of this is politics. Specifically, this budget is still only a proposal. The actual budget won’t be ratified for at least another six months, and only after tense negotiations with the Republican Party. (There is also the possibility that it won’t be passed at all, which is what happened with the fiscal 2011 budget). “House Majority Leader Eric Cantor, a Virginia Republican, said his party will propose ‘very bold’ changes to entitlements in their 2012 budget resolution.” Anything short of this wouldn’t dent the projected deficits and would push Social Security / Medicare closer towards the brink of insolvency.

In the end, the deficit merely represents business as usual for the US government. Barring a double-dip recession, it probably won’t be enough to seriously impact the Dollar’s status in the short-term as preeminent global reserve currency. However, that could start to change over the next decade, as the government either takes steps or does nothing to mitigate the looming entitlements crisis. At that time, the long-term viability of the Dollar (and the financial system as we know it) will become clear.

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Falling On Deaf Ears!

« The Storm Ahead? | Home

By Mike Conlon | February 17, 2011

At least that’s what appears to be going on here in the US, as yesterday’s PPI figures showed rising prices ahead of today’s all-important CPI report. Yet the minutes from the FOMC meeting told an entirely different story.

Bernanke and the Fed remain committed to the idea that either rising inflation is unimportant or that it is not taking place at all! So this is either a case of complete incompetence or intellectual dishonesty. Either way, the picture is not pretty.

Meanwhile, politicians in Washington are arguing over the proposed government budget yet no one is willing to tackle the major problems that affect the deficit so extend and pretend continues. Perhaps Bernanke and the Fed are aware of this so they continue to enable bad behavior rather than forcing politicians to make hard choices.

Today’s CPI report will show where inflation is “officially”, but I expect some sort of major disconnect that will leave the market scratching its head. Much like this month’s ubiquitous Non-Farm Payrolls report, I expect this figure to be an outlier.

I’ve been harping on the UK as of late and apparently someone over there has taken notice. Well not exactly, but the lone dissenter at the BOE came out and said that higher rates and a stronger Pound might actually be GOOD for the UK economy. Thus the Pound is slightly higher. Maybe Andrew Sentence is a closet reader of forex trading blog!

Lastly, it looks like news out of the Middle East is showing that unrest is spreading to various regimes, and a story yesterday about Iranian warships sent oil higher. There is still a good deal of event risk coming from that region of the world, and I’m not certain that the global financial markets are respecting the potential impact.

So markets are mostly flat this morning, waiting on the US CPI data which is expected to show inflation of 1.6%.

In the forex market:

Aussie (AUD): The Aussie is slightly higher this morning after stocks were higher in the Pac Rim markets. There is a slight bias toward risk-taking ahead of today’s CPI data.

Kiwi (NZD): The Kiwi is also higher slightly higher even though consumer confidence figures came in lower overnight. In addition, PPI inputs were higher but PPI outputs were lower which could suggest declining business margins. Industrial production figures were higher from last month. (Click chart to enlarge)

Loonie (CAD): The Loonie is trading mostly higher ahead of Canada’s CPI data which is due out tomorrow.

Euro (EUR): There hasn’t been a lot of news emanating from the euro zone lately which always makes me a bit cautious. The Euro is mostly lower as the current account deficit has increased from the previous reading. (Click chart to enlarge)

Pound (GBP): The Pound is mostly higher after comments from BOE policy-maker Sentence suggested a stronger Pound and higher rates was good for the UK economy. This is not a new stance, however, as he has been voting for rate hikes for some time.

Dollar (USD): I just had to wait this morning for the CPI report to see if what I suspected was right. Sure enough, the number is suspect. The headline came in exactly as expected, showing 1.6% headline inflation, yet the monthly figure increased by .4% vs. expectations of a .3% gain. It is now getting to the point where you can’t even rely on the data so it’s becoming almost a non-issue. Initial jobless claims came in at 410K, moving back to the “fours” after last week’s dip into the “threes”.

Yen (JPY): The Yen is showing a bit of strength this morning after a recent bout of weakness as safe haven demand has returned after yesterday’s FOMC report showed that the Fed isn’t going to change its stance any time soon.

The markets have had a muted response to the CPI data and its almost as if no one cares anymore. Jobless claims here in the US are also a non-issue, unless of course you are one of the 400+K people being laid off each week.

Government reports show that inflation is low, yet if you do anything today you know that is not the case. Trips to the grocery store or the gas station confirm what you already know. But it’s almost as if there is a magic vacuum that sucks those figures right out of the official reports so the Fed can continue to justify its easy money policy.

Confidence in government is an un-measurable metric in the economy, and my guess is that it is near an all-time low. The market reaction to today’s data confirms that. So I expect to see some range-bound action today.

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

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Australia to Lead the Way in 2011

The outlook for Europe and the U.S. remains mixed but on one thing all pundits can agree; 2011 will be Australia’s year. And even though the new year got off to an auspicious start with floods and other bouts of terrifying weather, Australia’s economy is well-positioned to continue to expand at an accelerated rate. In fact, the Reserve Bank of Australia (RBA) recently revised its 2011 growth forecast.

Noting that the recent floods and the expenses incurred in the aftermath will have a “material effect on the near-term profile of gross domestic product”, the RBA predicted that by June, the economy will be expanding at an elevated clip. The RBA now projects the economy to grow by 4.25 percent in 2011 from its estimate late last year calling for 3.75 growth. The RBA also notes it expects consumer prices to climb by 3 percent compared to its earlier estimate of 2.75 percent.

The revised outlook had an immediate impact on the Australia dollar as investors increased the odds of an interest rate increase. The current benchmark rate â€" known as the Official Cash Rate â€" is 4.75 percent and already far exceeds rates in western regions. The Official Cash Rate sets the interest financial institutions borrow money on the overnight market and a change in the cash rate has a trickle-down impact on retail rates. The extremely aggressive stance by the RBA is seen by the street as a strong hint that the Overnight Cash Rate will be pushed higher within the next few months.

Aussie Dollar Outlook

For 2010, the Australian dollar â€" with the exception of the Japanese yen â€" made significant gains against the major currencies. The outlook for 2011 calls for much of the same:

To understand the RBA’s reasoning, one need only consider the impact an expected increase in shipments of coal and iron ore to China will have on Australia’s exports. Even though China has made attempts to slow the pace of growth, its insatiable appetite for the resources its all-important heavy manufacturing sector relies upon will continue to expand. Australia is well-positioned from both a resources standpoint and geographically to benefit.

There is a dark cloud in what is otherwise a very sunny outlook; the higher Australian dollar adds to the cost of all exports and for markets unable to so easily absorb these extra costs, a decline in foreign sales is unavoidable. This has already become an issue in the manufacturing sector which has seen several months of declining sales.
 
Inflation is also a concern and while the RBA expects to contain expansion to within an acceptable rate, the prospect of further interest rate hikes is considered highly probable. In this age of low-yields in Europe and the United States, expect investor interest in Australia to spike even more in light of the RBA’s latest assessment.

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Hedging High Forex Uncertainty

In forex, everything is relative. That is no less the case for forex volatility, which is low relative to the spikes in 2008 (credit crisis) and 2010 (EU Sovereign debt crisis), but high relative to the preceding 5+ years of stability. On the one hand, volatility is approaching a two year low. On the other hand, analysts continue to warn of high volatility for the foreseeable future. Under these conditions, what are (currency) investors supposed to do?!

Despite the steady pickup in risk appetite in 2010, there remains a whole a host of forex risk factors. On the economic front, GDP growth remains anemic in western countries, unemployment is high, and consumer confidence is low. Budget deficits and national debts are rising, perhaps to the point that default by a major industrialized countries is inevitable. Emerging market countries seem to be ‘suffering’ from the opposite problem, whereby rapid growth, high commodities prices, and capital inflow has caused inflation to rise precipitously. Some Central Banks will be forced to hike interest rates, while others will try to maintain an easy monetary policy for as long as possible. Political crises flare-up without warning, the Euro risks breaking up, and inclement weather is wreaking havoc on food production.

As a result, most currency-market watchers expect 2011 to be a continuation of 2010. In other words, while we might be spared a major crisis, a generalized sense of uncertainty will continue to pervade forex. According to JP Morgan, “Implied volatility on options for major exchange rates averaged 12.34 percent this year, compared with an average of 10.6 percent since January 2000.”  The currency team of UBS predicts, “The divergence between the strength in emerging markets and the unusual levels of uncertainty in the world’s major economies will cause…super volatility,” whereby massive swings in exchange rates will become the norm.

In this environment, there are a number of things that currency traders should do. The first step is simply to be aware that volatility remains high, which means that wider-than-average fluctuations shouldn’t be a surprise. The next step is to decide whether you think that this volatility will remain at an elevated level for the near-term, or whether you expect it to continue declining. (It’s worth pointing out that volatility is not necessarily a perception of absolute risk, but investor perception of risk). The final step is deciding if/how you will tailor your trading strategy in response to changes in volatility.

In fact, you don’t necessarily need to limit your exposure to volatility. If you are a fundamental investor with a long-term approach, you may very well choose to write-off short-term fluctuations as noise. (Of course, if you are a short-term swing trader, you can’t afford to be quite so indifferent). In addition, if your primary interest is in another asset type, you may choose not to hedge any currency risk. Perhaps you believe that the base currency will continue appreciated and/or you relish the exposure to currency movements as an added benefit of asset price exposure. Along these lines, “During the planning stages of the UBS Emerging Markets Equity Income fund, UBS Global Asset Management considered offering investors a hedged share class. The team abandoned the idea when investors showed a preference for unhedged share classes.”

In addition, hedging currency risk is expensive, especially for exotic/illiquid currencies, and currencies characterized by above average volatility. Not to mention that currency hedges can still move against investors, resulting in heavy losses. Still, in 2010, “Corporations from the U.S., Japan and Europe increased the percentage of projected income protected against swings in exchange rates to a record,” which suggests that fear of adverse exchange rate movements still predominates.

Finally, there are those that want to construct second-order currency strategies based entirely on volatility. Using basic options techniques, such as spreads and straddles, it’s possible to profit from volatility (or lack thereof) regardless of which direction the underlying currencies move in. In fact, the CME Group recently introduced a new product series which seeks to perform this very function. Investors can already buy and sell futures based on short-term volatility in the EUR/USD, which will soon be replicated for all of the major currency pairs.

For those of you who like to keep it simple, it’s probably enough to monitor the JP Morgan G7 Currency Volatility Index, which is a good proxy for the risk associated with trading (major) currencies at any given time. When this index spikes, chances are the US Dollar and other safe haven currencies will follow suit.

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Where's The Love?

« Out Of Touch! | Home

By Mike Conlon | February 14, 2011

Happy Valentine’s Day!Though there was no love for me this morning as I had some computer issues which have prevented me from doing a video this morning. Apologies to my audience.

And today there is also no love for the Euro, which is trading lower across the board as Portugal reported that its economy shrank by .3% last quarter for the first time in almost a year as government spending declined and taxes were raised. Portugal is potentially the next shoe to drop in the European debt crisis as there is still no meaningful resolution in place. Adding to Euro declines was the industrial production figures, which showed a slight decline in December.

Tomorrow is a news-worthy day; as the Euro zone will be reporting GDP figures.

This is also a big weak for the Pound, as tomorrow will bring CPI data which is expected to show rising inflation of 4%, nearly twice the BOE target. This will be followed on Wednesday by the BOE Inflation Report and jobless claims numbers which will show if there is any sign of a slow-down.

Japan will also have its rate policy decision tomorrow after reporting that GDP shrank less than expected. There is no change expected for the rate decision.

So today is kind of light on news, with important data due out later in the week. Markets are flat to slightly higher, electing to pause a bit after the excitement of Egypt last week. Going forward, it will be interesting to see if there is any contagion from the events that spread to other areas in the Middle East, and what that does to risk themes and markets overall.

In the forex market:

Aussie (AUD): The Aussie is higher across the board as gains in home loans rose more than expected. This helped prompt some risk appetite as Asian stocks were higher overnight, also benefiting from better than expected GDP in Japan and higher expected CPI data from China.  Tomorrow is the release of the RBA board meeting minutes.

Kiwi (NZD): Unfortunately for the Kiwi, it is not benefiting from risk appetite but perhaps that is helping to mitigate losses as retail sales figures came in worse than expected, showing a decline of 1.1% vs. an expectation of a decline of .4%.

Loonie (CAD): The Loonie is trading mostly higher as oil is slightly higher to start the day. On Friday, CPI data will be released which will show if there is any inflation that might concern the BOC and cause a potential rate hike in the near future.

Euro (EUR): The Euro is lower across the board after industrial production figures came in slightly lower than expected, showing a decline of .1% vs. an expectation of no change. In addition, Portugal’s reported GDP decline as the market re-focusing on debt as Portuguese bond yields are starting to rise. With no solution in sight to the debt crisis, keep an eye on Portugal as potentially the next domino to fall. (Click chart to enlarge)

Pound (GBP): The Pound is mostly higher ahead of tomorrow’s CPI and home price data and Wednesday’s Inflation Report from the BOE. The Central Bank may be running out of time to do something about monetary policy if inflation continues to rise and any rise in jobless claims will be perceived as negative.

Dollar (USD): The Dollar is trading mostly lower, as recent strength due to Euro weakness and risk aversion from Egypt have abated slightly. There’s no news here in the US today, but Tuesday will show advance retail sales figures followed by CPI data on Thursday. Expect the inflation talk to heat up this week, but with no real fixes in sight.

Yen (JPY): The Yen is also mixed this morning as GDP in Japan contracted less than expected, showing a decline of 1.1% vs. an expectation of a 2% decline. While the Japanese rate policy decision is expected to produce no change tomorrow, a focus is now on Japanese fundamentals could induce further weakness despite any risk events. (Click chart to enlarge)

There will be no love lost this week when some of the inflation data gets reported. Higher prices are being seen around the globe and this was one of the initial catalysts of the uprising in Egypt. It is only a matter of time before outrage reaches “most established� economies as well.

The UK will be first to react, as inflation there is approaching 4% and the BOE has still not made any changes. Here in the US, we will most likely be told again that there is no inflation so the Fed can maintain low interest rates. While the usual supply and demand rhetoric will be used to explain away the problem, I can assure you that low interest rates here in the US are one of the major contributing factors to global inflation.

It is no secret that the US is trying to inflate away its debt, and will attempt to do so on the back of the consumer. So keep an eye on the CPI data, and whether or not there is any public backlash over rising prices.

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here! Don’t miss out on the world’s fastest growing market!

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Geithner Warns U.S. Debt to Hit Record

The U.S. has benefited from low-cost debt to rebuild the economy but the Treasury department issued a warning that the cost to service the debt will triple as interest rates rise. By 2016, it is expected that the interest cost alone to service the debt will reach 3.1 percent of Gross Domestic Product.

“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”

Source: Bloomberg

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Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates â€" and by much â€" may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation â€" rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

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Week in Review-Feb 11th

It was a tough week for the carry trader. The markets started out acquiring higher yields driven by solid global growth and seasonality in the carry and momentum strategies. By week’s end, the dollar is broadly firmer, as popular carry trades continue to correct lower. There is no obvious macro driver for that move.Thrown in the concerns about Egypt, the PBOC’s decision to fix USDCNY higher, cautious comments from RBA’s Stevens and a BOK leaving rates on hold are seemingly weighing on global sentiment. Let’s not forget the Euro-peripheries, Portugal is back on the radar. Below, we have some of the highlights of the week.

EUROPE

• Cold weather took a toll on German factory orders in Dec. Orders declined -3.4%, m/m, well south of the consensus forecast at -1.5%. However, this can be partly attributed to cold weather and also to a base effect from the very strong +5.2% gain reported in Nov.

• German IP came in weaker than expected at -1.5%, m/m in Dec. vs. +0.2% consensus forecast (-0.6% in Nov.). Again, the weakness can be attributed to exceptionally cold weather. In the 4th Q combined, IP still rose a solid +0.8%, q/q.

• Bundesbank President Weber will drop out of the race to succeed ECB President Trichet in October. Weber was considered the front-runner, and his departure throws the field wide open. Weber is considered a hawk.

• The UK trade deficit reached a new record high in Dec., with the deficit increasing to £9.2b (vs £8.6b expected). However, again, cold weather is to be blamed. On the positive side, last month’s trade balance was revised to £8.4b from £8.7b.

• UK industrial production for Dec. came in line with expectations. IP advanced +0.5%, m/m, after a +0.6% print in Nov. (revised up from +0.4%). The result is respectable considering the weakness in services and construction due to cold weather, but the growth was concentrated in the utilities sector. Manufacturing production declined -0.1%. The BOE left rates unchanged as expected (+0.5%). The market is pricing in a hike as early as May.

• Swiss CPI fell -0.4%, m/m in Jan. despite a Jan VAT hike. As a result, headline inflation fell to +0.3%, y/y from +0.5%, y/y in Dec., much weaker than the consensus forecast of +0.6%, y/y.

Americas

• Canadian monthly building permits rose in Dec. +2.4% vs. market expectation of +2%. It was the first in permits in three-months following a -10.5% decline in Dec and a -6.2% decline in Oct.

• Treasury’s $24b 10-year auction drew the most demand on record from a class of investors that includes central banks. Indirect bidders bought 71.3% of the notes, compared with 53.6% last month and an average of 46.4% for the past 10 sales.

• Bernanke kept to ‘his’ script and doused the hawkish comments of his colleagues, Lacker and Fischer who implied earlier this week that the Fed was nearing a change in course with QE2. Yesterday’s statement indicates that helicopter Ben has a strong hold on the FOMC despite the ‘undercurrents of discontent’. He stated that inflation was a problem overseas and not an issue in the US and believes that commodity prices will not undo a benign inflation environment. In translation, QE2 will run its course.

• US weekly claims fell south of +400k. It managed to print a 30-month low (+383k vs. +419k) and extended its declines for a second consecutive week. Over the recent months initial jobless claims have been volatile, alternating between flirting with the +400k mark and adding +40-50k to those levels.

• Federal Reserve Governor Kevin Warsh, who was one of Chairman Ben S. Bernanke´s closest financial-crisis advisers before becoming the only governor to question the expansion of record monetary stimulus in Nov., resigned after five years at the central bank. It should allow Obama to appoint another dove to the Board.

• The dollar value of the US trade deficit came in line with expectations, widening to -$40.6b in Dec. from -$38.3b in the prior month. The underlying details were broadly stronger, with petroleum accounting for most of the widening.

• Prelim UoM Consumer Sentiment advanced to 75.1 an eight-month high, a sign falling US unemployment and rising equity prices may be comforting consumers.

• Canada posted its first trade surplus in 10-months in Dec., as energy and metals powered the biggest jump in exports in three-decades (+$3b vs. -$0.4b). The surplus with the US now sits at +$5.1b (the widest in two years). It seems that exports are holding up well to CAD appreciation thus far.

ASIA

• Australian retail sales disappointed, advancing +0.2% over Christmas, after a revised +0.4% gain in Nov. The market had been expecting a +0.5% increase. Higher market interest rates was likely the main reason why consumers tightened their purse strings.

• The Chinese central bank (PBOC) hiked its deposit and lending rates by +25bp, in response to prescient inflationary pressures. Analyst’s believe their tightening will be front-loaded in order to quickly normalize policy. The market projects another +160bp of hikes in the one-year lending rate to +7.66% and another +175bp in the one-year lending rate to +4.75% by the end of 2011. This was only the second policy rate hike in this cycle, with PBOC preferring to hike commercial banks’ reserve requirement ratio (RRR) instead.

• China has joined India, Indonesia, Thailand and South Korea in boosting interest rates this year as Asian policy makers seek to cool the economies leading a global rebound.

• New Zealand Finance Minister English said that GDP may have contracted in the 4th Q as a result of higher-than-expected savings rates and weaker-than-expected consumption and housing market (release date is Mar. 24th). This should leave us with a more dovish RBNZ profile until at least the middle of this year. A stall in the economy should keep interest rate spreads moving against the NZD.

• The Aussie has reacted negatively to the mixed employment data, forcing the liquidation of the weak long carry trades who have been influenced by the market pricing for RBA rate hikes over the next 12-months dropping. Total employment rose +24k in Jan., higher than the +17.5k expected, but part-time employment (+32K) accounted for the rise, with full-time employment down-8k.The unemployment rate was unchanged at +5.0 %

• RBA Governor Stevens in his testimony to parliament that market pricing of no rate hikes until late this year was reasonable and that the RBA is ahead of ‘the game’ and can afford to stay on hold for the time being. Market pricing for rate hikes over the next 12-months fell 4bp to +34bp.

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Sterling Falls as Rate Hike Appears Less Likely

Sterling fell 0.7 percent to $1.5984 in early afternoon trading in London today following the Bank of England’s decision to hold interest rates at the current level. Opinion is swiftly moving to the view that there will not be an interest rate hike in the near-term and especially once the impact of the government’s planned spending cuts takes effect.

“The argument for a much stronger pound is not a good one based on current rates policy,” said Steve Barrow, the London- based head of research for Group-of-10 currencies at Standard Bank Plc. “At the moment the economy is still sufficiently vulnerable for inflation to come down. On that basis, one would tend to favor a scenario where rates only go up towards the back end of the year.”

Source: Bloomberg

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Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates â€" and by much â€" may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation â€" rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

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Out Of Touch!

« The Wait For Rates! | Home

By Mike Conlon | February 11, 2011

At least those are the claims of the opponents of Egyptian President Mubarak, who yesterday pulled a head-fake and defiantly is staying on as President. It had been reported that he was going to resign prior to his speech, but that clearly wasn’t the case. Now there is increased instability in the region as the protests have gotten bigger and the uncertainty of outcome has caused a flight to safety ahead of the weekend.

While this is obviously the major global story today, we also got some price data from different regions around the globe which are supportive of rising inflation.

In New Zealand, they are seeing biflation where the price of food has gone up and home prices have gone down. This is going to be a major theme going forward as asset bubbles (housing particularly) are bound to pop at some point. Because of the cheap flow of money around the globe, demand for housing pushed prices to levels could be deemed excessive.

In the Euro zone, German PPI data came in mostly as expected but UK PPI data came in much higher than expected. Luckily for the BOE, they made their rate decision yesterday so they bought themselves some more time to let inflation creep into the economy.

So this morning is marked by risk aversion in the currency market with Dollar and commodity strength, and equities weakness.

In the forex market:

Aussie (AUD): The Aussie is lower and has fallen under parity with USD as risk aversion has increased in the market. It should also be noted that RBA chief Stevens came out and said that leaving rates unchanged was “sensible” and that the RBA was “ahead of the curve”.

Kiwi (NZD): The Kiwi is also lower on risk themes with the added weight of biflation weighing on the economy. Home prices decreased 2.6% and food prices increased 1.8%, highlighting the dilemma that the global economy is facing. (Click chart to enlarge)

Loonie (CAD): With no news on tap, the Loonie is also susceptible to risk aversion though faring better than other currencies as higher oil prices due to Egypt have mitigated the selling.

Euro (EUR): The Euro is mostly lower on anti-Dollar sentiment as safe haven seeking is taking place. PPI data in Germany came in as expected which shows that they have a good handle on pricesâ€"for now.

Pound (GBP): The Pound is lower across the board after yesterday’s rate policy meeting left rates unchanged which helped the Pound move higher, only to fall back to lower depths after PPI data confirmed what the market already knows: that inflation is prevalent in the UK and that the BOE may be on an economic collision course with the government over the economic climate. (Click chart to enlarge)

Dollar (USD): The Dollar is putting in 3-week highs as risk aversion has induced a flight to safety and demand for the greenback. Yesterday’s initial jobless claims finally posted a 3-handle, meaning that only 383K people officially lost jobs last week vs. the expectation of the usual 410K. I find it amazing that the same media that blamed bad weather for the lousy Non-Farm Payrolls report completely discounted it in the analysis of the jobless claims. I expect this number to be revised higher. Later this morning, consumer confidence figures are due out.

Yen (JPY): The Yen is finally showing some strength but not nearly what would be expected under risk aversion scenarios. This highlights the fundamental weakness of the Japanese economy and could mean major weakness in the ensuing months.

The situation is Egypt is a microcosm for what is going on around the globe. Food and energy prices are rising, but economies are lagging. High unemployment and falling housing prices are dragging on various economies and this situation is highlighted by the turmoil.

The irony of Egypt is as the unrest and uncertainty continue, the higher both food and energy prices are likely to go! Instability in Egypt could set off a domino effect around the Middle East which topples governments and causes oil prices to rise. Add this too the already incredibly cheap money that is flowing around the globe and this is an inflation powder-keg ready to explode!

So I expect to see some more selling today as traders won’t want to carry the risk over the weekend, and I’d advise you to do the same.

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here! Don’t miss out on the world’s fastest growing market!

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Spin Doctors!

« Chinese Fireworks? | Home

By Mike Conlon | February 9, 2011

At least that’s what is going on this morning as there is little economic data due out that would sway markets in one direction or another. We have been hearing from various Fed officials recently and today the head honcho Bernanke will be out there trying to sell his version of economic reality.

This is not exclusive to the US as overnight the Finance Minister in New Zealand pulled out the “recession card” claiming the country could fall into one in the second half of the year. Talk about not pulling any punches! While it is true that normal economic drivers of growth are not present yet, this blatant attempt to lower the value of the Kiwi has not gone unnoticed.

In the Euro zone, a speech later today from the head of the EFSF (emergency bailout fund) could produce some market activity.

And the countdown to the BOE rate policy decision begins as tomorrow will show whether or not the Central Bank is serious about attempting to control inflation or whether they are content to allow the reduction in government spending to hopefully quell demand.

So stocks markets are lower to start the day, perhaps feeling some residual effect from the Chinese rate hike yesterday.

In the forex market:

Aussie (AUD): The Aussie is lower despite rising consumer confidence figures as risk aversion is starting to increase. Tomorrow is the Australian employment report which will show how the economy is faring. The market may be more concerned with the Chinese rate hike than it let on yesterday.

Kiwi (NZD): The Kiwi is lower after the Finance Minister said it was possible that New Zealand could slip into recession in the second half of the year. The MSCI Pacific stock index was lower, helping take the Kiwi lower. (Click chart to enlarge)

Loonie (CAD): The Loonie is mixed as higher oil prices and increased money flows from the Kiwi and Aussie offset general risk aversion in the market. There is no economic data to speak of for Canada due out this week.

Euro (EUR): It’s also quiet in the Euro zone as German exports decreased last month 2.3% vs. an expectation of a gain of .8%. The head of the EFSF will speak later today and I can’t imagine a scenario where this provides positive sentiment.

Pound (GBP): The Pound is mostly higher after the BRC Shop Index showed prices increased 2.5% lending further credence to the inflation proposition. The UK current account deficit came higher than expected, and a higher-valued Pound would not help correct this situation. Tomorrow’s rate decision couldn’t be more important.  (Click chart to enlarge)

Dollar (USD): The Dollar is benefiting from risk aversion this morning and with no news on the docket it will be up to Fed Chairman Bernanke to light the proverbial fuse.

Yen (JPY): The Yen is mostly weaker despite the mild risk aversion in the market as the Chinese rate hike does indeed affect Japan as well. The focus has shifted toward Europe and the US as worries over the Japanese fundamentals still persist.

Trading days like today can sometimes be difficult as the market hangs on every word of the “spin doctor” who is speaking. One never knows what will set off the market or when a proverbial bomb could drop sending the markets into a tailspin.

Generally speaking, these officials know better than to disrupt the markets with anything deemed overly positive or negative. But unfortunately this type of rhetoric has become accepted as a policy tool designed to affect a currency’s value.

Look no further than New Zealand for proof of that. As irresponsible as it may seem, that is the nature of the beast. These speeches can sometimes provide major volatility to the markets, which is welcomed by those who know how to trade, but feared by those who don’t.

Which type of trader are you?

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here! Don’t miss out on the world’s fastest growing market!

Tags: account, AUD, Aussie, blog, cad, course, currenc, currency, currency trading, dollar, dow, economy, Euro, forex, forextrading, free, fx, fxedu, gbp, Il, jpy, market, Mike Conlon, nzd, practice, ssi, time, trade, USD, Yen

Topics: What To Look At In The Market |

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Investors Return to Yen-Based Carry Trade

With Japan’s benchmark interest rate holding steady at 0.1 percent for over two years now, investors in Japan are turning to foreign investments in the search for better yields. Investors outside Japan are also entering into carry trades selling the yen in order to buy other, higher-yielding currencies.

“The prospect of any rate rise in Japan is so far away that at some point over the next year it will return as a funding currency,” noted Greg Gibbs, a currency strategist at RBS Australia in Sydney.

Source: Bloomberg

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CFTC / NFA Enhance Regulation of Forex

In 2010, the US Commodity Future Trading Commission (CFTC) formally released a series of new regulations governing all retail foreign exchange dealers. Having given all applicable firms almost six months to bring their operations up to speed with the new regulations, the CFTC is now moving to bring enforcement actions against those that are still not in compliance.

Among other things, the regulations required all retail forex broker-dealers to register accordingly with the National Futures Association (NFA), and for firms that “solicit orders, exercise discretionary trading authority or operate pools with respect to retail forex” to register as introducing brokers. Out of curiosity, I scoured the NFA Background Affiliation Status Information Center (BASIC) to see if/how forex brokers have registered themselves.

As you can see from the table above, there are approximately [I would be grateful if you could inform me of any known omissions!] 28 registered forex firms. However, only 12 of these firms are registered as retail foreign exchange dealers (RFED), and the CFTC recommends that (US) retail forex traders that manage their own accounts should deal with these firms exclusively.

Unfortunately, many firms continue to advertise that themselves as forex brokers when they aren’t registered as such, or even worse, aren’t registered at all. As a result, the CFTC recently filed simultaneous enforcement actions against 14 forex firms, alleging that, “In all but two of the complaints…a defendant acted as an RFED; that is, it offered to take or took the opposite side of a customer’s forex transaction without being registered. In the remaining two complaints, ZtradeFX LLC and FXPRICE, the CFTC alleges that the defendant solicited customers to place forex trades at an RFED without being registered as an Introducing Broker.” The following companies stand accused:

To be a fair, NFA membership doesn’t necessarily imply compliance with NFA regulations, nor does it even guarantee upright behavior. In fact, the NFA is currently scrutinizing all of its member firms “for any signs they are designing computer systems to take advantage of what is known in the industry as ‘slippage,’ or small price movements that happen between the time a customer orders a trade and when that trade is actually executed.” In October, the NFA settled two such cases with IKON FX and Gain Capital, assessing a combined $800,000 in fines. Let’s hope that this isn’t the real explanation for the fact that forex trading is vastly more profitable for brokerages than other types of retail securities trading.

While the NFA hasn’t indicated that this is the case, the current retail forex MO (whereby brokers also act as market-makers) could be under attack. As one advocate for traders told the WSJ, “If a foreign-exchange firm is acting as a market-maker, or taking the other side of a client’s trades, it is doubtful the investor is getting the best possible price.” The problem is at the moment, the industry remains far from transparent, and if not for the NFA investigations, traders probably wouldn’t be able to establish whether their broker(s) acted unscrupulously.

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Has the Swiss Franc Reached its Limit?

The second half of 2010 witnessed a 20% rise in the Swiss Franc (against the US Dollar), which experienced an upswing more closely associated with equities than with currencies. It has managed to entrench itself well above parity with the Dollar, and has become a favored destination for investors looking for a safer alternative to the Euro. Still, there are reasons to wary, and it could be only a matter of time before the CHF bull market comes to a screeching halt.

The forces behind the Franc’s rise are easily identifiable. It basically comes down to risk aversion. While it can’t compete with the Dollar and Yen â€" its main safe haven rivals â€" in size and liquidity, it benefits from its perceived economic and fiscal stability, as well as through contradistinction with the surrounding Eurozone. In fact, the Franc’s rise against the Euro has been even steeper than its rise against the Dollar. As the Eurozone crisis radiates further away from Greece, Switzerland has come to seem more like an island in a sea of chaos.

Even an abatement in the EU storm has failed to produce a Swiss Franc correction. That could be because the bad news coming out of Europe seems to be never-ending; one country’s rescue is followed by the downgrade of another country’s sovereign credit rating and warning of imminent collapse. In addition, even as investors have embraced risk-taking, they still remain prone to sudden backtracking. Thus, the Franc has been one of the primary targets of risk-averse capital fleeing the Egyptian political turmoil.

Capital controls and intervention have scared investors away from some currencies, but the Swiss National Bank (SNB) lacks the credibility afforded to other Central Banks. The SNB lost $25 Billion in 2010 in a vain effort to hold down the Franc, and currency investors believe that it has neither the stomach nor the mandate to engage in a similar loss-making campaign in 2011. Besides, the Swiss economy has held up remarkably well, and the trade surplus has actually widened in the face of currency appreciation. The markets might be keen to test the limits of the Swiss export sector, in much the same way that they have challenged Japan by pushing up the Yen.

Still, their are limits to high the Franc can rise, and it appears that I’m no longer the only analyst who thinks it’s undervalued. Don’t forget- the Swiss economy is comparatively minuscule. Its capital markets can absorb only a small fraction of the inflows that the US and Japan can handle, and the Swiss Franc represents a mere 3.5% of all foreign exchange volume, 12 times less than the US Dollar’s share. In other words, it’s only a matter of time before investors run out of Swiss assets to buy, at which point they will have to decide whether to accept short-term returns of 0% in exchange for capital preservation and financial security. My bet is that they’ll walk.

Of course in the short-term, it’s possible that a handful of risk-averse investors will continue to steer capital towards Switzerland, and/or that another mini political or economic crisis will trigger a spike in risk-aversion. When investors once again look at fundamentals, they will be forced to reckon with the Franc’s 40% appreciation over the last five years, and probably conclude that perhaps it was a bit much…

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