Transparency But Not Truth!

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By Mike Conlon | April 26, 2011

Tomorrow will the be the first of the new, transparent Fed where Bernanke will attempt to get out in front of the population and attempt to get people to suspend their disbelief. While the Fed Chairman is clearly on the wrong side of public opinion with QE2 and the inflation it has caused, trying to convince people that what they are feeling in the economy is wrong just won’t work.

The reason is because there will be no truth to go along with the transparency. It will be very difficult to sway public opinion that there is no inflation when people see it in their daily lives. The debate over which metric of CPI to use to see the true effects of policy have left people with a lack of confidence in those in power. How this speech tomorrow will change this sentiment is anyone’s guess.

So in my opinion this will all amount to much ado about nothing, with the markets hanging on every word spoken, though I don’t think we will learn anything new.

Europe is open again after yesterday’s holiday and European stocks are higher as are US equity futures to start the day. Asian stocks were lower as are commodities, though today can’t be classified as either a risk-taking or risk-averting day.

In the forex market:

Aussie (AUD): The Aussie is higher as interest rate differentials and carry trades are driving market sentiment despite mild risk taking in the marketplace. An index of leading indicators came in higher than expected.

Kiwi (NZD): The Kiwi is the biggest gainer this morning ahead of tomorrow’s rate policy decision as maybe the market is sensing that the RBNZ could turn hawkish again. While the current expectation is the rates will be left unchanged, the added benefit of Dollar weakness has been driving price action.

Loonie (CAD): The Loonie is also mostly higher despite oil prices pulling back to just above $112. Friday’s GDP report will give more clarity into the Canadian economic situation.

Euro (EUR): The Euro is mixed this morning as both Dollar and Yen are weaker, though reports about a possible Greek debt restructuring have left the market un-phased. CPI data due out tomorrow is expected to show higher inflation.

Pound (GBP): The Pound is lower across the board ahead of tomorrow’s GDP report. CBI business optimism figures came in slightly lower than expected, and perhaps the distraction of the Royal wedding later this week has left the markets unimpressed with the Pound. (Click chart to enlarge)

Dollar (USD): The Dollar is weaker across the board ahead of tomorrow’s Fed meetings. There is increased speculation that the Fed will somehow try to continue to support the economy even though QE2 is expected to end in June. Consumer confidence figures are due out later this morning.

Yen (JPY): The Yen is also lower as the expectation of continued weak monetary policy has pushed traders toward higher yielding currencies. Retail sales figures are expected to show big declines later this evening, ahead of Thursday’s rate decision.

While I expect little in the way of learning something new tomorrow from the Fed, there is always the possibility of a surprise. However, the Fed has been pretty clear about its stance and its denials of inflation so I highly doubt that will change anytime soon.

But the market may be more concerned with how the Fed plans to exit QE2 and what that will do to the economy. What is clear is that the Fed needs to pick up the slack for the inaction occurring on the fiscal side of the equation, with politicians in Washington unable to work together.

Don’t expect to walk away from this new Fed format tomorrow with a warm and fuzzy feeling about the direction the US is going, and continue to be cautious. While there is always major volatility surrounding the FOMC meetings, I could see tomorrow turning out to be one big dud.

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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Greek Debt Higher Than Expected

Greece’s deficit for 2010 was a higher-than-expected 10.5 percent for 2010 surpassing the projected 9.4 percent shortfall by more than a full percentage point. The news sent Greek bond yields higher and drew fresh comments suggesting Greece will require further assistance to avoid insolvency.

“I don’t think that Greece will succeed in this consolidation strategy without any restructuring in the future, or perhaps also in the near future,” Lars Feld, a member of the German government’s council of economic advisers, told Bloomberg Television’s Nicole Itano in Frankfurt. “Greece should restructure sooner than later.”

Source: Bloomberg

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Economic Theory Implies Canadian Dollar will Fall

Sometimes I wonder if I’m living in the clouds. All of my recent reports on the Canadian dollar were twinged with pessimism, and I argued that it would only be a matter of time before reality caught up with theory. While the continued surge in commodities prices has confounded everyone’s expectations, but other economic trends continue to work against Canada. In other words, I think that there is still a strong argument to be made for shorting the loonie.

To be sure, the rally in commodities prices has been incredible- nearly 50% in less than a year! Oil prices are surging, gold prices just touched a record high, and a string of natural disasters have driven prices for agricultural staples to stratospheric levels. Given the perception of the Canadian dollar as a commodity currency, then, it’s no wonder that rising commodity prices have translated into a stronger currency.

As I’ve argued previously, rising commodities prices are basically an irrelevant â€" or even distracting â€" factor when it comes to analyzing the loonie. That’s because, contrary to popular belief, commodities represent an almost negligible component of Canada’s economy. Canadian exports, of which commodities probably account for half, have recovered from the recession lows of 2009. On the other hand, the value of Canadian exports are basically the same as they were 10 years ago, when one US dollar could be exchanged for 1.5 Canadian dollars.

Consider also that Canada now imports more than it exports, and that the Canadian balance of trade recently dipped into deficit for the first time since records started being kept 40 years ago. Its current account has similarly plunged, as Canadians have had to finance this through loans and investment capital from abroad. Based on the expenditure approach to GDP, trade actually detracts from Canadian GDP. Any way you perform the calculations, commodities are hardly the backbone of its economy, account for about 15% at most.

As if that weren’t enough, the press is full of stories of Canadians that think their own currency is overvalued. Businesses complain that they can’t compete, and that banks won’t lend them the money they need to upgrade their facilities and become more efficient. Meanwhile consumers whine about higher prices in Canada, compared to the US. I think it’s very telling that their is now a 2-hour wait to cross the border from Vancouver, and shopping malls on the American side have reported a huge jump in business. Even the famous Big Mac Index shows that the price of a hamburger was already 12% higher in Canada back when the loonie was still hovering around parity with the US Dollar.

One area that higher commodities prices will be felt is inflation, which is nearing a two-year high and rising. At 3.3%, Canada’s CPI rate is now higher than in the EU. Given that the European Central Bank hiked rates earlier this month, it probably won’t be long before the Bank of Canada follows suit. In fact, forecasters expect the benchmark rate to rise by 50-75 basis points by the end of the year, from the current 1%.

This might excite carry traders, but probably few others. Besides, given that other central banks will probably raise rates concurrently, it can’t be assumed that carry traders will automatically gravitate towards the Canadian dollar. Not to mention that as I pointed out in my previous post, the carry trade is hardly a risk-free proposition. In this case, an interest rate differential of only 1-2% probably isn’t enough to compensate for the risk of a correction in the USD/CAD.

And that is exactly what I expect will happen. The fact that the loonie has shattered even the most optimistic forecasts is not cause for bullishness, but rather for concern. According to the most recent Commitment of Traders report, net long positions are reaching extreme levels, and it’s probably only a matter of time before the loonie returns to earth.

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Good Friday!

« Dollar Limbo! | Home

By Mike Conlon | April 22, 2011

But not good for forex trading!  Central banks are closed around the globe so liquidity is absent from the market.

I would avoid trading today even though the forex market is open, unless you want to line your broker’s pocket!

Happy Easter to those who celebrate it! 

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Forex Week in Review: April 16-21

It was a compact volatile trading week with the dollar hemorrhaging against all of its G10 trading partners and that includes Japan. With rate divergence influencing trade positions, this dollar bear market potentially still has ways to go. Some of the market moves have been exaggerated because of the lack of holiday liquidity, but, the dollars intention remains the same, and that is to underperform. The last dollar bear market between 1985 and 95 implies that the buck has ‘approximately-2% further to fall to match its depreciation at the same point in the bear cycle’.

EUROPE

• Greek government denies press reports on restructuring.
• Finnish elections saw an unexpectedly strong showing for the anti-EU True Finns party. The result could complicate negotiations over an EFSF package for Portugal and the mechanism for enlarging the EFSF.
• Spain successfully auctioned their bills, but at a lower bid-to-cover than at the previous auction.
• Euro-zone flash PMI’s surprised to the upside (57.7 vs. 57.5), showing little negative impact from the Japanese earthquake or higher oil prices.
• German PMI manufacturing on hold at record highs (61.7).
• Euro-zone services PMI moderated slightly from 57.2 in March to 56.9 in April, held down by a lower German print. The surveys continue to be consistent with very strong GDP growth at around 3% and supports expectations of additional ECB tightening, while at the same time reducing the expected impact of fiscal stress in the periphery.
• Finnish Prime Minister-elect backs Portuguese EFSF, but suggested that the Portuguese program may require some changes to secure Finnish approval.
• Riksbank hiked +25bp to +1.75% and revised CPI forecast higher.
• Spain sold €2.4b of 2021 bonds and €885.2m of 2024 paper to strong demand, supporting market expectations of the sovereign’s ability to weather its maturity schedule without resorting to EFSF funding.
• BoE April Minutes showed an unchanged voting pattern. Six members voted for leaving rates unchanged and three members voted for a rate hike. The sentence, indicating that some members from the dovish camp saw the case for rate hikes strengthening has been removed.
• Greek inverted 2/10’s yield curve spread reaches fresh extremes-1,244bp
• A soft German Ifo print for April (110.4 vs. 111.1). The level continues to point to very solid growth.
• UK Retail sales surprised to the upside with a +0.2%, m/m, gain in March (ex-petrol). In real terms, sales are flat on the quarter and rising only +1.0%, q/q in nominal terms due to the VAT hike in January. No real reason to hike rates any time soon.
• M3 and mortgage growth remained steady in Switzerland. M3 growth moderated slightly to +7.1%, y/y, while mortgages grew at +4.5%, y/y. This is should not impose any pressure on the SNB to consider policy tightening.

Americas

• S&P cut the US long-term credit outlook. “The US government risks losing its AAA credit rating unless policy makers agree on a plan by 2013 to reduce budget deficits and the national debt”.
• March US headline housing starts (+7.2% or 0.55m) bounced back from February’s very low levels (-18.5%), but the details suggests the US housing sector remains very weak. Building permits have climbed +11.2%, m/m, to an annual rate of +594k. However, year-over-year, overall new home construction was down -13.4%.
• Canadian inflation data beat all analysts expectations, marking the biggest monthly headline gain in 20-years (+1.1% vs. +0.3%) and the largest annual advance in nearly three-years (+3.3%). It puts the Governor on the back foot to hike in July.
• Canadian leading index rose faster than expected last month (+0.8% vs. +0.5%), it’s sixth consecutive gain, led by increases in the stock market (+2.2%) and housing index (+2.2%).
• US Sales of existing homes rose slightly last month (+3.7% to a seasonally adjusted +5.10m), but prices remain weak. The median sales price for an existing home was $159k, down -5.9% from the revised year-ago median.
• Canadian retail sales posted its first positive print in both nominal and real terms in February, providing a lift to February GDP growth. Headline retail sales rose at a slightly slower pace than expected in February, up 0.4% m/m versus expectations of a 0.5% m/m gain, while core sales accelerated by 0.7% m/m as auto sales dipped for a third consecutive month.
• US initial jobless claims fell less than expected last week, remaining above 400,000 for the second consecutive week. Both the extended benefits and emergency unemployment compensation benefits experienced declines.
• Philly Fed’s Business Outlook Survey plunged from +43.4 to +18.5

ASIA

• PBoC hikes reserve requirements another +50bp, for a cumulative +450bp of hikes since the cycle began. Market now expects the PBoC to hike the RRR another +150-250bp and the lending/deposit rates a further +135bp/150bp.
• NZD has sold off after proving resilient to last week’s carry-trade correction, the catalyst being weaker-than-expected CPI inflation of +0.8%.
• PBoC governor Zhou stated that China’s central bank FX reserves, which rose about +$200b into +$3trn in the first quarter, had exceeded a reasonable level and may have led to excessive liquidity and had exerted significant sterilization pressure.
• It’s rumored that the Aussie government is considering tax breaks on foreign sovereign investments in Australia, a good enough reason to want to own the highest yield G10 currency.
• Australia witnessed a stronger terms-of-trade, where export prices rose +5.2% and import prices rose +1.4%, q/q, pushing the terms-of-trade close to their 2008 and 2010 highs. This will give the RBA a good enough reason to want to raise interest rates (+4.75%).

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Icelandic Kronur: Lessons from a Failed Carry Trade

A little more than two years ago, the Icelandic Kronur was one of the hottest currencies in the world. Thanks to a benchmark interest rate of 18%, the Kronur had particular appeal for carry traders, who worried not about the inherent risks of such a strategy. Shortly thereafter, the Kronur (as well as Iceland’s economy and banking sector) came crashing down, and many traders were wiped out. Now that a couple of years have passed, it’s probably worth reflecting on this turn of events.

At its peak, nominal GDP was a relatively modest $20 Billion, sandwiched between Nepal and Turkmenistan in the global GDP rankings. Its population is only 300,000, its current account has been mired in persistent deficit, and its Central Bank boasts a mere $8 Billion in foreign exchange reserves. That being the case, why did investors flock to Iceland and not Turkmenistan?

The short answer to that question is interest rates. As I said, Iceland’s benchmark interest rate exceeded 18% at its peak. There are plenty of countries that offered similarly high interest rates, but Iceland was somehow perceived as being more stable. While it didn’t apply to join the European Union (its application is still pending) until last year, Iceland has always benefited from its association with Europe in general, and Scandinavia in particular. Thanks to per capita GDP of $38,000 per person, its reputation as a stable, advanced economy was not unwarranted.

On the other hand, Iceland has always struggled with high inflation, which means its interest rates were never very high in real terms. In addition, the deregulation of its financial sector opened the door for its banks to take huge risks with deposits. Basically, depositors â€" many from outside the country â€" parked their savings in Icelandic banks, which turned around and invested the money in high-yield / high-risk ventures. When the credit crisis struck, its banks were quickly wiped out, and the government chose not to follow in the footsteps of other governments and bail them out.

Moreover, it doesn’t look like Iceland will regain its luster any time soon. Its economy has shrunk by 40% over the last two years, and one prominent economist has estimated that it will take 7-10 years for it to fully recover. Unemployment and inflation remain high even though interest rates have been cut to 4.25% â€" a record low. The Kronur has lost 50% of its value against the Dollar and the Euro, the stock market has been decimated, and the recent decision to not remunerate Dutch and British insurance companies that lost money in Iceland’s crash will only serve to further spook foreign investors. In short, while the Kronur will probably recover some of its value over the next few years (aided by the possibility of joining the Euro), it probably won’t find itself on the radar screens of carry traders anytime soon.

In hindsight, Iceland’s economy was an accident waiting to happen, and the global financial crisis only magnified the problem. With Iceland â€" as well as a dozen other currencies and securities â€" investors believed they had found the proverbial free lunch. After all, where else could you earn an 18% by putting money in a savings account? Never mind that inflation was just as high; with the Kronur rising, carry traders felt assured that they would make a tidy profit on any funds deposited in Iceland.

The collapse of the Kronur, however, has shown us that the carry trade is anything but risk-free. In fact, 18% is more than what lenders to Greece and Ireland can expect to earn, which means that it is ultimately a very risky investment. In this case, the 18% that was being paid to depositors were generated by making very risky investments. As the negotiations with the insurance companies have revealed, depositors had nothing protecting them from bank failure, which is ultimately what happened.
Now that the carry trade is making a comeback, it’s probably a good time to take a step back and re-assess the risks of such a strategy. Even if Iceland proves to be an extreme case â€" since most countries won’t let their banks fail â€" traders must still acknowledge the possibility of massive currency depreciation. In other words, even if the deposits themselves are guaranteed, there is an ever-present risk that converting that deposit back into one’s home currency will result in losses. That’s especially true for a currency that is as illiquid as the Kronur (so illiquid that it took me a while to even find a reliable quote!), and is susceptible to liquidity crunches and short squeezes.

When you enter into a carry trade, understand that a spike in volatility could wipe out all of your profits in one session. The only way to minimize your risk is to hedge your exposure.

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A Familiar Game!

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By Mike Conlon | April 18, 2011

The markets are starting the week lower as risk aversion is dominating the action in this holiday-shortened week. In what has become a familiar scene, oil is trading lower as it gets bid up on Friday’s as market participants do not want to go short over the weekend as the risk in the Arab countries is still present.

Adding to risk sentiment are the usual Euro debt crisis rumors, which propose that rate hikes are going to cause Greece and Ireland to default. While this has to be a concern for the ECB, I’m surprised that more clarity isn’t being proffered. Perhaps some Euro weakness in the face of rising rates would be just what the ECB is hoping will happen.

In an attempt to slow down inflation, China raised the reserve requirements for banks again which is intended to curb lending.

Overnight, New Zealand reported CPI data that showed that inflation increased slightly less than expected. In the UK, asking prices for homes came in higher as lack of supply and overall inflation contribute to seller confidence. I guess it doesn’t hurt that London has become the “preferred destination” of former Arab dictators so the market could remain strong for some time.

It will be interesting to see if the US market can shake off the lower start and turn it around by the end of the day. Recently, the US market has seemed immune to negative news and keeps going higher, as Bernanke’s dollar destruction leaves traders few other alternatives.

In the forex market:

Aussie (AUD): The Aussie is mostly lower on risk aversion, but is faring better than the other commodity currencies due largely to its interest rate differential. The minutes from the RBA rate policy meeting are due out tomorrow, which I expect to have a dovish tone as a result of the recent run-up.

Kiwi (NZD): The Kiwi is lower across the board as CPI data came in lower than expected, perhaps dampening hopes of a rate hike any time soon. CPI showed a quarterly increase of .8%, pushing the YoY number to 4.5%, vs. expectations of 1% and 4.6% respectively. (Click chart to enlarge)

Loonie (CAD): The Loonie is also lower as oil has pulled back a day ahead of the release of CPI data. While Canada has not been seeing the inflation that some other regions have, building permits and housing starts figures will show whether or not the economy is moving forward.

Euro (EUR): The Euro is lower against all but the Kiwi as the rumors of a Greek debt restructuring and a possible block of aid to Portugal are making the rounds. PMI data is expected to contract slightly, and PPI data is expected to increase. (Click chart to enlarge)

Pound (GBP): The Pound is mixed under what would be considered a “normal” risk aversion day despite the fact that home asking prices came in higher than expected. The BOE rate policy meeting minutes will be released on Wednesday which could show increased worry over inflation. Retail sales figures come out on Thursday.

Dollar (USD): The Dollar is mostly higher on risk aversion, and Friday markets are closed here in the US. It’s a light week for news in the US, without today bringing some Fedspeak at various locations, and the Philly Fed is due out on Thursday, which could see higher volatility as we have a long market weekend.

Yen (JPY): The Yen is higher across the board on risk aversion as Asian markets were down over night. Trade balance figures are due out on Tuesday night, and I am a little surprised to see Yen continue to strengthen considering the major economic challenges they are facing.

We’ve seen this one before, folks. The markets push both oil prices higher on Friday’s because of the risk in the marketplace and when nothing significant happens, it sells off going into Monday. This helps take markets down (which isn’t a bad thing), and then US stocks tend to rebound to start the week. Rinse and repeat.

Except there is going to be the time when this game does not work, and the selling that starts the day could bring about a “big one”. The markets have been so pumped up on Fed easy-money steroids that sooner or later the bubble is going to burst. What the exact catalyst will be is anyone’s guess but at this point these markets are climbing the “wall of worry.”

In times like these it makes sense to proceed cautiously as no one knows where or when the next risk event may come from.

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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UK Growth Expected to Decline

The British economy continues to wrangle with very weak growth even as consumers are being hammered by surging prices. The result is an inflation rate double the target “ideal” of two percent annual inflation. And while the last few years have not been a walk in the park, there appears little prospect for immediate relief.

In a speech delivered in mid December, Charles Bean, Deputy Governor for Monetary Policy and member of the Monetary Policy Committee (MPC), noted that the economy is showing signs of improvement, but cautioned that “it may be some while yet before normality is restored”.

That assessment was made four months ago and one would be hard-pressed to see any progress since then. Indeed, for the first quarter of the year, the situation may have actually worsened.

For four straight quarters in 2010, Gross Domestic Product made positive gains yet for the first quarter of this year, GDP actually fell by 0.5 percent. Despite this, the government still expects growth for the full year to be in the range of 1.7 percent â€" this may prove to be a bit optimistic.

Last week, the International Monetary Fund (IMF) reduced its outlook for the UK from 2 percent growth to 1.7 percent. The Organization for Economic and Development (OECD) cut its position even deeper dropping its earlier 1.7 percent prediction to just 1.5 percent. This makes it unanimous â€" the 2011 perspective for the British economy is actually bleaker now than at the beginning of the year.

Adding to the quandary is that consumer prices are rising at a much faster rate than overall growth. According to Britain’s Office for National Statistics, consumer prices rose another four percent in March following a 4.4 percent increase in February. The resulting inflation is rapidly outpacing gains in salaries and wages and is seriously undermining consumer buying power.

Consumer Price Index â€" Annualized Rate

Nov 2010 â€" 3.2%
Dec 2010 â€" 3.3%
Jan 2011 â€" 4.0%
Feb 2011 â€" 4.4%
Mar 2011 â€" 4.0%

 
Will Get Worse Before It Gets Better

Like several other developed economies, England faces a huge deficit made worse by the recession’s double whammy of reduced tax revenues and greater expenses arising from monetary stimulus to support the economy. Truth be told however, Britain has struggled with deficits for many years now and the situation has finally reached the point where it can no longer be ignored. Even with higher revenues expected this year, the budget shortfall for the current year is estimated at £140 billion (US$228.5 billion).

In its last budget, the government outlined plans to introduce significant spending cuts to the tune of £83 billion (US$133.5 billion) over the next four years. This is thought to be sufficient to balance the budget assuming higher government revenue as the economy recovers. This also assumes that the spending cuts will not impact those revenues and this is where things tend to get a bit sticky.

For the past six months, Bank of England Governor Mervyn King has argued against hiking interest rates to deal with the mounting inflation. King defends his position by blaming rising food and energy costs for a “temporary” spike in consumer prices suggesting that “core” inflation is actually quite low. King also suggests that as the impact of government’s spending cuts take effect, overall growth could decline even further.

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Where are Exchange Rates Headed? Look at the Data

At this point, it’s cliche to point to the so-called data deluge. While once there was too little data, now there is clearly too much, and that is no less true when it comes to data that is relevant to the forex markets. In theory, all data should be moving in the same direction. Or perhaps another way of expressing that idea would be to say that all data should tell a similar story, only from different angles. In reality, we know that’s not the case, and besides, one can usually engage in the reverse scientific method to find some data to support any hypothesis. If we are serious about finding the truth and not about proving a point, then, the question is: Which data should we be looking at?

I think the quarterly Bank of International Settlements (BIS) report is a good place to start. The report is not only a great-read for data junkies, but also represents a great snapshot of the current financial and economic state of the world. It’s all macro-level data, so there’s no question of topicality. (If anything, one could argue that the scope is too broad, since data is broken down no further than US, UK, EU, and Rest of World). The best part is that all of the raw data has already been organized and packaged, and the output is clearly presented and ready for interpretation.

Anyway, the stock market rally that began in 2010 has showed no signs of slowing down in 2011, with the US firmly leading the rest of the world. As is usually the case, this has corresponded with an outflow of cash from bond markets and a steady rise in long-term interest rates. However, emerging market equity and bond returns have started to flag, and as a result, the flow of capital into emerging markets has reversed after a record 2010. Without delving any deeper, the implication is clear: after 2+ years of weakness, developed world economies are now roaring back, while growth in emerging markets might be slowing.

Economic growth, combined with soaring commodities prices, is already producing inflation. (See my previous post for more on this subject). However, the markets expect that the ECB, BoE, and Fed (in that order) will all raise interest rates over the next two years. As a result, while investors expect inflation to rise over the next decade, they believe it will be contained by tighter monetary policy and moderate around 2-3% in industrialized countries.

The picture for emerging market economies is slightly less optimistic, however. If you accept the BIS’s use of China, India, and Brazil as representative of emerging markets as a whole, rising interest rates will help them avoid hyperinflation, but significant price inflation is still to be expected. I wonder then if the pickup in cross-border lending over this quarter won’t slow down due to expectations of diminishing real returns.

Any sudden optimism in the Dollar and Euro (and the Pound, to a lesser extent) must be tempered, however, by their serious fiscal problems and consequent volatility. As a result of the credit crisis (and pre-existing trends), government debt has risen substantially over the last three years, topping 100% of GDP for the US and 200% of GDP for Japan. Credit default swap rates (which represent the markets’ attempt to gauge the probability of default) have risen across the board. To date, gains have been highest for “fringe” countries, but regression analysis suggests that rates for pillar economies need to rise proportionately to account for the the bigger debt burden. According to a BIS analysis, US and UK banks are very exposed to Eurozone credit risk, which means a default by one of the PIGS would reverberate around the western world.

While I worry that such a basic analysis makes me appear shallow, I stand by this “20,000 foot” approach, with the caveat that it can only be used to make extremely general conclusions. (More specific conclusions naturally demand more specific data analysis!) They are that industrialized currencies (led by the Dollar and perhaps the Euro) might stage a comeback in 2011, due to stronger economic growth and higher interest rates. While GDP growth and interest rates will undoubtedly be higher in emerging markets, investors were extremely aggressive in pricing this in. An adjustment in theoretical models naturally demands a correction in actual emerging market exchange rates!

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Where Rubber Meets The Road!

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By Mike Conlon | March 4, 2011

All eyes this morning are on the US Non-Farm Payrolls (NFP) report due out at 8:30AM EST. While this is always one of the most significant economic reports that will induce market volatility, it hasn’t been this anticipated for some time.

Last month’s NFP report was an outlier, in that the 36K jobs gains reported almost came with a notion of disbelief, as if it was a mistake of some sort. Bad weather was blamed for the disconnect; but the figure showed that only 36K jobs were created, yet the unemployment rate fell from 9.4% to 9%. As I said in last month’s NFP blog article, you can’t have the BLS without the BS!

So this month we are expecting there to be gains of 196K jobs, with the unemployment rate ticking slightly higher to 9.1%. Recent data of late has been better than expected, especially when considering that the ADP employment change showed better than expected gains on Wednesday, and initial jobless claims came in lower than expected on Thursday. “Only” 368K people lost jobs last week, beating the expectation of 395K losses.

So this number should be pretty good today then, right? I’m not so sure. As I mentioned last month, when everyone gets their hopes up so high for good numbers, they usually end up disappointed. There is no other news to rely on today, so this number will be critical.

Last month I offered a guess as to what the number would be, and will my prediction was correct that it was worse than expected, I couldn’t imagine how much worse it was. This month I think we may see more of the same. So my prediction (remember this is a guess and NOT a trade recommendation) is that we will see jobs gains of 112K, better than last month but missing expectations. I think this will somehow induce US dollar strength today, as the Dollar seems very oversold to me. Regardless of what happens, there will be major volatility as the market digests the data.

Speaking of volatility, who saw the crazy move on the Euro yesterday? It happened right around 8:30 and the talking heads tried to attribute it to the initial jobless claims numbers, but basically ECB head Trichet said that he could raise rates next month, sending the Euro higher to the tune of 150 pips. This also helped risk-taking as US stocks made tremendous gains.

Stocks and commodities are higher to start the morning, but will these gains continue? Stay tuned for NFP!

In the forex market:

Aussie (AUD): The Aussie is mostly lower this morning as Prime Minister Gillard said that Aussie strength “puts burdens” on some areas of the economy. In addition, a separate report cited Australia’s housing market as being in a tremendous bubble which could pose a risk to the economy.

Kiwi (NZD): The Kiwi is also lower as the International Monetary Fund (IMF) said it will likely cut it forecast of New Zealand’s growth as a result of the two earthquakes. The rate expectations for New Zealand actually show that a reduction may be coming before another hike. The Kiwi has had a tough week. (Click char to enlarge)

Loonie (CAD): The Loonie is mixed this morning as the tug of war between higher oil prices and Canada’s economic ties to the US battle for position.

Euro (EUR): Wow, what a move for the Euro yesterday. The ECB finally did issue the hawkish comments the market was waiting for, after about 45 minutes of hemming and hawing. Was that a timed announcement with US economic data at exactly 8:30AM? Let the conspiracy chatter begin! (Click chart to enlarge)

Pound (GBP): The Pound is mostly higher as rate expectations shrug off recent home price data that has showed declines.

Dollar (USD): The Dollar is actually trading higher this morning as despite the mild risk taking in the market: This “wait and see” approach should provide trading opportunities on the release of the NFP report.

Yen (JPY): The Yen is weaker across the board as it is still trading under expected risk themes.

Put up or shut up! There are no more excuses! The US needs to see jobs growth and today’s number will be critical. There are two competing arguments for the direction of the Dollar today.

The first argument says that if the number should come in better than expected, then the Dollar should rally higher as this means that the US economy is improving and Bernanke will have to move on rates sooner to combat inflation. If the number is worse, than it justifies his position of fragile recovery and the need for a weak Dollar.

The alternate argument is that a better than expected number while good for the economy, will cause Dollar weakness as Bernanke has been blind to the inflation story and will not pre-empt QE2 under any circumstance. This comes as just about everyone else around the globe is complaining about inflation.

I’m actually in the second the camp, but think that a worse than expected number will cause Dollar strength today (the opposite of the scenario I laid out above). However, I will not be taking positions before the release, as I always prefer to let the market tell me which way to go.

So I can envision a scenario where the number comes in worse than expected (see my guess above) and initially the Dollar trades lower, but then quickly rebounds and finishes the day higher. This feels like a “crescendo moment”, with a sharp price spike and major volatility to reverse recent Dollar weakness.

At least that’s what I hope will happen, otherwise the Dollar may be falling off of a cliff! See you at 8:30!

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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Week in Review-March 4th

The EUR continues to outperform the dollar as investors interpret the ECB’s view to oil price shocks as inflationary events requiring a tighter monetary policy, in contrast to the Fed and the BOE, who are focusing on the deflationary impact. Trichet has followed in the hawkish footsteps of his coworkers and plied the EUR with enough ammo to dominate the non-inflationary Bernanke effect. The ECB will take the fight to inflation, maybe as early as next month. With the Libyan situation showing little signs of improvement and with the sovereigns continuing to weigh on the dollar, safe heaven trading strategies are the only option in this current environment. Below, we have some of the highlights of the week.

EUROPE

• Fine Gael wins Irish election and is in coalition talks with Labour. Victory will give them a clear mandate to try to renegotiate its EU/IMF bailout package.

• Euro area January CPI was revised down to + 2.3%, y/y from flash estimate. Core-CPI was also a tenth below consensus. Market continues to see elevated risks of a hawkish shift from the ECB.

• Euro manufacturing PMI’s continued to surprise to the upside, with particular strength in Ireland and Italy, driven by the forward looking components. Greece remained the weak spot amongst the periphery. Euro area was left unchanged at 59.

• Swiss PMI and 4th Q GDP showed surprised strength. GDP grew +0.9%, q/q, while the PMI bounced to 63.5 (highest level in six-months). Strong external demand from Germany and Asia is pulling the economy along despite CHF overvaluation. No hawkish rhetoric is expected at this months SNB meeting.

• UK PMI was flat last month, 61.5. New orders moderated, but employment hit a fresh high of 61.7 from 59. The 2011 releases show a solid recovery in the UK manufacturing sector in 1st Q and supports the hawkish camp at the MPC. King continues to send distinctly dovish signals that ‘raising rates to make a gesture is self defeating’. Market is pricing a hike in May.

• UK services PMI fell to 52.6 from 54.5, m/m. Analysts view the softness as more of a technical reversion to trend after the weather-induced volatility in December and January.

• Euro-zone registered strong increases in services (56.8) and composite PMI’s (58.2) for February, but below the preliminary estimates. Strong services gains were driven by France and Italy. The peripheries saw substantial gains in Ireland and Spain. Services PMI’s coupled with the firm manufacturing PMI’s point to robust growth in the Euro region.

Americas

• US consumers are hoarding their stimulus. Consumer spending disappointed with a +0.2% gain. Offsetting this disappointment is income jumping +1%, more than double the expected pace.

• Strong proof for the US housing markets weakness was pending home sales falling for a second consecutive month in January (-2.8% to 88.9). Even the revisions went deeper, with December falling into negative territory (-3.2%) from its original positive print (+2%).

• February’s Chicago PMI print of 71.2 was the highest reading in 23-years, led by a surge in production to 78.2 from 73.7. This release is hot on the heels from the January ISM manufacturing index, and the Empire and Philly Fed surveys for February and providing more proof that manufacturing is picking up in the 1st Q, in part on a need to build inventories.

• Surprisingly strong Canadian 4th Q GDP of +3.3% vs. +3% expected and an upward revision to the 3rd Q print to +1.8% from +1% pushed the loonie to new three years high outright.

• US January ISM numbers expanded at its fastest pace in seven-years (61.4 vs. 60.8), as factories added workers and pumped up production, continuing the momentum for their expansion.

• US construction spending fell for a second-consecutive month in January (-0.7% vs. -1.6%). Builders have had trouble getting finance and even with the tighter credit conditions, demand for credit in some places remains weak.

• Bernanke will not be tightening monetary policy until he is more confident that US recovery can stand on its own. ‘Once we see the economy is in a self sustaining recovery and employment is beginning to improve and labor markets are improving and inflation is stable and approaching +2% or so….at that point we will begin withdrawing’. That being said, he is aware of the risk that the Fed will act too slowly and allow inflation to get controlled.

• The BoC held rates steady at +1%. Governor Carney expressed his concern about the strength of the loonie ‘the export sector continues to face considerable challenges from the effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance’. The new reality is a Canadian dollar at or close to parity as the economy adjusts to this paradigm.

• ADP Private Payrolls rose +217k last month, up from a revised +189k.

• Fed’s Beige Book suggests that overall ‘economic activity continued to expand at a modest to moderate pace in January and early February’ and that price pressures are increasing. All the districts recorded ‘solid’ growth in manufacturing and retail sales increased in all districts.

• US weekly claims fell by -20k to +368k, the lowest level in nearly two-years. The less volatile four-week-moving-average now stands at +388k.

• US ISM non-manufacturing was not much of a surprise, coming in at 59.7 last month, just above market expectations. However, it’s the strongest reading since August 2005. The headline print is proof that the service growth appears to be finally entering a ‘self-sustaining’ pattern.

• US job market rebounded last month, unemployment rate fell to 8.9%, lowest level in two-years. NFP rose +192k as private sector added +222k new jobs. The January number was revised to show an increase of +63k from a previous estimate of +36k. The Fed still expects unemployment to range from +7.5% to +8% at the end of 2012 as the economy only slowly regains the 8.75m jobs lost.

• US January factory orders reported a strong +3.1% increase. The mixed data (strong non-durables and weak durables) remains consistent with strength in the above manufacturing surveys.

• Canadian Ivey PMY continues to express extreme volatility rising to 69.3 last month from 41.4 in January. The correlation between PMI and total remains weak. Market perhaps should be looking at a six-month average.

ASIA

• NZD Confidence rose to 34.5 last month â€" a seven-month high â€" from 29.5 in January.

• Japan industrial output rose a weaker-than-expected +2.4%, m/m (+4% expected). Retail sales (seasonally adjusted) rose +4.1%, m/m, vs. +2.7%. Manufacturing PMI rose for the fourth-consecutive month to 52.9 in February, with the new orders and export orders again rising significantly. JPY remains very much a play on the US rate outlook and risk aversion trading strategies.

• Chinese PMI data provided little excitement and little new information. Headline was in line with expectations at 52.2 in January. Analysts are calling for growth moderation and do not expect a change in monetary policy from Beijing any time soon.

• Dovish comments from New Zealand’s PM Key this week. He said that a RBNZ rate cut priced in by markets for March was in line with his expectations given the economic impact of the recent Christchurch earthquake. Market is pricing a 25bp RBNZ cut on the 10th March.

• Australian 4th Q GDP was weaker than expected +2.7%, y/y vs. +2.8%. The data still point to higher policy rates and AUD appreciation medium term. Analysts continue to anticipate a strong positive uplift this quarter despite severe flooding and cyclones. The RBA noted that mildly restrictive rates are appropriate. Do not expect them to get too far ahead of the RBNZ.

• Australia reported a -15.9%, m/m, fall in building approvals in January. Market continues to look beyond January data severely impacted by the floods.

• China’s non-manufacturing PMI fell to 44.1 last month from 56.4 and inline with seasonal patterns. The PBoC hiking 1-year lending, deposit rates +25bp and reserve requirement +50bp in February has also weighed on consumer sentiment.

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Oil Prices and the FX Conundrum

I haven’t blogged about oil prices in quite some time. After prices collapsed in the wake of the financial crisis, there really wasn’t much to talk about. However, the price of crude oil has risen more than 50% since June, and it now seems to be at the forefront of investor consciousness. Currency market watchers, in particular, need to brace themselves for the nuanced and sometimes contradictory ways in which oil prices bear on exchange rates.

Under normal conditions, the impact of rising oil prices on the currency markets is somewhat straightforward. First of all, the currencies of oil-exporting countries will typically experience some degree of appreciation. In addition, since oil contracts are still mainly settled in US Dollars, oil prices and a weak Dollar tend to go hand-in-hand. Second, insofar as rising prices drive inflation, the same can be said for Central Banks that are proactive in tightening monetary policy. As real interest rate differentials widen, (risk-averse) capital will naturally gravitate towards the highest returns.

The same logic cannot be applied to the current situation, however. That’s because this time around, oil prices aren’t being driven by economic fundamentals and rising demand, but rather by concerns over supply. You don’t have to be an expert to understand the connection between the continuing Mid East political crisis and oil futures. In the last two weeks alone, prices have risen a whopping 15% and show no sign of abating, as long as tensions linger unresolved.

From that standpoint, you might expect the political tensions to drive safe haven flows to the US Dollar. On the other hand, you would also expect that the resulting high oil prices might crimp the US economic recovery, and cause traders to punish the Dollar. However, you also need to consider that rising oil prices might also cause the Fed to eventually raise interest rates, or at least rein in QE2, which would be Dollar-positive.

Enough with the theory; let’s look at what’s happening in reality! The Canadian Dollar and Australian Dollar are rising, even though oil accounts for only 7% of the  former’s exports, and is a nil factor in the latter’s economy. It looks like forex investors are confusing oil prices with commodity prices, which are also rising, but at a much slower pace. In addition, since higher energy prices will probably erode economic growth in energy importing countries, this could actually hurt some commodity currencies over the long run.

The US Dollar has fallen across-the-board. While Ben Bernanke has insisted that the impact of higher energy prices on the US economy will be minimal, the markets are either taking the opposite view or are punishing the Dollar for the Fed’s dovishness. In other words, if Bernanke isn’t concerned about oil, he probably won’t cap QE2, and certainly won’t steer any interest rate hikes in the near-term.

Meanwhile, the European Central Bank (ECB), whose mandate is tilted towards maintaining price stability, has begun to voice concerns about the impact of rising commodity prices on inflation. Consumer and producer price indexes are rising across the Eurozone, and members of the ECB have suggested that they will take a proactive stance in preventing them from spurring inflation.

In conclusion, while both the EU and the US are net oil importers, the Euro is poised to outperform the Dollar, all else being equal. In addition, as long as the mid east political protests don’t drive further instability and contribute to any major supply shocks (especially in Saudi Arabia and Iran), there won’t be any impetus towards safe-haven capital flows. At the same time, while I don’t pretend to be an expert on oil prices, I would expect prices to stabilize and for a handful of minor corrections to materialize in the fx market. Traders are still looking for an excuse to short the Dollar in favor of, well, everything else, but sooner or later they will have to accept the limits of this trade, high oil prices or not.

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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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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!

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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.

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Topics: What To Look At In The Market |

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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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