abob's fundies journal

Here is nice video interview with Joe Prendergast, head of FX Research with Credit Suisse, in which he gives the CS outlook on the USD. Well worth a watch. I particularly like his last point explaining recent yen weakness.

The USD view sounds quite simplistic, but that is not necessarily a bad thing. Importantly, it serves as a reminder to trade according to your time horizon. To do this you have to disentangle long-term and short-term factors. For example, many analysts see structural (deficits) situtation in the US as an overiding strong USD negative. However, if you are trading on say a 3 month horizon, I believe the deficit factor should be assigned a very low weighting in your decision making grelative to cyclical drivers. That's not to say it isn't a risk worth considering, but on a central scenario basis, unless you see a big impending change in foreign investors willingness to finance the deficit over the next 3 months, then it shouldn't be so influential in your call.

Listing all the positive and negatives for a currency is only the first step. Arranging them in order of importance relative to your trading horizon is the second step.

On the topic of the BoE decision and sterling, a few days ago I said:


Played out exactly to script. Talk about blowing your own horn!

(if only I still had that short GBP position!)

Finger burning intraday thought: I think cable may have gone into oversold territory at the current level (1.8762). Following on from the above rationale as to why it should have sold off on the no-change decision from the Bank of England, I think the next step is for the mkt to assess what this really means: in my view, all it means is that we get a hike in Nov instead of Oct. It doesn't really imply anything about the shape of the money mkt curve (ie expectations on the trajectory of future rate hikes). Because of this GBP could be an attractive buy, but I would square up the end of the session because tomorrow could be pretty volatile (UK IP, US NFP).

I said I would square up the trade before the end of the day so here it is. The current price is 1.8782, giving 20 pips profit before the spread. Day trading can be fun

Finger burning intraday thought: After the successful GBP intraday trade (above), I am going long EUR/USD at 1.2601 today with a stop at 1.2581. (I am thinking the response to the NFP is a little overcooked).

Fingers burned (just a little): Stopped out with a 20 pips loss, offsetting the 20 pip profit from the day before.

Well, that day trading effort was a bit of a waste of time. I know, I didn't give it much of a chance, but I'm knocking it on the head for the time being.

I think I'll stick to what I'm least worst at.

The Economist's Buttonwood column is quite interesting piece this week, discussing how low volatility has supported the carry trade (this makes sense intuitively and is supported by various empirical evidence). The piece links to a piece of BIS research that looks at low volaility in the financial markets.

What I find interesting is that the low volatility can be attributed to both permanent factors (eg: central bank independence, greater dispersion of risk in the financial system) and cyclical factors (eg: period of low rates, high liquidity, anchored inflationary expectations) and if you can disentagle the contribution of the two categories perhaps you can better gage the chance of a big fall out occuring - a sudden yen rally would be one of many implications of an unwinding of the carry trade.

As an aside, I wonder if investors can hedge against this risk by going long the VIX. If you look at the history of the VIX, the volatility of the VIX is clearly skewed to the risk of upside spikes. If VIX options are priced to account for standard volatility they may not be accounting for this skew and so could offer cheap protection (or the VIX could just be used a cheap and direct punt on the outside chance of volatility spiking up).

It's quite old (2001) but I highly recommend this 5th Edition of the Goldman Sachs Guide to US Economic Statistics. It starts with a primer on seasonal adjustments and a piece looking at which data has the greatest impact on financial asset prices (bonds, equities, and fx), and then goes on to describe the main economic data.

(I have attached the pdf, but in case you are wondering, the source is the investing in bonds website, http://www.investinginbonds.com/asse...Statistics.pdf )

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Seperately, here is an interesting chart I came across from the St Louis Fed. Interestingly, it looks like fx volatilities have converged quite considerably over the past decade. It's a puzzle, because they are not saying that fx volatility has declined (that could be rationalised quite easily, but it isn't what has happened), but they are pointing out a convergence in volatility...weird.

Korea has tested a nuclear device....Sell Asia! Sell asian equities! Sell their currencies! Buy gold! buy oil! Quick, quick, quick!

Actually hold on a moment. In terms of the spillover to other countries, the economic effects should be relatively contained. After all, North Korea is one of the most isolated countries in the world. Geopolitical tensions have risen, but I think military intervention is not even on the table for discussion right now, though tougher sanction measures look likely. Indeed, if North Korea ran the tests to give them more bargaining power with the international community, they may have shot (or nuclear blasted) themselves in the foot.

Anyway, back to the markets. The global ripples have been quite limited - European mkts have shrugged off the event (the FTSE is half a percent up). The chart below shows how the South Korean stock market has reacted to previous missile tests, and while this morning's test is much greater in significance, the KOSPI has already taken a hit of -2.4%. I think it may be more profitable to exploit the event as a buying opportunity. That's right, buy the KOSPI, and buy Asian currencies, especially the yen (which I think is an attractive medium term buy from a fundamental perspective). Sorry, I know this may seem a little cold-hearted....or you could say it's making the most of a bad situation. Whatever your view, history suggests the market impact of 'one-off' events like this tend to be ephemeral .

(Chart source: Korea Market Strategy)

Interesting facts from Reuters: 'More than 2000 nuclear tests have been conducted worldwide since 1945 by the seven acknowledged nuclear powers, the United States, Russia, United Kingdom, France, China, India and Pakistan....Israel is widely believed to have nuclear weapons but has never admitted it or carried out a public test. South Africa developed nuclear weapons during the apartheid era, but renounced them in 1993-4.'

abo, i must say buddy, this is my favorite journal on this site! awesome stuff man!

cheers Merlin!

USD/CAD hit two-month highs today, generating a bit of excitement as it broke above the 200 day moving average. It's currently at 1.1322 and I think it could go a lot higher, but this really is a patience trade - I don't normally like to chase moves, but because the downtrend in USD/CAD has been so firmly established over the past few years, it's comforting to see a little confirmation in the price action before putting on the trade.

http://i33.photobucket.com/albums/d5...otlongterm.jpg

You can see several instances of 'false bottoms' on the chart. So what makes me think it will reverse course in the coming months? Here are the fundamental drivers behind my thinking:

The loonie is a commodity currency. The chart below shows the super high percentage of commodities that comprise Canadian exports. Without the commodities component, the country would be running a trade deficit.

http://i33.photobucket.com/albums/d5...eofexports.jpg

As the chart of the CRB index below shows, commodity prices have been falling. Again, I'm not a technical analyst, but I have been of the view that commodities have been in a bubble - which has now burst - a view supported by the clear break in the commodity price trend. This opinion contrasts with the consensus view that suggests stabilisation or even a rebound in commodity prices.

http://i33.photobucket.com/albums/d5...rtCRBindex.jpg

Importantly, oil prices have fallen substantially - USD/CAD has a particularly strong correlation with this commodity. Over the last couple of weeks the CAD has failed to weaken in the face of falling commodity prices, but this could be because of signifcant M&A flows into the country, which have obscured the underlying forces at work. I have no faith in the durability of M&A impacts on FX and so think CAD has some catching up to do on the downside.

http://i33.photobucket.com/albums/d5...archartoil.jpg

The other leg to my reasoning comes from the monetary perspective:

This chart from the BoC web-site shows how monetary conditions have tightened considerably relative to the period when USD/CAD was falling like a stone.

http://i33.photobucket.com/albums/d5...herisC6twi.jpg

In part, this has been due to a stengthening currency. The chart below shows how the currency is close to its decade range highs.

http://i33.photobucket.com/albums/d5...conditions.jpg

...and in terms of future direction of rates, while the market sees some risk of another hike, I am more dovish. My central scenario is for no change for several months. Thet chart below shows how both core and headline inflation has been kept well contained.

http://i33.photobucket.com/albums/d5...PIvstarget.jpg

..and long-term inflation expectations are not a problem:

http://i33.photobucket.com/albums/d5...break-even.jpg

While the CAD-US interest rate spread hasn't really narrowed in recent weeks, Canadian rates are lower than US rates across the yields curve (so investors are being paid to hold USD over CAD).

http://i33.photobucket.com/albums/d5...earspreads.jpg

Risks to my view:
- The future evolution of the rate spread could be important to USD/CAD and I am not so confident in calling this as I am confident with my commodity view. This however, is partially countered by my view that the USD could continue to rally modestly going forward. Also, I am concerned over softeness in the Canadian labour market and see downside risks to the Canadian stock market (consistent with my view of falling commodity prices).
- Timing - Looking at the charts, the phrase 'catching a falling knife' comes to mind. By making this a 6m view (stop at 1.040) I am giving the trade substantial breathing room, and hopefully reducing the odds of premature entry.

Upcoming CAD data to watch for:
12 Oct: Canadian trade balance
17 Oct: BoC Rate announcement
19 Oct: BoC Mon Policy Report

Excellent - Edmund Phelps is the winner of the Nobel Prize! (interview here).

This guy's ideas about the inflation-unemployment trade-off blew the Phillips Curve apart. What I like about this dude, is that unlike some previous winners, Phelp's work is not esoteric - the essence of his ideas are relatively easy to grasp, and they directly influenced the lives of millions for the better (I am not exaggerating).

For all the non-economists out there, he effectively said that you can't make the trade-off of increasing long-run employment by allowing for a little more inflation in the economy. Nobel have summarised his ideas in an easy to read paper; you can get to grips with his ideas in the first few pages.

ps - the name of the interviewer from the Nobel Foundation is Adam Smith!

Deutsche Bank have launched a nifty currency ETF, offering investors the chance to participate in a simple carry (yield) basket strategy. The fund is leveraged on a 2:1 basis and simply goes long the 3 highest yielding currencies, and short the 3 lowest yielding currencies.

In their promo material (see pdf attached), they show how since 1994 volatility of their G10 Currency Harvest Index has been lower than the S&P, while delivering higher returns (less risk, more return).

https://index.db.com/graphs/20061011/DBCFH_57030.png

The fund is currently long AUD, NZD and USD, and is short CHF, JPY, and SEK (roughly in equal proportion).

While investors can easily replicate the strategy in Oanda, credit to DB for creating a simple product with a relatively low charge (0.75%...I think DIY in Oanda would be cheaper, but bear in mind their low volatility is due to their low leverage at 2:1).

The carry strategy is 'designed to exploit the trend that currencies trading with a forward discount , tend to on average perform better than those trading at a forward premium', exploiting the proven fact that UIP doesn't hold up in reality.

(PS - For long-term investments I still think equities have the edge because of the drift).

Great job!!

Barron's resident perma-bear, Mr Alan Abelson, says:

"We're in the midst of one of those aberrational stock markets that treats everything that happens as bullish.Good news, such as the revised employment data, is bullish because it signals a strong economy and more of the sparkling corporate earnings we've seen these past few years. Bad news, like the weakness in retail sales, is bullish because it will keep the Federal Reserve from lifting interest rates. It's like being in a bar with a perpetual happy hour.

Well, it's not just happy hour in the equity market. The USD has also been responding positively to all this news. While the interpretation of the economic data can be spun to fit the bears or bulls, what is interesting is that the markets have taken an outright positive view of the data. So what are we to make of this? Is the USD due a correction on the downside, or does the resilience of the price action in the face of mixed data suggest a bout of USD appreciation is about to occur?

I've been delving in to my treasury chest of economic research and have made an interesting discovery. In late 2003, EUR/USD was in an uptrend (see chart), a move that was so strong that economic data almost became irrelevent. Below is the some of key data for November along with the percentage EUR/USD move on the day. Note how the data is outright USD bullish, yet the USD continued to weaken right through the month.

The funny business started with outright USD bullish payrolls data:

7 Nov - non farm payrolls (consensus 65k, actual 125k, EUR/USD daily change +0.36%)
14 Nov - PPI (consensus 0.2%, actual 0.8%, EUR/USD daily change +0.54%)
17 Nov - NY Empire manufacturing survey (consensus 28, actual 41, EUR/USD daily change +0.16%)
19 Nov - Housing starts (consensus 1850k, actual 1960k, EUR/USD daily change +0.25%)
25 Nov - Prel GDP (consensus 7.8%, actual 8.2%, EUR/USD daily change +0.17%)
25 Nov - Consumer confidence (consensus 85, actual 91.7, EUR/USD daily change +0.17 %)
26 Nov - Durable goods (consensus 0.7%, actual 3.3%, EUR/USD daily change +1.09%)
26 Nov - Chicago PMI (consensus 56.8, actual 64.1, EUR/USD daily change +1.09%)

These observations are instructive. The common wisdom is that fx markets trend for 20% of the time and are rangey for the other 80%. Clearly, when there is a strong trend in play, economic fundamentals move to the back-burner as a driver of exchange rates. That's not to say there were no USD negatives at the time: around this period, there were major concerns over terrorism, potential protectionism, the long-term financing of the current account, and despite this run of strong data, there were ongoing questions as to the durability of the economic turnaround in the US.

This time around, the USD is not in a bull or bear trend, and the data has been open to interpretation, but the strong USD response does suggest market sentiment could be turning toward a more USD+ive stance. And while the case for USD depreciation continues to hold from a structural perspective (I believe this is more of a long-term consideration for the USD), it is clear that the cyclical drivers (primarily interest rate differentials) have clearly moved in favour of a stronger USD. If this divergence continues for a little while longer, I see scope for USD to break higher...something the market seems to 'willing' right now.

Chart: EUR/USD climbs in the face of USD+ive economic data:

Here are some interesting comments from todays Fed speakers:

Bernanke: nothing of note.

Poole on data:

In a recent six-month period, FRED received 21 million hits from over 109 countries around the world. FRED currently contains 1175 national time series and 1881 regional series. FRED data are updated on a real-time basis as information is released from various statistical agencies.

If you want to play about with free macro data, the FRED database is free and is an excellent playground to get familiar with macro data. You can even plot two series on the same chart on the web-page....very cool. 21 million hits eh...folk are clearly loving this database!

Contrast the current situation with the one in 1979. At that time, actions by the Board of Governors on discount rate changes were reported promptly, but there was no press release subsequent to an FOMC policy action and FOMC meeting minutes were released with a 90-day delay.

...it's good to see how times have a changed!

Poole on the economy:
While he indicates inflation should be headed lower:

``My best guess is right along with my colleagues that the rate of inflation is likely to be tapering down,''

This is the consensus view...he also goes on to note that:

"So the situation is asymmetrical in the sense that if the inflation rate drifts higher, it could be a substantial cost to correct. Whereas if the economy, short of a deep recession, is simply soft for a while, when we're already so fully employed, those costs are not likely to be very large," he said.

and:
``If it looks like the numbers this week and other information suggest to us that the inflation rate is in danger of hanging here or moving higher, rather than moving lower, then I am certainly very much in the camp that would favor, at some point, additional policy restraint,''

...this reminds me of Greenspans risk management approach to policy. Higher inflation expectations at this stage are more damaging than lower inflationary expectations may be beneficial, so any hint of evidence that prices are being sustained at higher levels could prompt a swift policy response. Monetary easing seems to be some way off in the Fed's eyes. The market is more balanced now than it was a few weeks ago, but it is arguably still a little out of line with the Fed in factoring in risks of rate cuts in early 2007.

Yellen on the economy:

Until we actually see inflation begin to slow down, I will be focused on the upside risks in the outlook,"
...The current U.S. jobless rate of 4.6 percent in September was below conventional measures of full employment at 5 percent, and labor markets are tight, she said.
"We would like to see the economy slow some to relieve wage pressures," This reinforces the idea that the Fed perceives there to be an assymetric risk with respect to prices (and policy). Slower growth is clearly preferable to risking higher inflation at this stage in the cycle.

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One point on the last comment is that globalisation of the labour market has made macro economic modelling and gaging the natural rate of unemployment much more difficult. The effect of a global labour pool is that it seems to be exerting downward pressure on wages. It has had a significant impact in the UK and could reduce the inflationary pressure in the US (at any given rate of unemployment).