FX News Trading For The Week Of June 3-And Beyond

There Definately Are Two Sides To This Coin

There's no doubt that last weeks data (and Fed minutes) will set a trend for the $ (along with equities and thereby carry trades), but the question is which way. There are compelling arguments for dollar and equity market strength and weakness depending on how you see things.

Equities:

Friday's data was unique in that it points to both increasing growth and decreasing inflation. Analysts point to a well balanced economy as being great for stocks and indeed the Standard & Poor's 500 Index surpassed its 2000 record and set two more peaks this week, while the Dow Jones Industrial Average today reached its 26th high for the year. Friday's rally off the data was broad based as indexes of commodities, energy, consumer and industrial shares touched all-time highs.

Equity markets are still at low valuations, meaning stocks are historiaclly cheap. Companies are buying back their stocks, taking equities of the market and driving up prices. Large caps are seen as the new leaders in the market and there remain many good LBO opportunities.

The Dollar:

Borrowing of the Yen (aka carry trade winding) is used to fund investments of higher yeilding assets all over the world and it's possible to see much more of this in the present bullish situation, especially as the BoJ likely will remain on hold for the foreseeable future and will be lucky to get away with one increase this year. Exactly how large a part this plays in things is not known, but obviously it's huge. All you need do is to look at currency charts during the February crash to see how large of a factor it really is.

Because of the way price is structured in pairs like the GBP/JPY and EUR/JPY, as carry trades are "winding" the dollar weakens vs the GBP and EUR while strengthening vs the JPY. In a bullish enviorment for stocks a very compelling reason exists for the dollar to perform exactly this way.

But there are good arguments for exactly the opposite as well.

The market is definately of the mind that the Fed will not be cutting rates this year and they're right. The Fed has unequivically stated they expect growth to be trending up (and inflation trending down). This removes the possibility of a rate cut, so that area of "boost" is not available. Since their predominant concern is still that inflation may fail to moderate, there's actually more of a chance that the Fed's next move will be an increase although the odds are the Fed is on hold thru Q4.

Bond yeilds have risen right along with the dollar the last few weeks and the 10yr is sitting at 4.95% just 5 basis points below the important 5.00% level.

There are 3 important effects seen with rising bond yeilds:

1. Bond yeild differentials may start to narrow in the dollar's favor, which is obviously very supportive. Although a rate increase is possible fron the BoE, it is by no means a sure thing so yeild spreads could diminish between US and UK bonds. It's already assumed that the ECB will raise rates next week, but what's to come after that is still debatable. If Trichet sounds at all dovish (or even not strongly hawkish), bonds yeilds may narrow towards the dollar there as well.

2. If bond yeilds continue rising, it becomes very tempting for investors to forego the riskier stock market investments for the nice safe 5.00% or better that bonds offer. Obviously, that takes demand for stocks out of the market.

3. Money becomes more expensive to borrow. That's extremely important for any stock rally and even more so for this one as liquidity has been a major (perhaps even the major) factor for the advances we've seen. $1T of M&A has occurred this year already and if the trend slows, equities in general might slow also.

And as rosy as things look, there is cause for concern.

Slower earnings growth at many companies may restrain hiring in coming months. First-quarter earnings adjusted for the value of inventories and depreciation of capital expenditures, known as profits from current production, rose 1.2 percent. Profits were up 21 percent last year.

There are also signs that the labor market may not have been as strong last year as earlier estimates suggested.

A report this month from the Labor Department, based on tax records from all businesses, showed the economy added 19,000 private-sector jobs in the third quarter. That contrasts with the government's monthly payroll figures, based on a smaller survey, which showed a gain of 498,000 jobs for the period.

Or Maybe Not:

AMR Corp.'s American Airlines, the world's largest carrier, last month announced plans to recall as many as 200 laid-off flight attendants to fill jobs left vacant by retirements and other departures. The Fort Worth, Texas-based airline, which returned to profit in 2006 after five years of losses, has also recalled pilots and mechanics.

Microsoft Corp., the world's biggest software maker, said last month it will expand its Fargo, North Dakota, campus to add space for 575 workers. Microsoft is also in the middle of a $1 billion expansion to its Redmond, Washington headquarters to add space for an additional 12,000 employees.

My own opinion?

The overall euphoria is likely to continue for the time being although how much longer is hard to say. At some point though, the worm is bound to turn. Probably the full 180 degrees.

If you're interested in equity markets and how carry trades will move, here are some expectations that market participants will be looking for:

GDP: A move up towards 2% in the first estimate of Q2. If it remains below 1, equity markets will be very disappointed

Earnings: Double digits are no longer expected. 7-8% is is the level that will keep equities humming along

Have you heard about Greenspan's new book coming out on 17 September? From what I've heard about it, he mentions that interest rates are very low now. He also mentioned that the books contains alot of other surprises. Can't wait to get my hands on it!

I am curious to hear any comments coming out of the IMC this a.m. that may effect carry trades.

Interest rates have been low in real terms for quite some time now Jody-that's one reason for the sea of liquidity that we've seen.

Thanks for reading and I hope you've been keeping up with my posts in the News and Analysis section.

There are those who are waiting for this market to burst. The question is where could it come from and the answer is from whatever disaster happens to dry up the liquidity that has been this market's main driver.

Hedge funds play a major role in this and right now, there's a battle brewing which could cause quite a boom should push come to shove. The reason you should be interested is because a liquidity squeeze would cause an immediate aversion to risk and that means a serious drop in carry trades. As we saw in February's crash, rapid unwinding of carry trade positions not only causes pairs like GBP/JPY and EUR/JPY to fall, it also brings about massive dollar appreciation vs GBP and EUR with massive depreciation of the dollar vs the Yen.

I'll be adding alot more to this later. Nothing is likely to happen right now-but i'll outline what to look for and how to trade it when I continue this in about 3 hours from now.

OK back to the aricle I was referring to:

Hedge funds can profit from the losses in the sub-prime market by shorting an index called the ABX index. Billions have been placed in short position by a Hedge fund called Paulsen and Co. (No relation to the treasury sec) and by other hedge funds also. They made money on those positions in the beginning of the year, but are starting to lose now.

Along comes Bear Sterns. Their EMC mortgage unit has bought sub-prime loans and wants to be able to re-write the terms in favor of the homeowners who hold those loans. By re-writing the terms it makes it very likely that the loans won't default, especially because people still have their jobs.

The proble is that Paulson and Co (and the other short sellers) stand to lose billions if the loans get re-written and people don't defaut. They are planning on waging a legal war to prevent Bear Sterns from re-writing those terms.

While Paulson is in favor of re-writing in valid cases, they are saying that blanket re-writing amounts to market manipulation by Bear. Paulson has written letters to the Federal Reserve and the CFTA and have hired former SEC Chairman Harvey Pitt to provide advice. Paulson is claiming that the re-writing amounts to "uneconomic transactions".

What could happen? Unknown at this point and it's not known if Bear can proceed. It isn't as if Bear has totally altruistic ambitions here; they stand to make billions by re-writing the loans and squeezing the other hedge funds.

If Bear gets to re-write the loans, the hedge funds that have billions bet on short positions will get killed, because they won't be able to close out their trades. There won't be anyone to take their short positions.

It's the homeowners who are caught in the middle.

On to today's market:

Production and wage numbers came out looking inflationary and that definately upset equity markets as the DOW has lost nearly 122 points at 1.00PM.

After the euphoria of Friday-markets have gotten nervous now. Carry trades have definately come off a bit, although the move wasn't exactly linear. GBP/JPY found repeated support around the 241 level.

If you're wondering why the dollar would depreciate vs the Yen when inflation looks higher-you've got a good question. The answer lies in carry trade positioning.

When there is bad news and carry trades unwind, the dollar depreciates vs the Yen and appreciates vs the GBP. Todays move down in GBP/JPY was due to dollar weakness vs the Yen and the fact that the dollar has come off the daily lows vs the GBP.

There was some positive data from Japan last night. Although the leading index was 20 percent in April, Japan's economy probably grew more than the government initially estimated in the first quarter, after a report showed business investment surged to a record. Economits are estimating that Gross domestic product grew at an annual 3.2 percent pace in the first quarter.

Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo said that ``Japan will achieve sustainable growth; almost all data indicate a solid expansion''.