FX News Trading For The Week Of 3/19

It's nice to be back at the Factory. As I see it, the markets and US economy are at a critical point so I thought i'd weigh in with a few ideas that will include some trading opinions. Please feel free to weigh in with a few of your own. I'm going to focus on equity markets at first and the reason will become apparent later on as I apply it to a currency trade.

The sub-prime problem and other growth issues have placed markets at a critical point that IMHO has the potential to turn on what the Fed says on Wednesday. Like everyone else I don't expect a rate change, but I do believe that the statement afterwards will be very, very important because it's likely to point the markets into a long term trend.

Let me first explain what an inflation bias means. Simply put, it's when the Fed believes there are more potential risks to the economy from inflation then from slower growth.

Right now, the Fed has (and has had since it stopped tightening) an inflation bias and as long this remains, the further the prospect of a rate cut is pushed out into the future. Equity markets would love to see a change towards a neutral bias at this time and I believe equities will weaken further in the coming weeks without one. Whether a change in the bias happens or not remains to be seen, so let's first review what the Fed has said and then i'll look at some scenarios that could play out. From the last statment on Jan 31:

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

I would suggset that those tentative signs of housing stabilization have dissapated and the timing of moderate growth in the economy is more questionable. Bernanke repeated the line regarding the outlook on the pace of economic expansion in his congressional testimony. Other Fed govs have repeated this in recent speeches also.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The readings on wholesale and consumer level core inflation have gotten worse so far this year. Consumer coreCPI is on a 3% YoY basis vs. a 2.6% rate for all of 2006.

The Committee judges that some inflation risks remain.

If risks remained as inflation was "modestly" improving, where do they remain now?

We'll compare the new statement to the old on Wednesday. In the mean time, let's take a look at what could happen.

I don't believe that they will be able to change their inflation bias and I believe they will have to mention that housing has the potential to slow or push out the pace of economic expansion, although they could mention that the job market remains strong and consumer spending has continued to expand. Still, what we're going to do is read the statement, compare it to the old statement and gather opinion from the published news sources.

If it becomes apparent that the inflation bias remains I feel very strongly that equity markets will continue to trend down for some time to come because the sub prime problem will look to get worse and possibly spread while the prospect for a rate cut will be pushed out into the future. If the inflation bias is moved to a neutral bias I believe equities will trend up, because the sub prime problem could be judged to be contained while a rate cut will look more certain. Now here's how I would look to trade that:

I'm going to focus on a pair that some of you may not be used to looking at, the GBP/JPY. Take a look at a chart on this if you haven't-you'll be amazed at how much it moves. After you do that, take a look at a DJIA chart and compare that to the price movement on the GBP/JPY. You'll be amazed at the correlation. While you're at it, compare the GBP/JPY to charts of the FTSE and Nikkei too.

In the meantime, we'll continue to discuss this and I would also pay attention to Tuesday's housing number. Don't be surprised to see equities and the GBP/JPY drop off a negative print there. I would judge the reverse to be true also.

Welcome Back News` Your commentary is the Best


"If it becomes apparent that the inflation bias remains I feel very strongly that equity markets will continue to trend down for some time to come because the sub prime problem will look to get worse and possibly spread while the prospect for a rate cut will be pushed out into the future. If the inflation bias is moved to a neutral bias I believe equities will trend up, because the sub prime problem could be judged to be contained while a rate cut will look more certain. Now here's how I would look to trade that:

I'm going to focus on a pair that some of you may not be used to looking at, the GBP/JPY. Take a look at a chart on this if you haven't-you'll be amazed at how much it moves. After you do that, take a look at a DJIA chart and compare that to the price movement on the GBP/JPY. You'll be amazed at the correlation. While you're at it, compare the GBP/JPY to charts of the FTSE and Nikkei too."

boy is it nice to see that "FX For the Week of..." thread title on FF!

welcome back NewstraderFX

we missed you man!!!!

Yay!!! Newstrader is back! Don't leave us again

Like the others have said: it's good to read your opinions again.

The correlation between the yen the global markets has been very high which cements the case for those with the view that people have been using yen to finance leveraged stock purchases.

In my opinion the whole sub-prime thing is being blown out of proportion. It seems that the market simply decided to revalue risk, since credit spreads were unrealisticaly tight, and the sub-prime market was always going to get hammered when volatilty returned to global markets.

Friday saw the dollar lose ground across the board on the back of strong volumes. I'm not totally sure why it did but I know it was a significant. Could we see the Fed lose some of it's inflation bias on the back of weaker equity markets and the poor housing market? I think it's very possible. There should be no change at the next meeting but like you said the statement could be more dovish. Consider how the eurusd rate paid little attention to the higher inflation numbers this week.

Thanks for the post, but I want to make a correction in what you say-

There should be no change at the next meeting but like you said the statement could be more dovish.

I'm not at all saying the statement could be dovish. I'm saying it's likely the inflation bias will remain, but i'm still waiting for the statement before making any trading decisions.

I don't see the sub prime problem as being "blown out of proportion". It's a problem that definately will get worse IF home prices continue to fall. I don't have a prediction for home prices yet, but any indication from the Fed that rates are not going to be cut any time soon wouldn't help them, I would think.

And BTW-let's not forget about the statement from the BoJ on Tues. Any indication from there that rates could rise further will surely put a strong damper on the carry trade and cause GBP/JPY to move sharply down, while the opposite is of course true as well. The situation in Japan is too complex to speculate on due to their long-standing deflation problem, but we'll have a look at what they say along with opinions gathered from the published sources.

So there's plenty of info available to trade this week and best of all, it will come right from the most important fundamental source of all: Central Banks.

What I was trying to say is that the statement will come out more dovish than expcted ie. it will focus on worries in the housing market and recent market decline (alhtough that wasn't really a big drop at all) and have less of an inflation bias.

The housing market has been weak for a while now. It's just now that the sub-prime market has become a headline. Why? Because credit spreads were so tight that these higher risk loans were considered almost as good as prime. Now it's not the case. But what I'm wondering is whether or not lenders could still be tight even with higher house prices if credit spreads widen dramatically.

There is only HOUSING data for US this week.

Seems like a gloomy week for USD once again.

The marklet is really focusing on the Fed language. What signs are in the market right now that indicate traders are expecting a cut in the future?

The spread inversion between the 3mo and 10yr and the rate on the the 2yr note. The inversion is over 50 and the 2 yr note is 62 basis points highter the the fed rate. Nothing really new on either of those two fronts, just an indication that the market has been telling the fed it wants a rate cut for some time now.

"Options on Federal Fund futures at the Chicago Board of Trade show a 24 percent likelihood the central bank will lower its target rate for overnight loans to 4.5 percent from the current 5.25 percent. Just seven weeks ago, options prices suggested no chance of that large a reduction this year. Options, among the cheapest way to bet on rates, may provide a more accurate picture than futures, according to a 2005 study the Federal Reserve Bank of Cleveland"-from BB.

There may not even be a need for a bias change from the Fed to get markets excited: "The Fed Open Market Committee, meeting for two days starting tomorrow, will most likely debate changing its tilt toward higher interest rates and may even add language to their statement underscoring concern about a weakening economy, economists say."-from BB

Adding this language could very well be enough to get equities going and cause the GBP/JPY to gain, especially if the BoJ indicates in their statement that further increases are not in the picture.

There is another spread that has accurately predicted every recession since 1970 and it's one that's published every day: the 10yr/fed rate spread. When it's in negative territory as it is now (currenty -68 basis points), that's the signal that a recession is likely unless monetary policy forestalls it.

The one occasion since the recession of 1970 when the yield spread turned negative and a recession did not occur was in the summer of 1998 at the time of the Long-Term Capital Markets arbitrage fund meltdown. The pace of economic activity slowed at that time and the Federal Reserve quickly dropped the fed funds rate by 75 basis points, thereby averting a recession.

Again, this does not mean a recession is definate-what it does mean is that without a rate cut, a recession seems to be very likely if the past data can be used to predict future events.

It's also worth noting how the Fed saw the economic future at it's past meetings and I want to point to the meeting in Aug when they stopped raising the rate.

The minutes showed that they expected the economy to behave pretty much exactly as it's doing now (slowing). At that time they expected to see 6 quarters of slowing GDP and slowing inflation, measured by the core PCE.

"The staff forecast prepared for this meeting (Aug 2006) indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending, and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters. Core consumer price inflation was projected to drop back somewhat later this year and next, mainly as the effects of higher energy and import prices abated."

What they didn't say, was what monetary policy would be if that occurred. Wednesday could be the first real clue in this direction.

yes, this is the yield curve predictor. here is a great article about that from the NY Fed....

http://www.ny.frb.org/research/capit...ets/ycfaq.html

to be honest, until i read this piece i was in the camp that thought there is not enough evidence to say inverted curve is a reliable leading indicator of recession. im a statistician, and ive been fooled too many times by statistics to be easily fooled again. but reading through the evidence, i can see that some very scientific approaches have been taken. im a believer now.

what had me confused earlier was the "negative values" observed in recent history. take this quote from the article, for instance...

so basically, for the past two recessions, we had no inverted curve. but that shouldnt matter, no one is claiming that EVERY recession is preceded by an inverted curve. the argument is that the curve predicts the reccession, and if you read the evidence, its not hard to believe.

thanks for making me take a second look at that!!

The yeild spreads can also be applied to predict the direction of future economic activety (GDP).

A growing demand for credit (signifying economic growth) is represented when the curve is expanding positively and vice versa. As the curve expanded negatively, it indicated a slowing demand for credit and ultimately a slowing GDP, which is exactly what was predicted by the FOMC in the August meeting.

You can also say that in times when the demand for credit ebbs and the price goes down, credit will look cheap-and when things start to look cheap, the smart will buy...

I'm also looking at the DJIA today and the concurrent rise in the GBP/JPY. It can be explained as traders betting on a change in the language in the Wednesday statement-a bet that says the language will indicate some easing of policy in the near future.

An aggressive trader could have taken that info-the overall sentiment in the market that there was a possibility of a language change-and run with that. That's a bit too aggressive for me, but it does indicate that such a change (if it happens) looks to be very helpful for equities and long GBP/JPY positions.

That change in language IMHO woud qualify as anything the Fed says regarding a lesser growth estimation, even if the inflation bias remains. And if this sentiment remains in the market all afternoon-don't be surprised to see GBP/JPY hit the 229.70-80 area...

Kind of an interesting breakdown on the housing numbers:

The overall number was up nicely. In areas of bad weather (Midwest & Northeast) new construction dropped by 14 and 30%, respectively. Areas with good weather (West & South) improved by 26 and 18%. So it's a question of whether the market will see the glass half full or half empty.

What I mean by that is this: If we didn't have the sub prime problem and market jitters and the market was moving along nicely, it wouldn't be looking for a sign from the Fed that rates could get cut. It would take the number and run with it. Since we do have those problems and the market is looking for a sign of Fed easing, the market may look at the number and think the Fed might not give an indication of a rate cut in tomorrow's statement thereby not getting the boost it was looking for.

You need to remember that the economy is moving pretty much along the lines of how the Fed outlined it back in August; Slowing housing and GDP and moderating inflation (which hasn't moderated fast enough anyway).

I just don't see them making any kind of major change in their thinking. They have repeated over and over that they see the economy picking up later in the year and growing around trend level. Unemployment is at record lows and there's no chance of a cut while it stays this low anyway (and throw out the Feb NFP number-they've all been revised anyway). They certainly are going to still see an inflation risk. They have given guidelines to lenders, who have already implimented stricter lending standards and there was a report of a hedge fund providing a $200 million line of credit to a lender. A real example of a free market solving it's own problems...

Still, we'll wait and see how it turns out, but one way or another tomorrow's statement is likely to set a trend at least until the next meeting in May. We could still be in what I have called "Bernanke's Goldilocks Economy".

Has anyone noticed that Allen Greenspan has done what he should have done all along-shut up?

how can i short greenspans public esteem

So much fuzz on the housing and neglecting the other sectors' performance.

Hmm.. perhaps its because everyone has a House to live... If it was the car industry, i dont think a car bust would create this much fuzz.

Today's fundamental developments:

From all accounts it looks like the BoJ will be remaining on hold for the foreseeable future, while the BoE certainly is threatened by the prospect of having to raise rates at least once more. You might take this as an automatic signal to go long GBP/JPY and indeed, the first two parts of the puzzle seem to be in place.

We know that the movement in this pair is all about the equity market's appetite for risk. As the desire to invest increases and risk becomes more accepted, the more equity markets gain and the more this pair moves to the upside in a big way. The last barrier to risk aversion is up to the Fed; any indication tomorrow that a cut seems to be in order will heighten the market's appetite for risk and investment.

I'm not saying that it's impossible for equities to gain without this happening. The sub prime problem could turn out to be contained, the economy could start to pick up as the Fed has predicted and things could start flowing again nicely. What I am saying is that if the door to a cut is opened tomorrow-it will give an immediate boost to risk appetite. Under those conditions I can see the GBP/JPY heading towards the lower 234's, with the potential of reaching the pre-correction levels of 237 on a sustained world equity rally.

I'm basing this not only on the charts, but on how every major economic mind from Bernanke to Paulson to King to the IMF see's the world economy on a fundamental basis; they believe it is sound and that there is every reason to expect good economic growth. Not "bubble-like" growth, but reasonable, sustainable growth, the safest kind.

So sit back for a while and let's see how things go tomorrow.

Yes, I'm glad you are back to a forum that is run by people with class compared to where you were.

Today was a chance to see how one fundamental drives 2 different currency pairs:

Bank of England policy makers voted 8-1 to keep its benchmark rate at a five-year high of 5.25 percent this month. David Blanchflower unexpectedly made the first call for a rate cut since May.

The dovish minutes casused the GBP/USD to go down and caused the GBP/JPY (and the FTSE) to go up. Why might this be the case?

The GBP/USD pair is an interest rate driven pair, while the GBP/JPY is a flow of funds driven pair.

Let me expalin what I mean by flow of funds. As it becomes apparent that interest rates are not to be raised in the future, the investment climate is improved as a more accomodative monetary policy stimulates the appetite for risk and investment. Funds will flow into an enviorment like this. In this case, becasue the Yen is a funding currency for all types of investments, money will flow from Japan to the UK.

The reaction to the minutes was somewhat tempered today by the last UK CPI numbers; the minutes may actually be a bit outdated, but they certainly indicate the BoE would much prefer to not have to raise rates further. I base this also on what the bank has said recently: they see inflation going down in no uncertain terms. If the CPI numbers had printed better, I believe we would have seen much more movement in these pairs and in the FTSE as well.