Current Market Conditions

For those of you that make a living (i.e. trade forex) from interest rate differentials, consider that the US Treasury yield curve is now steeper than at any point in recent memory. Short-term rates are still close to zero, while long-term rates just passed 4% and are still rising. The theoretical implication is that one can borrow at a low short-term rate and reinvest at a higher long-term yield. The question is: would you want to?

The meeting this week of the Federal Reserve Bank yielded few surprises, as the Fed voted to hold its benchmark Federal Funds Rate at the current level of nil, and indicated that they would stay “unusually low” for the near-term. According to one analyst, “It was totally the market doesn’t seem to have reacted that much. Everybody pretty much knew that for sure they wouldn’t raise rates anytime soon and they wouldn’t do anything to withdraw liquidity.”
At the same time, the Fed voted to maintain (though not to increase) its $1.75 Trillion asset price program, in order to prevent long-term rates from rising. This was probably directed at mortgage rates, which had begun to move higher in recent weeks, leading some analysts to fear that the nascent economic recovery would be stillborn. However, “Part of the rise in rates may be caused by fears that the Fed will allow inflation to get out of control down the road and that it will print money to finance government deficits. To the degree that those fears are out there, expansion of the Fed programs could be sending rates up rather than down.” In other words, the Fed is naive in its assumption that it can buy rates down, since its very act of buying is actually sending rates up!
This could be very bad for the US Dollar, which loses on both ends of the curve. Low short-term rates make it cheap to use the Dollar as a funding currency, while high long-term rates imply the expectation of inflation, and thus capital erosion. Current market conditions are unique, however: “The enthusiasm of the past three months has led many to believe that the Fed has actually provided more than it is critically important to remember that the dollar is the funding currency whose availability, or lack of … will drive all the markets in the world,” said one analyst.
This, the lack of liquidity in credit markets (the very problem that the Fed is trying to counter) is actually good for the Dollar, since it implies an under-supply. On the other hand, if the Fed is “successful” in its asset purchase program, then the supply of Dollars must necessarily increase relative to the demand, in which case the Dollar will fall. It’s not as cut-and-dried as it was prior to the credit crisis, but interest rate differentials (both short and long-term) still hold represent one of the crucial determinants of exchange rates.

Forestalling Deflation

Back on March 12, the Swiss National Bank issued a stern promise that it would actively seek to hold down the value of the Swiss Franc (CHF) as a means of forestalling deflation. The currency immediately plummeted 5%, as traders made a quick determination that the SNB threats were made in earnest. Over the months that followed, however, investors became complacent and the Franc slowly crept back up.
That was until this week, when the SNB sprung into action, buying Euros on the open market. As much as 2.4 percent versus the euro and 3.3 percent against the dollar, the biggest declines since…March 12.” It’s not clear why the SNB suddenly intervened after months of inaction. The Central Bank didn’t hold a press conference to “celebrate” its intervention, and the only indication was a vague declaration last week that “policy makers will act to curb any ‘irrational appreciation’ of the franc.”

Analysts have speculated that the SNB is (arbitrarily) targeting the exchange rate of $1.50 Francs/Euro, which is plausible given that the intervention occurred very close to that level: “They’re trying to put a at 1.50. There’s a big debate as to whether they will continue doing this, and for how long they will remain successful.” After all, the idea of intervention is more effective than intervention itself. The SNB can only buying so many Euros; the real value is in the threat to continue buying, which keeps investors from building up speculative positions.
While the SNB has been criticized as “protectionist” for its actions, its premise for intervention is well-grounded. According to the “Switzerland should keep interest rates close to zero well into 2010 and mull more fiscal stimulus to fight a deep recession and the risk of deflation.” Modest deflation has already set in, facilitated by a collapse in aggregate demand. Varying forecasts are calling for an economic contraction in 2009 equal to -2.5%-3%, and even a modest contraction to follow in 2010. Q1 GDP growth was negative and the consensus is that Q2 will prove to have been more of the same. If this trend continues, 2009 will be the worst year economically in over 30 years. Still, economic indicators suggest the bottom is soon approaching, and the overall picture is consistent with the rest of Europe.
The real concern is that other Central Banks will imitate the Swiss approach. “In the past couple of weeks we have had five or six central banks, including the Bank of Canada and the Bank of England,Like Switzerland, they are fearful that currency appreciation could offset the stimulus to the economy,” noted one analyst. Monetary and economic conditions remain abysmal worldwide, and most banks have already exhausted the tools available to them. Interest rates are universally close to zero; fiscal “stimuli” will push the OECD debt/GDP ratio past 100% in 2009; quantitative easing has given rise to wholesale money printing. Currency devaluation may be the only option left.

British Pound Is Going To be Breath

After a nearly 20% rise against the Dollar, the British Pound has been rangebound for nearly the entire month of June, with likening the situation to a “pause for breath.” For him, this amounts to a temporary cessation on the Pound’s inevitable upward path: “Compared to long term levels, the pound was still better value than its peers. He said: ‘It’s still cheap - about 10% below it’s trade-weighted average at present.’ ” For others analysts, however, the picture is not so cut-and-dried.

Forgetting about purchasing power parity for a minute, there are numerous factors which could halt the Pound’s rise. First and foremost is the British economy, which is still struggling to find its feet. “The U.K. economy will recover ‘mildly’ next year, according to the compared with a previous projection of a 0.2 percent contraction. Gross domestic product will drop 4.3 percent this year, versus a March forecast of 3.7 percent.”
Some economic indicators have begun to stabilize, but the two most important sectors, housing and finance, are still wobbly. Economists warn that “any recovery could be because banks are still unwilling to pump loans into the economy.” In the latest month for which data is available, mortgage lending slowed to a record low, with consumer lending not far behind. With regard to housing,”The annual fall in house prices in England and Wales slowed for a third consecutive month in June, according to property data company Hometrack, but prices were still 8.7 percent lower than a year ago.”
There is the possibility that the BOE’s quantitative easing plan and the government’s fiscal stimulus will provide the economy with the boost it needs. At the same time, both programs will have to be reined at some point, sooner rather than later in the case of government spending. With UK national debt predicted to reach 90% of GDP by 2010, “Most people - the prime minister excepted, apparently - believe that taxes will have to rise and/or public spending fall after the next election. This would at least threaten to hold back economic activity.” Not to mention that both QE and government spending could actually backfire and generate inflation without economic growth (i.e. stagflation). BOE Governor Mervyn King captured this overall sentiment, when he said, “I feel more uncertain now than ever. This is not the pattern of a recession coming into recovery that we’ve seen since the 1930s.”
In short, from a purely economic standpoint, it doesn’t look good for the Pound Sterling. But of course forex is about much more than GDP…stay tuned for Part 2, in which I’ll elaborate on this point, and bring interest rates and inflation into the discussion.

Economics Situation

While the overall number of jobs added or lost in the economy is obviously an important current indicator of what the economic situation is, the report also includes several other pieces of data that can move financial markets:
1. What the unemployment rate is in the economy as a percentage of the overall workforce. This is an important part of the report as the amount of people out of work is a good indication of the overall health of the economy, and this is a number that is watched by the Fed as when it becomes too low (generally anything below 5%) inflation is expected to start to creep up as businesses have to pay up to hire good workers and increase prices as a result.
2. What sectors the increase or decrease in jobs came from. This can give traders a heads up on which sectors of the economy may be primed for growth as companies in those sectors such as housing add jobs.
3. Average hourly earnings. This is an important component because if the same amount of people are employed but are earning more or less money for that work, this has basically the same effect as if people had been added or subtracted from the labor force.
4. Revisions of previous nonfarm payrolls releases. An important component of the report which can move markets as traders re-price growth expectations based on the revision to the previous number.

National Committee

President Barack Obama dismissed critics of his ambitious agenda as naysayers on Monday and vowed to have health care, energy and financial regulation initiatives in place by the end of the year.
"Then we have a whole other year after that," Obama told about 400 cheering top Democratic Party fundraisers.
Sounding confident and defiant before the party stalwarts, the president pointedly went after critics of his health care plan, many of whom assert that the system needs change but object to his proposal for public health insurance as an option to private insurance.

"You'll hear a bunch of muttering and yammering and they'll say, 'Well, we agree with reform, too,'" he said. "Well, OK, if you agree with reform, then step up."
The confrontational tone delighted the partisan crowd and came as more and more Democrats voice skepticism that Obama will succeed at getting a bipartisan health care bill through Congress.
Obama ran through a list of successful administration initiatives, including a $787 billion economic stimulus, a budget resolution, a fair-pay bill and a reversal on a ban on federal funding of stem cell research.
"It's not bad for six months," he said to laughs and cheers.
But, he added: "We can't be satisfied. We should be confident in our future but not complacent."
Obama warned that critics would get louder and pundits would grow impatient-"a time when cynicism seems to reassert itself."
The event was billed as a thank you from Obama and the Democratic National Committee to members of his presidential campaign's national finance committee and members of the DNC's National Advisory Board. No money was raised.
Obama, whose campaign broke fundraising records, last held a fundraiser for the national party committee in May in Los Angeles, amassing about $3 million in donations. May was the national party's best fundraising month of the year, with more than $8 million raised. The party is not expected to report raising as much in June.
The DNC outraised the Republican National Committee in May. But the Republican Party had $21.5 million cash on hand at month's end, whereas the Democratic Party had $12 million and a $5.6 million debt.

Economy and forex

Prime Minister Vladimir Putin on Monday urged Russia's state-controlled banks to boost lending to major industries and advised their heads not to take their summer vacations until this was done.
Russia's economy has been hit hard by the global financial crisis, with borrowing reduced sharply. Stock markets and the national currency have regained some of their initial losses, but businesses still complain that credit is hard to come by.
At a meeting with government ministers and bankers, Putin urged state-controlled banks to boost their loan portfolios by at least 150 billion rubles ($4.8 billion) in July, and by similar amounts in August and September.

He cited the government's decision to allocate 300 billion rubles ($9.6 billion) in guarantees on loans to strategic enterprises.
"The government has met you half way and takes on the main risks," Putin said in televised remarks. "In return, the government hopes that with these new opportunities the banks will gradually expand lending for priority sectors and cut the cost of the loans."
The 300 billion rubles was included in this year's budget. The government has previously voiced concern that the banks were reluctant to lend to strategic enterprises, which include military plants, carmakers and agriculture producers.
Russia's economy has continued to slide, with gross domestic product dropping by an annual 11 percent in May. A deputy economics minister warned last week that it would be a "heroic achievement" if Russia posted a GDP decline this year of 6 percent to 8 percent-roughly in line with official forecasts.