the dollar

Fed heads like me will be parsing the FOMC statement on Wednesday for clues regarding the future of monetary policy, which naturally will affect the valuations of all asset classes including currencies, stocks, and commodities. The first thing that any Fed watcher does is to look for changes from the previous statement, so let’s break it down to the three main areas of interest.

Interest Rates

No one expects interest rates to change on Wednesday, but it will be important to see if the language regarding the need for “exceptionally low levels of the federal funds rate for an extended period” is retained. The odds are that it will be however, expect to see the dollar gain as traders in Fed Funds Futures price in a rate hike perhaps as soon as December if it isn’t. One of the world’s great Fed watchers, Bill Gross of PIMCO, is of the belief that the Fed won’t be making a move on rates until well into 2010, if then.

Inflation

Because of the output gap, the difference between potential and actual GDP, the Fed is of the belief that “substantial resource slack is likely to dampen cost pressures,” and that “inflation will remain subdued for some time.”  (By “resource slack,” the FOMC is referring to the amount of workers who are unemployed).

Be aware that when the Fed talks about inflation what they really are most concerned about is the potential for a wage-price spiral as seen during the 1970’s. The reality is that there’s very little chance of seeing that occur anytime over the next several years. For one thing, there are much fewer unionized workers. Second, and even more important, there obviously is an oversupply of workers relative to the amount of jobs available which means there’s little pricing power among employees. Third, companies don’t need to hire more workers because contrary to what usually happens when companies eliminate jobs, productivity (worker output per hour) is rising (6.4% in Q2 on an annualized basis according to Tuesday’s report). Aside from that, the report also indicated that labor costs fell the most in eight years over the period.

Economic Growth

Most economists, including such luminaries as Paul Krugman and Nouriel Roubini, believe the economy has bottomed although in the case of Roubini the opinion is that the economy will remain in recession through the end of the year. The Fed itself was fairly sanguine about the prospects for economic growth in June, saying that “policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.” Nothing has really happened since June 24 to change that outlook given the improvements seen in the ISM’s, housing, Q2 GDP along with the July jobs report and unemployment rate, so expect to see a similar opinion expressed in Wednesday’s statement.

Putting these three together really indicates that a sweet spot exists for stocks, because the economy is set to improve while policy looks to remain expansionary as inflation remains low. The latter point is especially important because it means that in real terms (taking inflation into account), any percentage gains will be that much higher, i.e. that the purchasing power of the dollars you receive when you cash in your investments will not have eroded to an appreciable degree.

Those factors certainly have been great for stock investors; the S&P has gained nearly 12% since the FOMC met on June 24. The problem is that for forex traders, the concurrent movement in the dollar (short) against the euro, pound and A$ hasn’t been quite as pronounced during that period although those currencies did make significant moves against the yen (they have made significant gains on the USD overall since March). Also of note is that USD/JPY, which basically mirrored S&P movements for several years, hasn’t done anything of note since the March rally although it the yen does gain rather dependably on days when stocks retreat.

The Fed may also make a decision regarding whether to extend its $300B program to purchase Treasuries. If they choose not to continuing purchasing U.S. debt it could cause interest rates to rise, which will tend to put downward pressure on the dollar. Also, Congress wants the Fed to extend its program to purchase commercial mortgage backed securities for another year, so look for the FOMC to comment on that.

Commercial real estate is likely to present the biggest obstacle to economic growth over the medium term. There’s a crisis looming there because of the inability of property owners to refinance debt which is coming due. Rents and property values have fallen dramatically, which means that there will be less income available to service the debt and that banks will require any loans they do make to have lower loan to value ratios.  Property values are forecast to remain depressed which means that many owners are underwater on their mortgages, another recipe for rising foreclosure rates.

I’ve been thinking about this for a while and while I can’t say that I’ve read through every trading strategy, what I have found through my years of experience is that in order to make real and lasting profits you need to attune yourself to the Major Fundamental Events (MFE’s) that set the trends-and then get in when price is most advantageous.

When I refer to Major Fundamental Events I’m not just referring to the monthly reports, although those can be used along the way. I’m talking about something that can cause a radical shift, which I’ll explain.

One thing before we start though-these MFE’s may only happen a couple times per year, if that. That’s OK though, because these trades are going to yield 1000’s of pips. One trade may last for weeks or months.

Also, we’re not at the start of an MFE now, at least in my opinion.

As you might have guessed, an MFE can be (and usually is) initiated by the Fed although certain earth-shaking events (the Lehman bankruptcy for example) can certainly do the job. Sometimes several MFE’s can occur simultaneously which is great because those tend to build on each other, strengthening the trend.

The 2 keys for profiting from this are as follows:

1. You have to recognize when an MFE has occurred.

2. You have to understand how markets will be affected after the MFE has occurred and the correlations between the different asset classes (currencies, stocks, bonds and commodities).

The most recent MFE began on March 15, the day of Bernanke’s 60 Minutes interview in which he said the Fed was “electronically” printing money. Go to this page: http://video.google.com/videosearch?…um=4&ct=title# and see the “The Chairman Part 1″ video at about 8 minutes in.

It’s true that economists and commentators were talking about the Fed printing money before the interview because everyone was well aware that the Fed had already expanded its balance sheet (quantitative or credit easing = money creation).  But the Federal Reserve admitting it on national television was a whole different matter in my opinion. The dollar bear market began in earnest from there while stocks, commodities and Treasury yields rose.

In other words, Bernanke created a rally in risky assets because he convinced investors that the value of the so-called safe assets (the dollar and Treasuries) would depreciate.  What also was interesting about this MFE was that none of the so-called experts, including the financial press, picked up on it.

Then again, none of the so-called experts said anything about what would happen to the dollar after Lehman went bust either, including such luminaries as Jim Rogers who’s been a commodity bull forever (and who got crushed in the 2008 commodity collapse) as well as Peter Schiff who also lost his shirt because he didn’t recognize that a dollar-boosting flight to safety would occur after Lehman’s bankruptcy.

Why did Bernanke make the radical decision to allow himself to be interviewed on 60 Minutes? I think that it was because despite all of its previous balance sheet expansion, the Fed to that point had been totally unable to accomplish its goal of boosting stocks and creating some measure of inflation (making commodities more expensive) by weakening the dollar in order to counter the far more dangerous deflationary pressure of the financial crisis. The S&P had made a fresh low just one week before and had declined nearly 58%. No question they were concerned that all of the actions taken to that time could potentially fail, sending the global economy deep into a depression.

By the first week in June, the S&P had gained about 40% from the March low. The dollar had lost thousands of pips to the euro, pound and A$, oil was threatening $70 and yield on the benchmark 10 year Treasury was up near 4%. That created another set of problems for the Fed however, because of the detrimental effect that rising energy prices and interest rates naturally would have on consumer spending and housing (because of rising mortgage rates).

From that point, the Fed began a serious effort to talk up the risks of deflation (while talking down the risks of inflation) and from there, the markets basically went sideways. In other words, just as his efforts to convince investors that the dollar would depreciate helped boost markets, his deflationary concerns helped throw cold water on the rally he created with his printing-dollars comments.

Market correlations are pretty straightforward once you realize something:

When you trade spot forex, you’re trading pairs-GBP/USD for example. When you buy the pound you are simultaneously selling the dollar. When you’re trading currency futures, the contract is listed in euros or pounds or A$’s-there’s no “pair” in futures. However, despite that you’re still “selling” the dollar when for example you buy the euro contract because you are trading in dollars and your contract moves against the dollar.

It’s the same thing for any instrument which is priced in dollars no matter what the asset class is. So when for example you’re buying a stock, for all intents and purposes you are “selling” dollars-your bet is that your stock is going to appreciate against the dollar.

Think of it this way-if an asset class priced in dollars goes up, what does it go up against? The dollar of course. So when all of these asset classes are appreciating, it tends to put downward pressure on the dollar.

It’s the same for the S&P-the S&P is priced in dollars so for all intents and purposes if you are long the S&P you are short dollars.

So think of it this way:

S&P/USD
OIL/USD
GOLD/USD

Or just:

Commodities/USD
Stocks/USD

How about bonds (Treasuries)?

First, by convention, when people say bonds are up or down they are talking about price.

Second, bond prices and yields move in opposite directions for a very simple reason: If you buy a bond today for $1 that yields 2% and yields go up tomorrow, of course the bond you just bought is going to be worth less simply because it yields less.

Stocks and commodities are risky assets while Treasury bonds (and notes and bills) are “risk free.” They’re risk free because if held to maturity your principle and interest are guaranteed by the full faith and credit of the U.S. government. So when the market is “risk averse” (like it was after the Lehman collapse, another MFE)), stocks are sold and bonds are bought.

So in general, stocks and Treasuries are inversely correlated. We saw that after Lehman and we saw it happen again after Bernanke’s little interview.

It all comes down to investors appetite (or lack thereof) for risk, which obviously is heavily influenced by what I call Major Fundamental Events. “Risk aversion” places tremendous upward pressure on the dollar while the acceptance of risk has the exact opposite effect.

That’s why you want an MFE to occur-things can only move one way after one happens and when you recognize it early, you can absolutely make a killing.

There are  times when deciding not to trade is the best trade you can make and right now appears to be one of those times. I know, I know, there are a certain number of you guys out there who claim to be very nimble when the market is moving sideways (as it has been over the past 6 weeks or so) but for the vast majority of traders (me included), sideways movement is just too hard to deal with. The problem is that staying on the sidelines is difficult for many to do because they develop a syndrome I call ‘trader’s finger,’ which means your finger gets itchy to push the buy or sell button.

It’s very important to resist the urge to trade just for trading’s sake or because you feel you have to “do something” like earn a certain amount of pips each week.  I haven’t taken a trade since I saw the markets moving sideways weeks ago and I’m feeling better about my decision every day.

I can’t feel comfortable in a trade if I don’t have a clear idea of where the market will be in a few weeks or months and what’s even more important is that I’ve avoided putting myself through the mental anguish of making bad trading decisions and losing money, which I hate to do and which I know is inevitable when markets get choppy.

Basically, I have the same goal in trading that I have when I get in my car, which is to not get into an accident. The way I look at it, as long as I avoid crashing, the odds are a lot higher that I’ll eventually get to my destination.

What’s interesting is that over the past few weeks I’ve seen so many “professional” opinions on Bloomberg or wherever turn out to be totally wrong. Even good ‘ole Marc Faber, one of my favorite people, appears to have gotten things incorrect when he said 2 weeks again that the dollar was set to gain over the next two months or so. Since then, he might be ahead a little bit but what’s more likely is that all the back and forth movement has caused him a lot of aggravation.

Now, Marc Faber is probably one of the world’s great traders but even he looked to be suffering from trader’s finger during his last Bloomberg interview. Back in March when markets were really crashing, he seemed to go out of his way to say that stocks were set to rally-and that turned out to be one of the year’s great calls. He didn’t have quite the same confidence 2 weeks ago however-in fact, it looked more like he was saying something in order to justify being interviewed. After all, it’s hard to get in front of the cameras and advise people to stay on the sidelines!

But when you think about it, why should that be so? I know that I put just as much effort into making a judgment not to trade as I did when I called a 1000 pip short trade on the pound last summer (my “Four Figure Trade” article), or when I went long on GBP/JPY and AUD/JPY in May (see twitter) and made about 900 pips over 4 days, or when I made about 400% on some A$ options (twitter again) between April and May.

Now, what am I looking for that could start a trend? Simple really if you use some logic. Let me ask you a question.

Is it not true that all of the fiscal and monetary policies have been put in place because the economy is in an emergency situation? Of course it is. So then doesn’t it follow that if and when the signs are given that these extraordinary policies can begin to be withdrawn it indicates that conditions are improving and will continue to do so? I would think so. In fact, I was hoping against hope that the G8 might signal just that last week but unfortunately, they did just the opposite when they said that now is not the time to begin withdrawing liquidity. Apparently, they weren’t in a “green shoots’ mood in Italy (although we did learn that Obama has a preference for satin-clad booty…lol).

Likewise, when economists like Paul Krugman are talking about the need for a second stimulus, that doesn’t exactly instill much confidence in me that the economy is set to improve in a meaningful way any time soon. And when I hear Nouriel Roubini talking about unemployment going to 11%, an anemic recovery and the chance of a double dip recession along with housing prices falling another 20%, somehow it just doesn’t put me in the mood to buy and hold for the long term.

In fact, I think that professor Roubini helped put the kibosh on the spring rally, so what we need to see is some data proving his opinions on the economy are wrong (a tall order, I know). So, it would be great to see new unemployment claims fall below 500K per week and for the number of continuing claims to stop making fresh records with each report. Stabilization of housing prices as measured by the S&P/Case-Schiller Home Price Index would be helpful. The ISM’s above 50 would be very significant.

Obviously it’s going to take some time to see these data points materialize but what I’m also going to be looking for are any surprises like Bernanke announcing the Fed was “electronically” printing dollars. Listening to what’s being said at Jackson Hole next month could prove to be valuable.

Also, check the Fed’s H.4.1 report each week, specifically the line regarding the amount of deposits commercial banks are holding at the Fed banks under liabilities. In normal times there’s about $14B or so on deposit being kept there because of reserve requirements but at the height of the crisis banks were hoarding nearly $1T .

All that money sitting at the Fed means  the banks aren’t lending (or doing very little lending). We need to see that trend towards normalization because as the amount on deposit decreases, the velocity of money increases as banks make more and more loans.  The amount kept on deposit decreased to about $625B just before stocks took in March but increased to about $900B during the stress tests, so I would like to see it get at least to that level (and decrease further) again.

Fed Chairman Bernanke’s little stock rally, which was initiated when he announced on 60 Minutes that the Fed was “electronically’ printing dollars, has apparently come to an end (at least for now). As a currency trader and market observer, you’ll want to know why and the reason has to do with the most famous currency pair you’ve never heard of. Ready? It’s called…

S&P/USD

That the dollar moves inversely to riskier assets like stocks (and commodities as well) isn’t a matter of some kind of mystical correlation that can somehow “break.” The key to knowing this is to understand what really is happening when stocks (or commodities) appreciate, which is easy to see once you accept the existence of S&P/USD.

Look at it this way; when stocks go up, what are they going up against? The dollar of course. The same for goes for commodities because those are priced in dollars all over the world. Well, if these riskier assets have gone up, isn’t it than also true to say the dollar has depreciated. Absolutely. So when the market is buying risk, the dollar will tend to fall as a matter of due course.

What’s really interesting is that in the rare instance (like now) when the Fed is actively trying to devalue the dollar (because the economy is faced was the more serious threat of deflation), the Fed can create a stock rally just as Bernanke intended to do by admitting to the electronic printing of dollars on national television. Why? Because if you are convinced the dollar is going to depreciate, doesn’t that also mean that anything you can buy with it is going to be more expensive? Of course. And the convinced you become that the prices of liquid assets (like stocks and commodities) are going to rise, the more inclined you will be to buy them.

So what’s really happening in the current environment is that the Fed, through its actions and comments on the dollar (and on deflation/inflation which is the same thing) is pushing the market for riskier asset classes up and down. Let’s look at some recent action.

Bernanke’s rally pretty much fizzled out in the middle of May, but it got a temporary boost (about 4%) in the week following the last meeting on June 24 when members removed the deflationary concerns which had appeared in the April 29th statement. But then something interesting happened.

On June 30, San Francisco Federal Reserve Bank President Janet Yellen expressed some deep concerns about deflation. “I’ll put my cards on the table right away,” she said. “I think the predominant risk is that inflation will be too low, not too high, over the next several years.”

Now, remember what we said; if the market is convinced the Fed is depreciating (creating inflation), riskier assets are going to be bought because inflation means their prices are going to rise (at least nominally). No one wants to hold cash if the potential for inflation is on the horizon, because cash is guaranteed to lose value in an inflationary environment.

Conversely, if inflation really isn’t a threat and the possibility of deflation exists, there’s no reason whatsoever to buy riskier assets. Afterall, your cash is guaranteed to increase in value in a deflationary environment because prices are going down!

In fact, in a deflationary environment you make more money simply by being a “lender” (keeping for money in the bank or in Treasuries). A little arithmetic will show you how this works.

Your real (inflation adjusted) rate of interest is equal to the nominal rate (what the bank is paying you) minus the rate of inflation or R = N – i.

Let’s say inflation is 3% and your bank is paying you a nominal 4% on your deposit. Your real (R) interest rate is the Nominal (N) rate minus inflation or R = 4% – 3% which equals 1%. In real terms you’ve only earned 1% on the money you have in the bank

Now, let’s say there’s deflation (negative inflation) of -2% for the year and your bank is paying you a nominal rate of 3% on your deposit. What’s the real rate of interest you’ve earned?

R = N – I or R = 3 – (-2) = 5%. In real terms, you’ve earned 5% on your deposit!

Now, if I’m guaranteed to earn a risk-free return of say 5%, and I think prices are going down, why in the world would I buy a riskier asset? In the hope that someday its price might go up? Hope is a bad rational for making a trade.

So, Ms. Yellen, with her deflationary concerns, helped kill the rally. She wasn’t alone however; the Fed, with its expert manipulation of the media via the pundits seen all over Bloomberg, started so make plenty of deflationary noises around the middle of May.

As a trader, there are times when you can put this to very good use for longer term trends (which really is where the money is made). If the Fed does start talking about inflation and making noises like it might raise interest rates, do yourself a favor and sell the dollar as you buy riskier assets like stocks and commodities.  But if they continue to talk about the risks of deflation, there’s little reason to sell the dollar or to buy riskier assets. Buy the dollar at that point because it will be in demand.

BTW, Thursday’s weak market action off the surprisingly good unemployment numbers, along with the subsequent decline of S&P futures overnight, bodes very poorly for stocks and very good for the dollar. I can hardly think of a more bearish sign for stocks than the market failing to rally on good news. Afterall, it the market can’t rise when the news is good…

Range Bound Markets

In case you haven’t noticed, things have been kind of range bound over the past month or so for the major currency pairs as well as the S&P 500. Understanding why that’s happening  will lead you into the next trend when conditions change, setting up a good trade.

For many traders, this kind of back and forth movement is much harder to trade than when prices are moving in a trend. I posted a long trade on GBP/JPY and AUD/JPY May 26 on twitter that returned about 1000 pips by June 1 but on June 8 I said “it isn’t a good time to trade currencies due to the lack of a strong fundamental driver.”

This is exactly where trend-following trading systems fail, because there’s no indicator to tell you that markets will go range bound. You have to rely on fundamentals (and your instinct) in order to make a judgment call like that.

While there are a number of arguments that can be made regarding why this is occurring now, for my money it’s the fundamental state of the economy which is dictating the action here at the end of the second quarter. Simply put, it appears that a depression has been avoided and that the recession is slowly coming to an end.  But what also appears to be the case is that the economy will remain sluggish for a period far beyond the end of the recession as the unemployment rate edges inexorably towards 10% (or higher).

This is the view of none other than Nouriel Roubini, who believes that 2010 will “fell like a recession” even if the economy is technically out of one. Meanwhile, San Francisco Federal Reserve Bank President Janet Yellen believes that although the recession is likely to end later in 2009, a “frustratingly slow” recovery marked by continued high unemployment is likely to follow.

“I am not optimistic that the economy will spring back to normal anytime soon,” she said on Tuesday during a scheduled speech. “I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery.”

Unemployment will “remain painfully high for several more years,” she said, which obviously points to more troubled loans for the banks in both residential and commercial mortgages.

She also implied that policy makers will leave the Fed Funds Rate near zero for the next several years, saying that such a policy is “not outside the realm of possibility,” in the press conference which followed her remarks.

Here’s something interesting I found on Bloomberg regarding a Goldman Sachs currency trade:

“Goldman Sachs exited a bet that the Canadian dollar would strengthen versus the Mexican peso,” the article said. “Goldman entered the trade on June 8 and stands to lose about 5% including the cost of carry after being “stopped out” when the peso traded beyond 11.40 per Canadian dollar yesterday.”

This just goes to show that even the best of the best can lose when the fundamentals are too unclear or when they fail to provide a strong impetus.

On To The NFP

The much smaller loss of jobs last month (-345K vs. -504K previous) was accompanied by an increase to 9.4% (from 8.9%) in the unemployment rate. Stocks fell a bit on the news and the dollar gained that day.  Stocks gained for a few days afterwards on the realization that the increase was due in part to greater labor force participation (people who had given up looking for jobs started to look again, a good sign). The rest of the month was basically flat.

Now, if we put the NFP together with what we believe to be the prevailing view of the economy, what we (as traders) want to see is some data that indicates the prevailing view is wrong. So what I would suggest is to come back to this article after the NFP is released; not for an immediate short-term reaction but to see if a reason exists for a trend to be established which will be where the best potential for a good trade will exist.

For example, if by some miracle the unemployment rate were to fall, there would be a good chance to see stocks get a boost over the next few weeks. That would put some pressure on the dollar vs. the euro, pound and A$, and it probably would be positive for those currencies against the yen as well.

A Great Trader

In any discussion of great traders, Marc Faber (the original Dr. Doom) surely comes to mind as being right at the top of the list. He correctly called the commodity rally and dollar bear market early in the decade and more recently said back in March that stocks had probably bottomed.

I always look for his interviews on Bloomberg and CNBC because they’re both entertaining and informative. And I just love the way he concluded his monthly bulletin back in June 2008:

“The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer/software it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I’ve been doing my part.”

Faber was on Bloomberg the other day saying that the dollar was likely to gain over the next 4 to 6 weeks. If we get a big jump in the unemployment rate he could turn out to be right, especially if riskier assets like stocks and commodities are sold (we did get a jump of 0.5 last month and we didn’t see a strong sell off). But if the data goes the other way (meaning the unemployment rate falls), he’ll likely wind up with egg on his face.