currency

What Really Killed The Rally?

July 10th, 2009 @ 3:29 am by Matt "NewstraderFX" Carniol

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 29^th 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…

Posted in News Trading Perspective | 6 Comments »

The NFP And The Markets

July 1st, 2009 @ 3:16 pm by Matt "NewstraderFX" Carniol

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.