Nouriel Roubini

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.

As a trader, in this environment, there’s a credo you really need to live by. Perhaps you’ve heard the expression “I’m not married to my positions?” Well, I’ve expanded that as follows: “I’m not married to my positions-I’m just dating them casually.”

The point here is that when circumstances change, your thought process needs to change and right now, in my opinion, circumstances have changed to the point where I have to close my short dollar and long S&P positions which were taken last Sunday night.

What’s turned me off to that trade is that the coming crisis in commercial real estate came into sharp focus on Wednesday.

First, Fed Chairman Bernanke told the Senate Banking Committee that a potential wave of defaults in commercial real estate may present a “difficult” challenge for the economy, adding that one of the main problems was that the market for securities backed by commercial mortgages (Commercial Mortgage Backed Securities, CMBS) had “completely shut down.”

Second, the profit reports from two of the nation’s largest commercial lenders, Morgan Stanley and Wells Fargo, are likely to bring the market’s severe problems into much sharper focus.  Morgan reported a $700M write-down on its $17B commercial property portfolio this past quarter while its CFO said he doesn’t see “a light at the end of the commercial real estate tunnel yet.” Meanwhile, Wells Fargo saw its non-performing commercial loans rise an eye-popping 69% over the same period. The news here implies that regional banks like PNC and Keycorp are likely to continue facing the same issues since their portfolios are heavily weighted with commercial loans.

I can tell you from firsthand experience that commercial lending is at a virtual standstill right now, because I recently started working at a commercial mortgage bank run by my family. Our firm specializes in the only real form of commercial lending which exists at this time; FHA insured loans for properties like multifamily apartment complexes, senior independent living buildings, and assisted living facilities. For all other types of commercial property (malls, retail strips, office and industrial buildings), unless you have access to private equity (which only the largest players do) you are virtually shut out.

Aside from the problems of commercial property owners being unable to pay their mortgages (a serious enough problem) there exists the problems with performing properties that need to refinance.

Typically, commercial loans are amortized over 20 to 25 years but the terms can be between 5 and 10. At the end of the term, the owner will owe a balloon payment to his or her bank because of the longer amortization period. In normal times, it wasn’t too difficult a problem to just refinance and avoid the balloon but now, in the vast majority of cases, these people cannot find new funding despite the fact that their properties are still performing. And even in the rare circumstance where they can refinance, they’re facing larger down payments (lower loan-to-value ratios), higher interest rates and shorter amortization periods (which naturally makes their monthly payments higher).

The net result of all this stifled lending is going to be a huge amount of defaults and foreclosures. The worst for this market is still in the future.

Now, here’s where the trading lesson is. The situation in commercial property isn’t really new- people like Nouriel Roubini have been warning on this for more than 2 years and prices have already declined about 35%. So the fact that the situation isn’t news might lead you to think that the circumstances regarding commercial property are priced in to the market, meaning that investors have already discounted future value.

What I would say to that is when the Federal Reserve warns members of Congress in public testimony and when banks report on the situation in black and white profit reports, the situation comes more into focus. I would also say to not overestimate the intelligence of investors-they certainly didn’t do such a great job judging how the housing situation would lead to the huge declines in equity markets.

Just to play devil’s advocate here, you might want to argue that despite all the negative news today the market really didn’t decline all that much with the S&P only losing 0.5 points. The answer to that is as a trader, you want to do what good hockey players do-skate to where the puck is going, not to where it’s been. That’s a judgment call obviously but really, isn’t all trading when you come right down to it?

There’s another old expression you should be aware of: housing tends to lead the economy into and out of recessions. Let’s now amend that to read residential and commercial property leads the economy into and out of recessions. If that’s true (and with commercial real estate amounting to about 10% of GDP it likely is) by all accounts it would appear that commercial property isn’t about to lead the economy anywhere but down.

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.

There were two very good articles (actually, one is a thread in the forum section) posted on FF recently that I thought had a lot of relevance for traders. What I’d like to do here is expand on both and tie them together because I think there are some very valuable forex trading lessons to be had. The first was an article posted by Piptrain called “How The USD/JPY Can Predict The End Of The Recession” and the thread that caught my attention was called “Giving Up” by Jimmy Jones.

Piptrain made the very astute observation that USD/JPY had gone from being a co-incident to a leading indicator for the S&P. This is incredibly important because if you know the market is setting up to be in either a “risk on” or risk off” trend, you can enter some trades with potentially huge returns.

To review, “risk on” means investors are buying riskier assets like stocks and commodities as they sell the safe ones-the USD and Treasury’s. Risk off is of course the opposite. The market went into severe risk off mode after Lehman Bros. collapsed last September and we’ve now come to the end of the risk on rally that Bernanke ignited in March.

What also happens when the market is in risk on mode is that the yen falls as traders sell it against the (formally) higher-yielding currencies. At least, that was the case until USD/JPY apparently became a leading indicator of the market’s appetite for risk.

USD/JPY (as well as the other yen crosses) had basically been falling right along with the S&P ever since the market peaked in October 2007 and the move into the yen accelerated when global stock markets collapsed through last Fall after the Lehman bust.  But starting at the beginning of 2009, things changed.

USD/JPY started appreciating in January even as the S&P headed lower, making a bullish divergence just as the MACD sometimes does. The way things look now, what USD/JPY was telling us was that the market was setting up to be in risk on mode; the only thing it needed was the right fundamental catalyst which it got on March 15 when Fed Chairman Bernanke went on 60 Minutes and announced the Central Bank was “electronically” printing dollars. Active depreciation of the dollar is a pretty sure way to ignite a stock rally because if the dollar looks set to depreciate, anything you buy with it (like stocks and commodities) has to gain in nominal if not real terms.

Even more interesting is that during most of the recent rally, USD/JPY was going down-in other words, it was making a bearish divergence, signaling that the rally could only go so far because investors were not truly buying risk. All it needed to completely kill it off was perhaps something like the poor NFP report we got 2 weeks ago.

An even stronger indication that the market is moving into full risk off mode is that USD/JPY is continuing to depreciate even as stocks head lower-in other words, it isn’t making a bullish divergence now which is entirely justified especially after all the recent talk about deflation being a bigger concern than inflation along with the G8 saying that now is not the time to begin withdrawing the extraordinary monetary and fiscal policies that have been implemented during the crisis.

So what can be gained from this?

1. It does indeed look like stocks and commodities are headed lower, which means the dollar will gain against the higher-yielding euro, pound and A$.
2. If stocks do go down and USD/JPY starts showing a bullish divergence, we’ll know the market is at least prepared to gain given the right set of economic fundamentals.
3. If stocks eventually gain and USD/JPY shows a bearish divergence, stay ready for an eventual decline
4. If USD/JPY gains along with stocks, the rally probably has legs.

Giving Up

Jimmy Jones is talking about giving up trading because after finding success during the rally, he’s found things to be very difficult more recently. The exact reason why Jimmy Jones has found it so difficult to trade lately is because the market entered a consolidation period where price moved back and forth but did not trend. Trading is relatively easy when markets are trending because you can “set and forget” or even take profits along the way and buy on dips (in an up-trending, risk on market) or sell on strength in a down trend. But when markets are moving sideways, as they have been over the past few weeks, it’s very easy to see your account get shredded.

Trend following systems like moving average cross-overs all share the same characteristics-they look good in a trending market but fail utterly when markets are moving sideways. They cannot tell you when a trend will end and they certainly can’t tell you when markets will go sideways, which as we know are the most difficult markets to trade. In fact, sideways markets are the main reason why so many forex traders fail.

There are some traders who claim to be good in these types of markets but for the vast majority of us (myself included), they’re just too hard. I basically avoid them like the plague and if that means I don’t have trades for a few days, weeks, or even months-fine. I’ll keep my powder dry for the time when I believe markets can trend. In other words, the decision not to trade is a trade itself.

The only way to avoid this type of price movement is to be an astute observer of what’s happening with the markets in terms of the willingness to buy (or sell) risk and what makes that especially hard is that is that different circumstances create a different set of conditions. For example, what killed the March rally in my opinion was all the talk about deflation from people like Bill Gross of PIMCO, economist Nouriel Roubini and FOMC member Janet Yellen. Why? Because if deflation is truly the risk, the dollar is not likely to depreciate which means the risky assets bought with it (stocks and commodities) are not likely to gain.

I’m not saying this is easy. You have to do your homework. But being aware of what’s going on will help you spot when the trends might start and more importantly, end.

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.