February 20, 2010

Market Insights - 20 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Charts Of The Week
• Weekly Barometers 
• A Token For The Fed's Sugar Daddies? 
• US Mortgage Debt versus US GDP 
• The Next Move For The US Dollar 
• Something About Technical Analysis 

Weekly Snapshot
• US consumer prices rose 0.2% in January and increased 2.6% annually (BLS)
• The Fed raised the discount rate to 0.75% but insisted that this does not tighten policy (Economy.com)
• Barclays reported that pre-tax profit almost doubled in 2009, to £11.6bn (Economist)
• BNP Paribas, France’s biggest bank, saw net profit almost double last year, to €5.8bn (Economist)
• Producer Price Index in the US rose 1.4% in January, seasonally adjusted (BLS)
• US Leading Economic Index up 0.3% in January after a 1.2% gain in December (Conference Board)
• US Industrial production in January advanced 0.9% following a 0.7% jump in December (Bloomberg)
• US Housing starts in January rebounded 2.8% after dipping 0.7% in December (Bloomberg)
• US Building permits decreased 4.9% since December, but are up 16.9% from January 2009 (ESA)
• The ZEW Indicator of Economic Sentiment for Germany decreased by 2.1 points in February 2010 (ZEW)
• Japan's real GDP grew 1.1% in the fourth quarter of 2009 (Economy.com)
• U.K. annual inflation rate surging above the 3% upper end of the BoE's target range (Economy.com)
• Foreign demand for US Treasury securities falls by record amount as China reduces holdings (AP)

Chart Of The Week (click on chart for larger image)
The Fed announced a 0.25% hike in the discount rate right after US markets closed on Thursday.  In the currency markets, the US Dollar gained against all major currencies immediately after the announcement. The Euro consequently got hammered, dropping over 100 points in just 10 minutes (see 5 min chart on the left below).  And after Friday’s benign inflation data, the Euro went right back to where it started. Text-book moves like these don't happen all that often; traders live to catch one of these once in a while...

Euro-2010-02-19  Euro-2010-0220-b

Weekly Barometers  (click on chart for larger image)

Stocks-2010-0219  FX-2010-0219

A Token For The Fed's Sugar Daddies?  
Widely publicized and with plenty of market reaction, the Fed raised the discount rate to 0.75% on Thursday, but insisted that this does not tighten policy. As Reuters reported on on Friday:

The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."

Well speak for yourself Mr. Dudley and Mr. Bernanke, but the market sure did not take your words all that serious.  In currency markets, the reaction was immediate as we saw in a sudden increase in the US Dollar against all major currencies (see Euro chart above).

However, the Fed’s "surprise move", maybe not be so surprising after all. In previous FOMC meetings, the end of quantitative easing had been alluded to already. But let's look at the the Fed move from another angle.  Central Bankers almost always base monetary policy on "controlling" interest rates and money supply. Looking at a Central Bank from a business perspective however, the Central Bank is in this most enviable position in that it can essentially write its own ticket, i.e. tell its creditors what rate they are prepared to pay for incurring yet more debt.  But what if government finances were so out of whack that it became increasingly difficult to service the debt at these ultra-low rates? Now the objective is no longer that of "control" but rather a question of creating incentives to find buyers for yet more debt. As Dow Jones reported:

"Treasury prices slipped a bit more Thursday, with the 30-year Treasury down by nearly a point in price, after a disappointing 30-year Treasury auction, the government's final offering of the week."

Further, the Department of Treasury announced the major foreign holders of US Debt where a similar "soft surprise" occurred.  As of latest data from Dec-09, Japan outranked China again as the number one holder of US Treasuries with total holdings of $768bn.  China, now second, was holding $755bn worth of US Treasuries having scaled back their US holdings by about $45bn since last summer.  Maybe it is just a coincidence that the Fed moved ahead with a rate hike. But we cannot helping considering the pressure that has been building up for the Fed in terms of continuing to financing the growing US debt.  The prospects of further US budget deficits are daunting and it is too early in the game to derive any conclusions for the timing on further rate increases.  However, this small teaser move in higher rates may just be the right token for the Fed's sugar daddies...

Major-Foreign-Holders   MajorForeignHolder-2009-12

US Mortgage Debt versus US GDP
Speaking of deficits, the economic report of the President is out and along with it pages upon pages of data, charts and tables.  This report was written by the Chairman of the Council of Economic Advisors and you can download the entire document here

At some 450 pages I have neither the time nor the energy to read this in its entirety.  However, as I was browsing through some of the data tables, I noticed two numbers that seemed too similar to ignore.  US GDP is about the same as the total mortgage debt outstanding, roughly $14.4 trillion, give or take a few billion.  This ratio of US GDP versus mortgages hasn't always been so closely matched as the chart below indicates.  On average, total US mortgages were below 50% of the GDP until about 1977 when the ratio started to gradually increase culminating in the year 2006, the height of the US housing market when for the first time in history US mortgage debt outranked US GDP.


I have a hard time comprehending how public and private household debt could ever get this far out of hand, but the graph essentially expresses my personal sentiment as to what is wrong with the US economy.  To get back to sustainable economic growth, something's got to give.  In this case, either US GDP vastly improves, or the more likely development occurs - US mortgages, the biggest portion of US household debt, have to continue to delever to bring back this unique ratio to a more tolerable level and in line with historic averages.

The Next Move For The US Dollar
On to the multi-million Dollar question: Where is the Dollar heading now that there is a possibility that the US rate tightening cycle has begun? Here’s my 2 cents on this question:

In 2009, practically everyone and their mother were dumping Dollars in favor of any other semi-stable currency.  Word on the street was, the US Dollar is doomed for sure, so let’s find an alternative.  Biggest gainers were the higher yielding currencies for instance Australian and New Zealand Dollars which were also the favored plays for a carry trade.  Eventually that trade got very crowded and particularly when sovereign debt concerns surfaced, most notably in Dubai and Greece, the flight to the safe haven US Dollar re-emerged.  Perception about future events is what drives the markets and at the moment, the fundamentals in the US are perceived to be stronger than in Europe or in Japan.  The Fed’s move may or may not be the beginning of a rate tightening cycle, but it gave a signal to the markets.  In terms of rates, the ball is now in Europe’s and Japan’s court but a move by either seems unlikely.  Japan has effectively not raised their rates in two decades, why should they do it now?  Europe has their share of issues dealing with potential defaults by one of more PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries.  A slightly weaker Euro may play into the hands of the stronger European economies who are very dependent on exports.

The question therefore is, which of these major currency/country components is perceived to be in a stronger position going forward?  Looking merely at attitudes, the US appears to have the momentum as Americans are perceived to use more aggressive measures to fight their way out of an economic downturn.  Attack is viewed as the best defense.  Europeans and Japanese by contrast are generally more subdued and defensive in their outlook and that attitude is a component of the recent currency movements too.  Hunkering down and waiting out the crisis appears to have been the prevailing attitude in Europe as well as in Japan.

This means, in terms of a short to medium-term outlook, there is continued pressure on the Euro and, to a lesser extent, the Japanese Yen.  But the US Dollar outlook versus some other currencies may not be as one-sided.  Referring to the Weekly FX Barometer above, the currency movements of the past week are in our view indicative of a possible short to medium-term trend going forward.  It won’t be a one-way trade as it was in 2009 which means, one cannot simply buy US$ and sell every other currency.  The commodity currencies Australian and Kiwi Dollar (and to some extent, Canadian Dollar, Brazilian Real, Russian Ruble etc.) will be closely correlated with the price of Gold and other industrial commodities.  They could be an ideal inflation hedge.  And as long as the US rates remain roughly at current levels, there is still enough room for a carry trade, taking advantage of the higher deposit rates “down under”. Any further softening of inflation data however, will be a signal to get out of the carry trade, something that in view of the recent CPI figures needs to be watched closely.  

Looking at some of the Asian currencies, a different story emerges. Fundamentally, the arguments for a stronger US Dollar are not nearly as compelling.  Take China and India out of the equation, as very special cases, and you are left with some potentially interesting currencies, albeit slightly more difficult to put on as a trade.  In terms of strong fundamentals, Singapore, Taiwan and South Korea may be countries where a stronger currency could emerge simply because of their superior (to the US) government finances.

Going forward, the Greenback may have a slight edge against the Euro until the Europeans sort out their internal issues with sovereign debt.   Other currencies however, may show a fair amount of resilience against the US Dollar and despite the current momentum in favor of the US$, they are more likely to remain stable with potentially more upside against the Euro.

From a technical perspective, the US$ Index has gained back nearly half of its losses from 2009.  It is now in an interesting territory approaching the 50% Fibonacci retracement level.  It will be intriguing to see if and how fast the Dollar Index can take these next technical hurdles to consolidate the ongoing up-trend.


On a final note, we need to remind ourselves that the underlying economic and fiscal conditions in the US are still very precarious.  In particular, the outlook on US government’s finances, which lead many to believe that the Dollar is toast in the first place, has not changed.  As recently noted, the US budget deficit is at a record $1.56 trillion for the current fiscal year only to be followed by another deficit of $1.27 trillion for fiscal 2011.  There is no indication that the US government’s finances will improve anytime soon, which goes back to a point made earlier.  In order to continue keeping its “sugar daddies” somewhat happy, the Fed must take a hard look at finding the right balance between incentivizing for US treasury buyers and stimulating the economy.   In terms of trying to balance this via interest rates, it looks like a double-edged sword to me.  But given the choice, it would seem more likely that the Fed would let go of a strong Dollar policy for the sake of keeping the US economy alive.

Something About Technical Analysis (Warning: For Technical Traders Only)  
Last week, we featured an S&P500 chart by Serge Perreault as our chart of the week.  Here is another copy...


A good friend pointed out a discrepancy in that chart from the data he was gathering.   An interesting discussion then ensued and we noticed that Serge Perreault’s chart was drawn using a semi-logarithmic scale whereas my friend was using an arithmetic scale to draw the chart.  The differences in terms of drawing trend-lines can be significant, potentially giving wrong entry/exit point signals for major trends.  See both versions of the scales for the same S&P500 chart:

Semi-Log Scale Arithmetic Scale
SPX-Log Chart SPX-NoLog

Which one of the two settings is used by the majority of traders?  I posed this question to numerous colleagues and traders and interestingly, the jury isn’t out yet.  Doug Short from www.dshort.com wrote me and said:

A log scale on the y axis (correctly speaking, a "semi-log" chart) makes a lot of sense for longer time frames and even on shorter ones when the range on the y-axis is large. See this article at the StockCharts website for more detail, especially the section on scale settings:


I have also received plenty of feedback, particularly from Forex traders, who felt that arithmetic charts which are typically the default settings for many trading platforms, were the right ones to use.  Another dear friend, who is a Quant, was very skeptical about using log or semi-log charts for Forex.  He noted that log-charts for Forex appear are not ideal because each currency trade consists of 2 moving components making up the price of the currency pair.  Unlike trading stocks, one is never just long or short of a currency.  In reality, one is always long one currency while simultaneously shorting the other.  As a result, the movements in currencies have sort of a natural filter or break and the kind of large scale movements one might see in stocks are less likely in Forex.  Rest assured that the mathematical concepts of proving such a statement are beyond my capabilities but I can second that assessment from personal trading experience. 

In closing, I would recommend that you test very thoroughly what works for you before you base any trading decision on any given technical indicator. 

Good luck and good trading!

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Anonymous said...

I was intrigued by your plot of mortgage debt vs. gdp (http://lh4.ggpht.com/_Ws8RVJ7UJ5I/S4BshaMKwzI/AAAAAAAAA3c/-KZ6pgLwcfQ/s1600-h/US-GDP-versus-MortgageDebt%5B3%5D.png). Could you share the sources you used for this? When I look at the fed data from (http://www.federalreserve.gov/releases/z1/current/accessible/b100.htm) row (Households and nonprofit organizations home mortgages liability), it shows $10.3235 trillion for outstanding mortgages but you show $14 trillion.


info@fxistrategies.com said...

the numbers are from the economic report of the president: http://www.nber.org/erp/2010/2010_erp.pdf
It's the summary table on page 420. Send an email to info@fxistrategies.com for more information and full data sources.