2008 Global FOREX Outlook

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Ashraf Laidi

The currency developments of 2007 were undisputably dominated by two main themes; risk appetites trades benefiting AUD, CAD, NZD, GBP and AUD at the expense of USD, CHF and JPY, and; USD-specific selling against all major currencies including JPY. JPY amassed broad gains during periodic episodes of risk appetite reduction as global stocks sold off aggressively in the midst of subprime-related losses in the US finance/banking sector.

The two performance charts below illustrate that USD was the broadest losing currency in 2007, while the top four performing currencies against the USD were CAD, AUD, EUR and NZD. The commodity currencies of CAD, AUD and NZD were boosted by a favorable price environment for energy, metals and agriculture as well as high interest rate policies. EUR was propped by its role as the anti-US dollar and by the European Central Bank’s persistently hawkish rhetoric. While the three commodity currencies were clearly in command in the ranking of currencies’ performance against gold, no currency registered any gains versus the metal, illustrating the secular rally in gold and other commodities. As we will see below, this suggests significant implications for gold in 2008 as the onset of low global real interest rates -wide is maintained by a rising inflationary environment relative to nominal interest rates.







Current Dollar Rebound to Continue Into Mid Q2 2008

The current 4% rebound in the US dollar index off its November lows is a broad USD play emerging on a combination of end-of year repatriation by US institutions and more pronounced signs of slowdown in the UK and Eurozone. Year-in-Year out, currency markets have shown a noticeable reversal in December of the trends emerging from mid October to mid November. This has worked consistently in favor of the euro against the dollar in December of 1999, 2000, 2001, 2003, and 2005 as the single currency declined markedly during the prior 2 months in each of those years. The opposite of this pattern took place in December 2006 as the euro lost ground, reversing the gains of October-November 2006. Year-end repatriation and unwinding of cash and futures positions are behind such seasonal moves.

Fundamentally, the argument that the Federal Reserve intends to stick to its newly adopted liquidity-injecting policy, rather than reducing the fed funds rate may be less detrimental to the US dollar, while the Eurozone is seen moving towards reducing its inflation hawkishness-an element largely responsible to the euro’s recent resilience relative to AUD, GBP, NZD and CAD. Finally, the interest rate cuts from the Bank of Canada and Bank of England have cemented the cap on CAD while accelerating downside in GBP, solidifying the foundation of the USD rally.


Sources of Prolonged Dollar Rebound

1) Despite market perception that the Fed’s liquidity injection measures are behind the curve in alleviating the credit crisis and that the lack of aggressive rate cuts remains insufficient in bringing the US economy to a soft landing, growing inflationary pressures in the short-term may bolster the central bank’s non-interest rate easing liquidity solutions for the struggling money market, thus, underpinning the dollar from a relative yield perspective. This would be especially USD-positive at the expense of GBP due to more ample downside for UK interest rates. More on BoE and GBP found below.

2) The extent to which the ECB’s intransigence holds rates steady in the midst of further economic slowing is perceived by markets to be exacerbating the existing economic slowdown, business activity and investor sentiment. Markets are also fixated on the next European victim from sub-prime investment such as IKB. Preliminary reports of EUR 5 billion in writedowns from IKB banks have not bee followed by subsequent announcements from other banks.


A Repeat of 2001?

As the dollar strengthened in the last 6 weeks of 2007 despite prospects for further Fed cuts, the unavoidable question becomes whether 2008 will be a repeat of 2001, when markets rewarded currencies of growth-oriented central banks? Two business days into January 2001, the Fed delivered an inter-meeting 50-bp rate cut to start a 475-point rate reduction campaign which took the Fed funds rate to a 45 year low of 1.75% by end of the year. Although the Fed funds rate dropped below the overnight rates of all G7 nations with the exception of Japan, the US dollar outperformed all currencies in 2001.
But one of the many factors distinguishing the current environment from that of 2001 is the purpose of the Fed’s easing. The rate cuts of 2001-02 were driven by conventional dynamics of macroeconomic slowdown (cooling business activity, weak GDP growth, rising unemployment and falling equities). Today, the Fed is forced into uncharted territory highlighted by the following factors:

1. A pronounced shortage of money market liquidity, unwillingness of lending by commercial banks, uncertainty regarding the size of remaining write-downs and the resulting impact on banks’ rating, capital cushion and bottom line. Tightening lending requirements for private households and business are also expected to weigh on overall capital formation and aggregate demand.

2. The macroeconomic impact of i) falling prices of new and existing homes on construction and consumer spending 2) falling sales of new/existing homes 3) increased layoffs in housing-related industries, banking/finance and manufacturing jobs, will impose a severe test on consumer spending once the post-holiday sales season is behind us.

3. The Fed’s task of shoring up growth will be complicated by persistent inflationary pressures that are unlikely to abate as was the case in past economic contractions. The prevalent inflationary environment originating from high food and fuel prices is unlikely to abate due to weather factors bolstering agricultural supplies and a combination of supply/demand dynamics propping oil prices.

Accordingly we project the Fed to deliver 100-bps more in interest rate cuts, bringing the Fed funds rate down to 3.25% by end of 2008.
Unlike in 2001, 2008 will be accompanied by the economic spillover of broad erosion in the housing sector, dictated by falling prices, sales, construction and layoffs in related industries. Robust growth from Asian economies should also help fill in the slack from the US and Western Europe, which will likely support the Eurozone’s external economy and stabilize the anticipated downdraft from the US.


Fed’s Liquidity Injection is No Substitute for Rate Cuts

Although the Federal Reserve has distinguished its monetary policy maneuverings between liquidity injection operations (aimed at relieving funding shortages in the money market) and interest rate-cutting moves (aimed at shoring up the economy), we do not expect these liquidity measures to stave off the risk of recession. While the Fed is seen extending the expansion of its discount window via the Term Auction Facility “TAF”, we expect it to cut the Fed funds rate by 75-bps in H1 2008, taking the rate down to 3.50%. There is likely scope for 50-bps of easing in H2 that will push the fed funds rate down to 3.00% by year-end. The inflationary repercussions of the Fed’s easing will remain an in issue for the central bank, especially as food and energy prices remain robust. Although the Fed has recently begun stressing the durability of price pressures on the headline inflation front (headline CPI and PCE), an anticipated deterioration on the macro economic front (rising unemployment rate, higher jobless claims, soft post-holiday consumer demand and slowing prices/construction activity on the commercial property front) will maintain the Federal Reserve’s policy bias towards the downside, as per its December FOMC statement and November forecasts for lower term inflation and higher unemployment for 2008 and 2009. This in turn is likely to limit the dollar’s rebound against the euro, especially in the event that the ECB succeeds in maintaining interest rates at 4.00% throughout 2008. More on ECB and euro below.


Gold’s Secular Rally to Continue in 2008

While the increase in gold versus the dollar in 2007 was largely associated with an acceleration of the dollar’s declines, the strengthening of the metal was broad-based throughout the year. Gold rose 27% against the USD, 26% against GBP, 22% against JPY, 21% against JPY, 17% against EUR, 16% against AUD, 10% against CAD and 8% against NZD, totaling 146% in gains for the year against the major currencies. The global growth-backed commodity story as well as emerging inflationary pressures played a significant role in gold’s advances.

One theme expected to continue triggering further advances in gold is that of real interest rates. The modest declines in gold relative to the more protracted and uninterrupted recovery in the dollar since mid November are due to falling bond yields. As the Federal Reserve, Bank of England and Bank of Canada blitzed the money markets with over $600 billion in liquidity injections in the last two weeks of 2007, market interest rates headed lower while inflation continued to push upwards. Persistent liquefying operations of central banks are likely to highlight the luster of the precious metal relative to paper currencies, especially as the real cost of money is dragged down by high inflation and lower interest rates. The inflationary consequences of these expansionist monetary practices coupled with persistent robustness in commodity prices are expected to offset any downward pressures on inflation resulting from cooling economic activity. While the relationship between strong commodities and cooling economic growth may prove untenable, agriculture, energy and metals are likely to remain supported by supply constraints rather than demand factors.

We anticipate real US interest rates to remain pressured by a combination of an expansionist Federal policy and robust energy pressures. This should continue to reward gold versus the US dollar as well as the rest of the major currencies as inflation remains at the upper end of the targets set by most G10- central banks.

But the $900 target isn’t expected to be realized before a temporary decline to as low as $720. Periodic bouts of reduction in risk appetite are likely to trigger episodes of profit-taking in the metal. The expected pall on the metal is also expected to emerge from a modest slowdown in Chinese demand for commodities. The People’s Bank of China’s policy tightening coupled with the yuan’s 10% appreciation as well as the slowdown in the US, Canada, Eurozone and UK is likely to temper China’s appetite for metals and energy.


No Need for Textbook Recession Definition

While there has been much emphasis on whether the US economy has entered (or will enter) the textbook definition of recession --two consecutive quarterly GDP growth declines-- the consequences to the overall economy are sufficiently worrisome in the event of a back-to-back quarterly GDP growth of between 0.1% and 0.3%. The 2000-2001 recession was such an example, when GDP growth declined by 0.5% in Q3 2000, rebounded by 2.1% in Q4 2000 before contracting by 0.5% in Q1 2001. A subsequent rebound of 1.2% in Q2 2001 was then followed by a 1.4% contraction in Q3 2001. This time the impact goes beyond sluggish manufacturing and a shrinking wealth effect from falling equities, and extends to tens of billions of losses in the books of banks, which carries ominous implications for overall credit and capital formation.


EUR: Further Downside Prior to H2 Recovery

The prospects of a durable foundation in the euro lies primarily on the European Central Bank’s focus on upside price risks as inflation exceeds the 3.0% mark, its highest level in 6 years. But with the ECB also recognizing that the balance of risks for economic growth are clearly to the downside, the central bank may be closer to easing interest rates than its inflation vigilance suggests. Although the ECB has been the largest injector of liquidity since August, these operations have been proven more helpful in relieving short-term funding for commercial banks than in assisting an increasingly struggling corporate sector. With the euro retreating 5% off its highs against the dollar, any dovish overture by the ECB may risk furthering externally driven inflationary pressures, especially as energy prices maintain their lofty levels.

But just as markets punish currencies whose central banks are seen behind the curve in containing inflation, they also drag down currencies when central bank policy is perceived to be exacerbating the downside risks to growth. Signs of a possible growth contraction in Spain and Italy in Q1 2008 may prove highly euro negative especially if the ECB shows no signs of shifting away from its hawkish stance. Germany’s IFO and ZEW surveys on business and investment sentiment continue to trend lower over the past 6 months reaching 2-year lows but still do not suggest an accelerating loss of confidence. Eurozone GDP growth is expected to slow to 1.9% in 2008 from 2.5% in 2007, surpassing US growth for the second consecutive year.

We expect the ECB to continue stressing the downside risks to the economy and the upside risks to inflation, while being forced to cut rates once to 3.75% and continuing to maneuver policy via liquidity injections and FX rhetoric. In the event of persistent credit constraints and deteriorating economic dynamics, any signs of a retreat in headline inflation towards the 2.1%-2.2% range, accompanied by a decline in core CPI towards 2.0% from the current 2.3% will pave the way for another ECB rate cut. Further downside ground seen testing $1.42, while the risk of accelerating losses is projected to stabilize at $1.37. Renewed gains seen emerging in early H2, retesting $1.48 before claiming $1.55 in Q4.


JPY: Benefiting from Lower Carry Trades

Chances of further yen gains in 2007 will hinge on the interplay between further unwinding of yen carry trades and the onset of slowing demand from Japan’s major trading partners. Our expectations for further dislocation in US equity markets as well as prolonged uncertainty in global credit markets support the case for renewed yen gains as risk appetite remains under pressure and global liquidity is curtailed. And although futures speculators have boosted yen long contracts to 2-year highs against the dollar in early December, there remains wider scope for yen buying amid fresh revelations of write downs from US banks.

But we must also heed the yen’s downside risks from the downdraft of slowing growth. With 22% of Japanese exports going to Newly Industrialized Asian Economies (Hong Kong, Korea, Singapore and Taiwan) and 21% to the US, cooling economic growth should cast a pall on Japanese exports, especially with the risk of a US contraction weighing directly on Japan and indirectly via Japan’s trading neighbors. China’s absorption of 15% of Japan’s exports does play a significant role in filling the slack. But the downside risks to China’s economy may provide an indirect negative spillover on Japan, thereby exacerbating the already slowing demand from the US. With the combination of lower US demand for Chinese exports, a prolonged correction in Chinese equities, the transmission effect of the People’s Bank of China’s rate hikes and further strengthening in the yuan, the risk of a region-wide slowdown can be significant.

Internally, Japan’s 2008 GDP growth is seen slowing to 1.7% from 2.0% in 2007, still within the nation’s potential growth range of 1.5%-2.0%. We expect the combination of increased market volatility along with the onset for 100-bps of Fed funds rate cuts in 2008 to redefine the playing field for global carry trades. As a result, 110 yen is seen as the new anchor for USDJPY before retesting the 105 figure in late Q3.


GBP: Further Losses Ahead

The British pound’s breach above the $2.00 level may have been the only positive story for the currency in 2007. But even against the dollar, sterling gave up most of its 9% gains to end the year barely in positive territory up 1.0% against the greenback. The currency was the worst performer among G10 currencies after the US dollar. We anticipate continued losses in sterling as the Bank of England is seen cutting rates by 100 bps throughout the year.

Although official and IMF forecasts project 2008 UK GDP growth to slow towards 1.9% from 3.1% in 2007, the risk of a more protracted housing correction may drag growth down to 1.5% for the year, with the risk of recession an increasing possibility. The domestic savings ratio fell below zero, a level not seen since the late 1980s while household debt service soared to 14% of incomes, the highest since 1991. With over 1 million of fixed rate mortgages due for reset next year, the risks to the personal debt market are considerable. UK estimates place the number of homes to be repossessed in 2007 at 30K and 45K in 2008, the highest since the property crisis of the 1990s.
The Bank of England had already been forced into a unanimous decision to cut rates in December, one month earlier than it predicted at the November inflation report. We expect the BoE to cut by 100 bps in 2008, taking down rates to 4.50%, which would deal sharp erosion to real interest rates, currently at 3.40%.

Sterling weakness will be a major theme in currencies for 2008, which should help the US dollar obtain some stability. This also means further divergence in GBPUSD away from EURUSD, which should trigger further strengthening in EURGBP. GBPUSD downside is seen extending through $1.92, with the risk of extending losses towards $1.88. Upside remains capped at $2.06. Further carry trade unwinding is likely to drag GBPJPY towards 210, with downside acting on $235.00.


CAD: Limited Downside from the US

The Canadian dollar was the highest performer in 2007 among all G10 currencies thanks to rising prices of energy and agriculture products as well as robust economic growth resisting the downdraft from the US slowdown. Currency strength and retreating manufacturing activity did force the Bank of Canada to cut interest rates in December, partially due to some help from cooling inflation.

GDP growth is seen edging up to 2.8% in 2008 after an estimated 2.5% in 2007. With 80% of Canada’s exports going to a recession-bound US economy, the negative risks on overall growth can be significant. The 8% share of total exports going to the healthier Europe and Japan may help offset the situation. But the composition of exports is also crucial. Considering agriculture and energy exports make up over 25% of Canada’s exports, or 10% of GDP, the sector make up is expected to help the situation especially considering the expected favorable climate for commodity prices ahead.

While oil prices will continue acting as the wild card, we do not foresee any prolonged declines below the $70 level. Steady prices should be CAD-neutral, leaving the currency equation to be determined by inflation and BoC policy. We see a 100% chance for a 25-bp rate cut in Q1 2008, followed by another similar move in Q2 that will take the overnight rate to 3.75%.

Unlike most of its G7 counterparts, Canada’s currency remains characterized by high real interest rates, standing at 2.7%, versus 2.1%, 1.0% and -0.6% for the US, Japan and Eurozone respectively. Although real UK interest rates stand at 3.4%, expectations of 100-bps in BoE rate cuts have already began weighing on the British pound.

We expect a 25-bp rate cut in Q1 to boost USDCAD to as high as $1.070 as the currency sustains losses from a combination of risk reduced risk appetite and falling yield differential. One more rate cut in Q2 to 3.75% may be needed by the Bank of Canada to stave off further slowdown, but as long as the market deems these cuts as precautionary, there is upside ground for a CAD recovery in H2 towards the $US 0.95 level.


AUD: Yields & Commodities to Counter Risk Aversion

The unwinding of high yielding FX carry trades and the broad USD rebound in the last 6 weeks of the year has overshadowed the strengths of the Australian dollar and the currency’s potential to retest parity with the USD. Standing at 23-year highs versus the US dollar in November, the Aussie was 6 cents away from parity as the Reserve Bank of Australia raised rates to an 11-year high of 6.75% and signaled to do more. We expect the RBA to raise rates by 50-bps in 2008 to stem an accelerating inflation rate, already projected to exceed 3.00%, well over the central bank’s preferred target of 2.0%-3.00%.

Baring any negative price shocks in agriculture and minerals, the Australian dollar is set to be amid the highest performing currencies in the G10 in 2008. In addition to a strong yield foundation, the currency stands to gain from a favorable price environment for commodities, as the sector makes up 65% of exports. Specifically, grain prices are widely expected to pursue their upward run in 2008, delivering higher returns for wheat and barley. And with minerals making up 50% of overall exports, steady demand for items such as copper --propped by China’s power generation capacity --the benefits would combine price and volume. The latter is also expected to soften the shock from falling US construction expenditure.

Another likely boost for the Aussie is the exposure of Australia’s exports to a robust regional market. Over 40% of Australia’s exports are destined to Japan (19%), China (14%) and the Republic of Korea (8%), all of which are expected to maintain their robust expansion in 2008. Yet even, a modest cooling in these economies is unlikely to pose any headwinds for the currency.

The downside risks to the Aussie include a prolonged decline in commodities prices resulting from a global growth slowdown and extended bouts of risk appetite hitting global investor confidence as well as high yielding currencies. Accordingly, these dynamics may drag the pair down to as low as 77 cents. But as long as the RBA retains growth and inflation arguments for a tight policy, we expect the Aussie to maintain its potential to rebound from risk aversion declines. Further Fed easing will likely lift AUDUSD past the 90-cent figure and test 95 cents by Q3. Chances of seeing parity in Q4 stand at 70%.

Equity Index Update

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Brad Sullivan

The index markets zigged when many a trader was looking for a zag on Friday. A tame headline on the PPI reading and a weak Retail Sales report may have rekindled some hope of a FED easing before the calendar year ends. However, Friday’s sharp bounce seems reminiscent of many moves during the past couple of years in the index world.

Seemingly many shorts, players on the sideline and active traders continue to wait for that elusive “green light” to get short. Days like Thursday get the interest going and players tend to walk into a bull trap type of session. The strong buying that hit the market around 9:10-9:20CDT (which remains a KEY time zone for relative highs/lows intraday) pushed the SPM7 back into the critical 1504-1507 trading zone. From there the index was able to register a 30 minute close above this key zone and turn bullish. However, as I pointed out on Friday, the odds were to get long back in the key 04-07 zone for a push higher. That push happened on heavy buying near the cash close of Friday’s trade, eventually leading to a settlement in the SPM7 at 1512.20 and all but erasing Thursday’s downdraft.

So…what was learned from Friday’s session? Simply the same pattern we have seen play out over and over the past couple of years in the marketplace – the comeback rally -lives on. And in each of these instances, the market has eventually found its way higher. The fact that we recovered so much of Thursday’s decline during one session and that we are heading into option expiration week, puts the potential for another round of higher highs clearly in view. Certainly CPI and Housing Starts (released on Tuesday and Wednesday respectively) will have something to do with that. But, keep in mind that option expiration weeks tend to trade one of two ways – a slow push higher…or a violent decline. The odds of the decline look small – however, we must register them with the data hitting the tape this week. If CPI were to come in “out of line” with inflationary readings, the snowball selling potential would be in play for the majority of the week.

As for today, here are the levels for SPM7. On the upside, look for a moderate choppy zone between 1512 and 1514 as players begin to establish their positioning in here. Above 1514 we hit the key zone between 1515 and 1518.50. Any 30 minute close above this zone is bullish – however, once again I will not be chasing ‘em in here. I will, however, use any dip back into the zone (15-18.50) to enter long positions with a potential trade towards the 1520.50 and 1522 zone. If there is no chance to enter the long side in this zone, wait for the final 30 minutes and look for an aggressive push higher into the bell.

Support zones are found from 1509.50 to 1508.50…below this is the key zone from 1507 to 1504. Any 30 minute close below this zone adds a certain amount of confusion moving forward and should be sold short with a target of 1496-1495.

Equity Index Update

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Brad Sullivan

The index markets held serve after an attempt to push the indices lower failed to pick up steam at short term support levels. A late morning, lunchtime push higher allowed the market to probe, but never get above the unchanged level in all but the NQ futures. Volume was moderate ahead of both the CSCO earnings report and today’s FOMC statement.

As for CSCO, the stock was not able to match “whisper” expectations in its report and during the subsequent conference call. The issue is called to open about -1.45 at 26.90. This has put moderate pressure on the futures with the NQ contract trading lower by -5.00 at 1900.50. The SPM is trading lower as well, at 1510, down -2.25 on the session.

While we may have some moderate trading around the CSCO news in the first 45 minutes today, the odds play seems to be one of hands-in-pocket until the 1:15cst FOMC release. Attempting to handicap this release is generally futile as one verb added or subtracted can mean a few billion in market cap changes hands in the SP over the ensuing minutes. In other words…keep it close to the vest post announcement. Expectation wise, the markets are continuing to expect similar wording from the FOMC as it has received in the recent past. A change in this wording will move the markets…but to what extent?
From a trading perspective, the question we have to ask ourselves is pretty simple…is it time to fade this move and put a counter trade to work? So far, only the DJIA (as I showed yesterday) is extended from its 200 day MA. All things being equal, this represents a good time to get flat (if long the DJIA) or look to premium sell/outright sell the index. HOWEVER, the warning trade in this environment is that we are at the cusp of a major mega-cap upside explosion. If this scenario occurs, the extension readings could move sharply, possibly towards the +15% zone. Accordingly, proper use of stops and such are needed when fading a beast.

The other night I pulled down a book from the coming of age master J.D. Salinger and turned to a page that had a Taoist tale. Without rehashing the whole section, I will include this portion which is the tale end of a conversation between a Duke and his horse breeder that is about to retire. The breeder has sent the Duke to another breeder…a few months later the new breeder sent the Duke a horse that was supposed to be a dun-colored mare, but, turned out to be a coal-black stallion. When given this news the old breeder was amazed at how advanced his friend had become in choosing horses.

“In making sure of the essential, he forgets the homely details; he looks at things he ought to look at, and neglects those that need not be looked at.”

A traders mantra if I have ever read one…accordingly I have enclosed 4 charts for viewing today. One is the NDX extension readings for the 200 and 20 day MA’s. So far, the readings are elevated but not overbought.

Also included is an analog chart showing the performance of the Euro/Yen and SPX over the past year. The linkage is simply amazing. The third chart is showing the cumulative SPX breadth for the top 100 issues only. This continues to show the mega-cap extension as the upside ride continues. Finally, the last chart shows the 2007 performance for both the NDX and SPX top 100 from the OPEN print, in terms of net breadth for that session. You will see that yesterday showed a divergence in the NDX/SPX performance…it can possibly be explained by buying into the CSCO number. However, that seems a bit simplistic and it could be that mega-tech will continue to move higher.

Japanese Yen

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Sally Limantour

After a break in the overnight market the yen is now holding firm above 86.00 level in the futures market. There was a piece about the yen in Market News. Apparently State Street developed an indicator called the, “Japanese Yen Foreign Exchange Flow Indicator, or FXFI that makes a point that over the last six months the average short yen position established was 119.70. They assess the majority of yen shorts were probably put on above 118.00 (86.00 level in the yen futures) and,

“Thus institutional investors are significantly underwater, even when one takes into account positive carry. We believe that these accounts will use any rallies in dollar-yen to reduce their short yen exposure and limit further losses.”

It is interesting that State Street only goes back six months. The carry trade has been something that has been going on for years and most likely the level is closer to levels from Jan 2005 at the 105 level (98.00 level in futures) as Barbara Rockefeller discusses in the March issue of Currency Trader Magazine, The Yen: Canary in the Currency Coalmine (www.currencytradermag.com). I also suggest an article published yesterday in the Economist magazine called, The Yen also Rises (www.economist.com).

Assuming this is true, we are not close to breakeven levels and we would most likely see massive liquidation prior to that. Keep that on your radar.

Long yen positions are held with the next target level coming in at 88.43 (Upper Bollinger Band on JY H7 Weekly Chart).

Equity Index Update

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Brad Sullivan

This morning the indices are trading sharply lower on the heels of a mini-crash in China where the market lost -9% of its value in their Tuesday session. In addition, the unwinding of the Yen Carry Trade has begun in earnest as the YEN is higher by +1.2% vs. the Dollar overnight. I have said for quite sometime that this is the key, the liquidity primer that has become one of the primary reasons for the decrease in global volatility. Now…if this Carry trade turns into a fiasco of “last one turn out the lights” it will have major negative implications across the global index and commodity markets.

Given that I have laid out the bear case, it is worth noting a couple of key points. IF THE YEN CARRY UNWINDING IS MODERATE IN NATURE, the markets should have little trouble adjusting to this liquidity squeeze. On the flip side…all one needs to do is examine a chart from last years steep selling in the index market --- REMEMBER IT ALL BEGAN WHEN THE YEN RALLIED SHARPLY VERSUS THE DOLLAR ON COMMENTS OUT OF THE BOJ REGARDING THE END OF THE EASING CYCLE. Granted, the subsequent rally was tremendous and has carried the indices to new trading highs. However, being a short term trader we are concerning ourselves with the outlier event…and that is volatility. If I am correct, I suspect that today will usher in a several week period of increased volatility - time to put away the sunscreen or ski boots.

As volatility begins to come back into the marketplace, it will widen the true depth within the bid/ask. We have grown accustom to size up at every tick in the index futures markets – this will subside as market maker programs adjust for the uptick in volatility. Subsequently, this will increase the impact a large order has on the market – for example, an order to sell 1500 sp minis at the market during a liquid time of day may only move the index a couple of ticks. Today, that same order could move the market as much as 1.75. Be prepared for strong program playing and liquidation. In addition, be ready for some quick and aggressive short covering moves.

S&P, Yen and Gold

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Sally Limantour
February 16, 2007

The risk appetite is increasing in the financial markets and the shortest term indicators are now back at high levels. Consequently, my short term model is back to a sell signal. There was a notable short covering of put options yesterday and the 3 day put to call ratio is also moving back towards a sell. Closing long positions today ahead of the 3 day weekend and will execute short positions with a stop loss of about 1% above current levels between today and Tuesday.

The monthly capital flow report from the Treasury yesterday showed a net portfolio inflow of only $15.6 billion in December versus the “norm of $50-80 billion (Nov. was 84 billion). This is due to record net outflow of foreign investment from US equities and record US investment in foreign securities, according to Bank of NY economist, Woolfolk.

The Yen moved higher against every currency and the probability a rate hike at next week’s BoJ policy meeting is growing. The question is if the BoJ yields to foreign pressure, thereby raising rates, will the whole carry trade unwind and if so, will it be orderly? The Carry Trade was covered here on my February 4th post. The last time we saw an unwind was the summer of ’98 when the carry trade ended violently and some are concerned given the size of the short position today we could witness a protracted and painful event. This must be monitored closely. The BoJ members are in a “blackout” mode ahead of the policy meeting next Tues/Wed., so we will not hear policy statements until after this time.

Gold has formidable resistance between $668-674. Gold is trading lower this morning and next support for April gold is 663. Many cycle folks are writing about a cycle high due at the end of February. Perhaps if the market continues to reject closes over the 672 area we will go back and test the low 650’s. The real action of late is in the base metals, particularly nickel which rose 5.4% yesterday due to tight supplies. Nickel is up 22.3% for the year, versus copper which is down 7.2% year-to-date. There are a number of attractive companies to look at in the base metals sector.

The Carry Trade

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Sally Limantour
February 4, 2007

The yen was in the spotlight last week and volatility increased as speculation about the currency’s fragility would be a topic of concern with the G7 meeting. Hank Paulsen, the US Treasury Secretary added fuel to the fire when he told the US Senate last Wednesday that he was watching the Japanese currency “very, very closely.” The yen rallied right after these remarks. On Thursday, he came out and said that he did not think the yen was at an artificial level or had been influenced by political pressures which caused the yen to sell off. Political volatility is a dangerous game.

Japanese interest rates are at rock bottom and while concerns of deflation are being talked down, there does not seem to be a compelling reason for the BOJ to raise rates. The perception that rates and the yen will stay low is fueling the carry trade where any hedge fund can borrow in yen, invest in something with a higher yield, apply some leverage and achieve returns of 20 per cent or more. How long this game can go on is an important question as the unwinding of this carry trade could affect many different markets when it occurs.

Different analysts try to estimate the total size of the carry trade, but it seems a daunting task. Some economists guess at about $35 billion, while pi Economics (www.pieconomics.com), in their research report, The Credit Bubble and the Yen, thinks it is more like $1,000 billion. The yen has thus been labeled the “ATM of the global credit world.”

It is not just hedge funds, but investment banks and other institutions that fund their deals with ultra cheap yen. Most of them do not seem worried as they are betting that Japan’s economic recovery will be slow, thereby keeping the yen weak and the carry trade alive and well. There are also too many interest groups that oppose a stronger yen.

Market volatility has been low making it cheap to use derivatives to insure against the risk of a rising yen. As a result, many hedge funds are buying protection against a stronger yen while playing the carry trade game. In a recent letter to the FT, Vineer Bhanasali, Executive Vice President of Pimco recently commented on this, “low volatility and high carry pairs -is due to “invisible hand” collusion between sellers of exchange rate volatility via options (everyone is selling options as a means to generate income in their portfolios, including many of the central banks) and the authorities, which are setting transparent, low inflation rate policies. The two continue to feed each other. Nothing short of a confidence can shake this fearful yet stable equilibrium. Waiting for that crisis, unfortunately is unprofitable and, given the cheapness of protection against the tail risks, not the course of action you should expect most profit-driven speculators to follow.”

For now, the general consensus is for the yen to stay weak as UBS, AG and RBC Capital Markets both reduced their estimates for the yen. There is, however, a dissenting voice from none other than our irreverent and insightful Marc Faber of the famed, Doom, Gloom and Boom report. In the recent Barron’s Round Table he shared a different take on it. Marc is betting on volatility this year and would play it this way:

“Consider the carry trade – investors buying in yen and investing in higher-yielding assets around the world. They’re not buying dividend-paying assets, but assets like the Indian stock market. The yen carry trade will unwind when, suddenly, these risky assets begin to perform badly relative to cash rates in Japan or the Japanese stock market. Then leverage will be reduced and people will reinvest in yen. When the reversal occurs, the yen will soar against, say, the dollar. My macro pick for 2007 is to buy the yen long or long-dated calls on yen. In the long run, it is a bad policy to borrow in a low-yielding currency and invest in a high-yielding currency. It works for one year, two years, three years, and suddenly it massively doesn’t work.”

As traders we have to understand both sides of the argument and, in addition, we must look at the charts, the Commitment of Traders report and consider the seasonal tendencies. Last week the yen took out the previous week’s high and low and closed higher for the week. In making that low the yen went below the lows going back to December of 2005, but quickly rejected it. I would consider this a critical area as we made a low last week of 82.38, taking out the 2005 low of 82.52. Back in 2003, we had a double bottom at 82.20 and then rallied sharply to 97.00 into 2004. So, this 82.20 - 82.50 area is critical support and taking it out could see prices break quickly to the 80.00 level.

The Commitment of Traders report (COT) reveals a market that is not overly short. On the CME the net short yen positions still represent only 38 per cent of all yen contracts. I would want to see the COT with a larger share of short positions to begin thinking about fading the short side. Also, the seasonal tendency for the yen is to sell off during this time of year. Over the last 10 years, the yen has consistently lost anywhere from 2.15% to 3.17% between February 3rd through April 12th. If we follow the seasonal pattern this year we could see the yen trade down and test the 80.00 level. Perhaps, then we could find some attractive long-dated calls on the yen.

We have to keep in mind that anything can happen and realize too that the Japanese investor’s appetite for overseas assets continues to be insatiable which adds to the yens weakness. Despite big outflows, 93 per cent of Japanese household wealth is still yen-denominated. All of this plays a role in the value of the yen, but as we all know trends do not continue forever and things can change rather quickly. Like Hank Paulsen, I will be watching this very, very closely both for direction and volatility - for volatility is the enemy of all carry strategies.