economics

February 23, 2010

news Feb 22nd 2010

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Commentary by Kathy Lien: Dollar: Policy Making in Focus this Week

DOLLAR: POLICY MAKING IN FOCUS

It has been an extremely quiet day in the currency, equity and commodity markets with virtually every asset class ending the day unchanged.  The dollar’s performance was mixed with the greenback strengthening against the euro but weakening against the Japanese Yen and British pound. This is the type of price action that we would typically expect on a holiday but with all of the major markets open for normal trading hours, the movements in the financial markets are more indicative of hesitation. Last week, the Federal Reserve raised the discount rate by 50bp and this week Bernanke is scheduled to deliver his semi-annual testimony on Wednesday. Traders will be listening in on each of his words for clues to what the central bank will do next.

Dovish Comments from Fed President Yellen

Based upon the latest comments from Federal Reserve President Yellen, the central bank really wants the market to believe that their discount rate hike does not signal anything. More specifically, she said the hike is not necessarily the first of many steps, that “this is not the time” to remove monetary stimulus and more purchases of Mortgage Bank Securities could be conducted if there as a significant and serious change in the economic outlook. Yellen believes that the recovery is underway but credit is tight which means the housing market could weaken again. The full impact of foreclosures and bank failures have not been felt yet and like the NY Times article this weekend suggests, unemployment could remain painfully high for years although the labor market may be close to a turnaround. She predicts the economy will grow by 3.5 percent this year and then quicken to 4.5 percent next year. The only thing she said about tightening is that it will occur before full employment (which is obvious) and there is reasonable consensus within the Fed about the tightening process.  There is a good chance that Bernanke could adopt a similar stance where he downplays the significance of Thursday’s announcement. The dollar’s reaction will depend upon how far he goes in suggesting that their action does not represent a change in monetary policy.

U.S. Consumer Confidence Could Falter

Despite the improvements in the U.S. economy, tomorrow’s consumer confidence report is likely to indicate that consumer sentiment deteriorated in February. The Conference Board’s report is the second of 2 major confidence reports that are released every month. The University of Michigan conducts a monthly survey of 300 consumers about their attitudes and releases their preliminary report near the beginning of the month. They then survey another 200 consumers and release their final report at the end of the month. The Conference Board on the other hand only releases one report which polls around 5,000 households (usually 3,500 respond) about current and future economic and employment conditions. Although the Conference Board’s survey is much broader, it has a 90 percent correlation with the UMich survey for the past 3 years. This means that Conference Board is likely to report a small deterioration in confidence, just like the University of Michigan did earlier this month. The following chart illustrates the strong correlation between the UMich survey and the Conference Board report and explains why confidence could falter.

EUR: GREEK SAGA CONTINUES TO UNFOLD

The lack European economic data and quiet trading in the U.S. equity markets has caused Friday’s rally in the euro to fizzle. With nothing to latch onto, traders have been itching for updates on the Greek saga.  The deadline for Greece to provide Eurostat with details on their recently discovered swap agreements was last Friday and Greece completely blew it. According to the European Commission, “Athens told us that the reason for the delay was partly due to the four-day strike which affected the ministry of finance.” This additional embarrassment adds further doubt about the government’s ability to meet their deficit reduction targets. There is no new deadline and no consequences for missing the deadline, which provide Greece will little urgency. According to a Bloomberg who quotes a source that has direct knowledge of the swap contracts, Greece may have arranged swap agreements with 15 securities firms. These swaps allowed them to receive upfront payments before 2008 when EU regulators changed rules to limit the use of the contracts. However the question about swaps have fallen to the sidelines as traders realize that another skeleton in the closet won’t do more harm than what has already been done. Instead, traders have latched onto two other stories about Greece – the first is their possible willingness to finally request and accept aid from the European Union and the second story is the possibility of the EU/Germany providing up to EUR25 billion in aid. If these stories are true, this could be the beginning to the end of the Greek saga. Of course, it will be sometime before it is finally resolved and in the meantime, Euro traders will turn their focus to the German IFO report. Despite a slowdown in service sector activity, manufacturing activity in Germany has been humming along and therefore the market expects business confidence to improve.

GBP COULD COME UNDER PRESSURE FROM DOVISH BOE COMMENTS

The British pound ended the NY trading session slightly higher against the U.S. dollar and euro.  It has also been a very quiet day in the U.K. with no economic data on the calendar. In fact, it will be an extremely quiet week data wise with nothing significant outside of the second estimate for Q4 GDP on Friday. Therefore last week’s sharp disappointments in economic data should weigh on the currency for most of this week.  Sterling touched a fresh 9-month low on Friday and the odds are skewed another test this week as long as the GBP/USD does not break above 1.56. Despite the pound’s rally against the euro today, the gains should be short-lived if the German IFO report beats expectations. Although there are no major economic releases from the U.K. in the front of the week, comments from Bank of England officials could affect the currency. Bank of England Governor King, Charles Bean, Spencer Dale, David Miles and Kate Barker are scheduled to comment on the February Quarterly Inflation Report. If you recall, the central bank lowered its growth and inflation forecast which implies a more dovish stance. The recent trend of economic data will only add pressure on the BoE to keep monetary policy easy. Therefore we except monetary policy makers to remind traders that they remain the only major central bank contemplating more rather than less monetary stimulus.

AUD RALLY WILL DEPEND ON RBA BATTELINO’S TONE

Although the Australian and New Zealand dollars inched higher against the greenback, the Canadian dollar gave back some of its gains.  Like U.S. equities, commodity prices were virtually unchanged. The only commodity producing country that released economic data over the past 24 hours was Australia who reported a 3.4 percent decline in new motor vehicle sales. This was the first monthly drop since July which suggests that higher interest rates may finally be crimping demand. Australia will once again be the only commodity producing country with event risk this evening. Reserve Bank of Australia Deputy Governor Battelino will be speaking in Sydney tonight and the tone of his comments could have a meaningful impact on the Aussie. When the RBA decided to leave rates unchanged at their last monetary policy meeting, the AUD/USD collapsed but the hawkish tone of the RBA minutes helped the currency recover. This indicates how sensitive the AUD/USD is to the outlook for interest rates. The reaction of the Aussie will be dependent upon whether Battelino focuses more on the gradualness of rate hikes or the need for additional tightening. China is also back in the markets this week after taking all of last week off for Chinese New Year. Although there are no Chinese economic reports on the calendar this week, the 50bp hike of their reserve requirement ratio takes into effect on February 25th.

JPY: S&P SAYS LITTLE CHANCE OF DOWNGRADE

The small sell-off in U.S. equities drove all of the Japanese Yen crosses lower. In this weekend’s Wall Street Journal, there is an article about how the carry trade does not always pay off. We wanted to add our two cents about what type of environment carry trades tend to perform well. For carry trades to thrive, risk appetite needs to be strong, central banks need to be raising interest rates and volatility needs to be low. As you can imagine, this is certainly not the type of market environment that we are in right now but we will eventually get there. After falling throughout the past week, volatility has stabilized. In the meantime consumer consumption remains weak with little pickup in supermarket and convenience store sales. The Yen may have received some boost from Standard & Poor’s comment that there is relatively little chance it would downgrade Japan’s sovereign debt rating this year. There has also been a lot of talk that a $36.7 billion investment trust fund for Japanese investors is set to launch this week in Japan. The fund has large holdings denominated in foreign currencies which suggest that in order for the fund to be structured, Yen may need to be sold.

EUR/USD: Currency in Play for Next 24 Hours

The currency in play for Tuesday is the EUR/USD. Germany will release its IFO report at 4:00 AM EST or 9:00 GMT. The U.S. will follow up with Consumer Confidence at 10:00 AM EST or 15:00 GMT.

After having been in a very strong downtrend for the past month, the EUR/USD is once again attempting to break higher. Unfortunately the lackluster price action today leaves the currency pair between the Sell Zone and the Range Trading Zone, which we determine using Bollinger Bands. The lack of continuation after Friday’s strong rally suggests that for the time being, the downtrend remains intact and the EUR/USD is prone to more losses.  This is especially true since the currency pair has been unable to break above the 10-day SMA. In order for the downtrend to really be broken, we will need to see the EUR/USD trade above 1.38. In the meantime, if the EUR/USD slips back below 1.3575, a move towards its yearly low of 1.3455 is possible

Commentary by Kathy Lien: The Strongest Forex Correlations 2010

As the world changes, so do the correlations between different currencies and different instruments. It is a quiet morning in the forex markets with no U.S. or European data on the calendar.  The dollar is trading slightly lower against most of the major currencies but the weakness is extremely nominal.  Therefore we take this opportunity to update one of the most popular forex education articles that we have ever published is on the topic of correlations.

In this article, we have provided the latest correlation number and outlined the top 3 correlations for each currency pair on a 1 month and 12 month basis. The stronger the correlation, the more likely the instruments will move in tandem, which means that if you are long both instruments for example, you are basically doubling up on a position. The weaker the correlation between different currency pairs or instruments, the more diversification it can provide to your portfolio. For example, over the past month if you were long the EUR/USD and short USD/CHF, you basically had 2 opposing trades that moved against each other nearly 100 percent of the time, resulting in little profits. Meanwhile the 85 percent negative correlation between the VIX and the S&P 500 over the past month suggests that stocks are particularly sensitive to volatility and the reason why they recovered last week is because of volatility has fallen sharply. These correlations can and will change with time but to be an effective trader, it is extremely important to understand how different currency pairs move in relation to each other to better understand your exposure and manage risk.

Here is the detailed breakdown of correlations for our more data savvy traders.   We have tabulated the 1 month, 3 month, 6 month and 12 month absolute correlations between different currency pairs. Some traders also like to look at correlation on a 20 period average basis because the data is smoother and the numbers can be more reliable so we have provided this table at the very end. Enjoy!

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