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Global Demand Required: All Applicants Accepted

Written by A Forex View From Afar on Thursday, July 30, 2009

A larger number of market participants are saying that the business cycle is likely to recover in early 2010, and that it will be driven by strong demand, now that the global economy appears to have diminished the pace of contraction.

A fundamental question rises from that thought process; from where is that demand likely to come? We have two main groups to pull from here; consumers, and from industry, and both seem increasingly unlikely to assist in the expansion phase.

Consumer demand is usually driven by credit. However, credit card and loan/mortgage defaults are surging to a record high on both sides of the Atlantic, while, the velocity of money – which speaking from a theoretical point of view, measures the level of economic activity – has reached very low values for the vast majority of developed economies.

The U.S. saving rate increased exponentially, in-line with the drop of available credit, to 7% in the last few months, the highest rate seen since 1993, after being at negative rates just a little more than a year ago. This situation points to a consumer that has started saving for their financial safety, rather than building a pile of unsustainable debt as in previous decades that aided economic expansion, but ultimately proved toxic for Wall Street and Main Street.

As admirable as it is that savings have been forced on consumers, and the heady days of Main Street excess look to be fully restrained, the administration will be pushing for an increase in consumer debt to fund the expansion that pays back the stimulus packages. Strike one; the U.S. consumer will not be consuming the economy into growth anytime soon.

The glimmer of hope, is that global savings rates eclipse the rate at which Americans save, and as such the overseas savers may be able to spark a consumption rally. That however, remains nothing other than a glimmer, rather than a ray of consumption sunshine.

Industrial demand is in a comparable situation to the consumer driven demand. During the economic downturn a high percentage of factories have been temporarily closed, or have reduced output dramatically, while employees are fired. This means that when the economy picks up and factories see a stronger backlog of orders, they will simply re-open the idled machineries, instead of buying or building new.

This economic phenomenon is known as economic slack, and can be measured using the capacity utilization report and detail. Since the U.S. economic slowdown started, the capacity utilization rate has dropped at a very strong pace, and has been far stronger than in previous economic slowdowns.

Due to the economic slack, industrial demand is likely to stay at low rates, until the economy reaches once again the 2007 production levels. That is something that is not likely to happen until the consumer in the U.S. starts to consume. Strike two: the industrial sector will not be manufacturing its way to economic growth anytime soon.

All this put together shows that the recovery period will be slow, and long, and when translated into market momentum will likely transpose itself into a side-ways trend in the currency market over the medium to longer term.

Investors and analysts will try to value regional business cycles and local economic growth, and while that is unfolding divergence will be seen in regional valuations and expectancy. The same divergence was seen recently when the forex market was unable to push the dollar lower in spite of one of the longest, and strongest, equity rallies of the last few years.

The forex market might come back to life on its own, going forward, breaking some of the high correlations it had with S&P futures over the last year, as the regional debt-to-growth ratios are absorbed and valued.

The easiest way to generate growth, historically, is to cut interest rates, lower taxation, and force credit onto banks. However, as we have witnessed from 2003 to 2007, there is a harsh price to pay for the famine to feast business cycle that the U.S. is travelling, as it goes from contraction to peak, and back down again, in record time.

The troughs get deeper, whilst the cycles get shallower, and that creates a unique U.S. based conundrum that may, over time, impact negatively the Usd perception that the consumer will save the day. Just how will the consumer be able to do that? Strike three: the administration may be issuing a new, bigger, better, stimulus package, that covers the interest on the previous package, that looks to be like a drop in the ocean of what is really required.

Inefficient Pricing Models Defy Gravity

Written by A Forex View From Afar on Monday, July 27, 2009

The recent equity market rally had a strong driver behind it; investors’ optimism, which has helped the financial market sustain one of the longest trends of the last few years.

In trade on Monday, equity markets are heading higher for the eleventh consecutive day, the longest streak of the last few years, and a similar pattern to the period when the housing and credit bubbles were being inflated. In particular, the Nikkei closed in the green for the 9th consecutive day, making the current rally the longest in a little more than 20 years.

However, the present rally seems to defy the macroeconomic picture, some are saying. The global economy is still in a contraction phase, even though the pace of decline had a noticeable slowdown, the unemployment rate is projected to surge to around 11%, although just a few months back the estimates were pointing out to a 9% rate. Add to that the fact that the consumer spending sector appears to be deep in contraction, as credit card defaults head towards record highs in U.S. and European markets. Moreover, the major central banks together with the IMF forecast a slow recovery period, which would have a strong weight on both consumer and business revenue streams and expenditure.

Despite these issues, investors have been lured by the number of companies that had better than expected reports in the Q2 earnings releases. Out of the nearly 200 major companies that reported so far, a huge majority beat analysts’ estimation, probably making Q2 appear as one of the best earnings quarters in history. Things are not so rosy after all, it would seem, since the reported earnings so far are lower by 30% than the numbers seen in the second quarter of 2008.

This confirms, via a reduction in income, that consumers have indeed cut their spending, and that is not something that is expected to pick up anytime soon. There is a huge slack in the global economy right now, something that will further delay the recovery period. The current situation has the feel of the April 2009 rally that was initiated by the Federal Reserve, but then fueled by earnings reports.

To some extent, this shows again that the stock market does not reflect the state of the economy, but rather the outlook of the public companies as weighed by investors. As long as the remaining companies continue to beat expectations, chances are that the current rally will continue. Suddenly, 1000 points on the S&P does not look so far away.

Moreover, the current rally shows once again that the free markets are rather inefficient, even though the pricing models that most investors rely upon are built on the market efficiency hypothesis. If the equity rally continues the traded market will see inflated equity values, higher commodity prices, and a lower Usd, all backed by an inefficient valuation model. The issue with that is the ease in which those values can realign themselves, especially when not backed by robust employment, access to credit, and diminishing income flows.

The divergence is also being seen in oil prices, a market where speculative interest has increased in-line with equity valuations going higher. The perfect example of automated trade that has been allowed to grow, with nothing programmed to cover the lack of foundation in the corresponding market. Global oil consumption is forecast to move lower in 2009, but to keep aligned with inflated equity valuations, the pricing models are sending out buy orders, like equities, that do not match the forward valuations. Something will soon give, in the form of price reduction, or economic expansion that gets things aligned. Right now, the economic expansion thought process looks as flawed as the inefficient pricing models that run the automated order process.

The final line in the equity play may be the question of where the XLF is trading. The financial sector historically has lead or backed each sustainable move the equity markets make, and throughout the recent rally, the XLF has been stuck trading around the $12, and held there for the last two months. The markets are not rallying financials, and as such a red flag is running up the pole

The Free Markets Are Dead, Long Live The New Free Markets

Written by A Forex View From Afar on Thursday, July 23, 2009

CIT’s success to find someone to lend it $3bn and (temporarily) avoid the bankruptcy filing was seen as a staggering victory of the free market, a market that does not need any more help from the Fed or anyone else.

However, just a day after the new free market was crowned, the details of the transaction came to light, showing a rather painful picture: the price of survival. After being rejected by the F.D.I.C. (which until now was the financial system’s last resort) CIT managed to strike a deal with 6 of its bondholders to provide a $3bn loan.

The cost of the loan is huge, since the 6 creditors require the loan to be paid back at a 13% interest rate (14 times more than the interest rate the government pays for a similar loan), a 5% commitment fee and assets as collateral worth more than three times the size of the loan. Let’s just put this into perspective for a moment; if a person from main street goes to a bank, requests a loan, and then tomorrow he defaults, he would get better terms….

However, even these funds are not enough for the company to survive, TheLFB-Forex.com Trade Team said. In addition to the $3bn, the company will need bondholders to accept a 17.5% reduction of the $1bn debt that will expire next month. Moreover, the company’s total debt is around $60 billion right now, from which $10 billion is expected to mature over the coming months, TheLFB-Forex.com Trade Team said.

Taking a closer look, this does not look like a good deal, but rather as a desperate attempt to survive and therefore avoiding entering the bankruptcies’ hall of fame. The new free markets might be here, but they look like rough ground, on which many corporations are expected to trip over. Interestingly though, the economy is recovering, China grows by 8%, so we are told by the People’s Republic, and the banks keep failing.

Debt Monetization: The Real Affect On An Open Market

Written by A Forex View From Afar on Tuesday, July 21, 2009

In this article we are going to see what debt monetization is all about, since, lately, there has been a lot of talk about the Fed having to monetize the Treasury’s debt.

Our example’s imaginary government needs to spend about $5000 over a year, but its income is only $4000. Thus, our imaginary government will be forced to run a $1000 deficit, which would need to be funded somehow.

At this point, the Treasury comes into play, taking the task of issuing and selling the $1000 of bonds (IOU’s) to the public, to help the government cover its expenses. Following this process, the private sector will hold $1000 in bonds, but this has the effect of reducing the money supply (less money available for consumer spending), and puts upside pressure on the interest rates.

The imaginary Central Bank (CB) does not want this to happen, so they will step in to the market, and buy $1000 worth of bonds from the private sector. The CB’s purchase increases the money supply by $1000 (excluding the multiplier effect), something that sends yields lower again, to where they were before the bond’s auction.

Everything should look normal by now, but things are not really that good on the inside. The CB increased the money supply by $1000, or considerably more if the multiplier effect is included, which is a huge sum compared to the size of the economy. This will cause inflation, because in the shorter term it shifts the AD (aggregate demand) line to the right, corresponding to higher prices, so long as the AS (aggregate supply) holds steady.

The logical justification of this would be the government uses an extra $1000 to fund spending, thus increasing the demand side of the economy. However, in the short-term, the supply side lags the cash drivers, thus a new equilibrium point is reached (E’), in the short-run, which corresponds to higher prices (P).

This is important because it is happening in the economy right now. Most governments are running deficits (from which some are huge) in order to support the demand side and kick-start the economy. However, deficits – especially the ones monetized by the CB - have a strong inflationary pressure built in, and send the local currency spinning lower. Does these sounds familiar? Think of the dollar now, and we get a very clear picture.

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The China Story: Fact Or Fiction?

Written by A Forex View From Afar on Saturday, July 18, 2009

Should the market expect a strong bounce from the global recession, helped by China?

Not likely.

Should the market expect a slow and sluggish recovery period, with lots of “green shots” similar to the one we have now?

Most likely.

If current market valuations are driven higher by green shots, then China is at the tip of the arrowhead, being solely responsible for much of the recent rallies in global markets
From the first few months of the credit crisis, during the summer months of 2007, analysts were saying that the economy will recover relatively quickly (Q1 2008 was estimated), as China and the rest of the emerging economies would drive up demand, helping the developed economies recover.

Time passed, Northern Rock and Bear Stearns bankrupted, but still, China (or any other emerging country) failed to sustain the demand side of the global economy. This caused the recovery date to be delayed, to somewhere around the last quarter of 2008, but still China was the one which should pull the global economy out of contraction.

The global economy did not recover in fourth quarter of 2008, but Merrill Lynch, Lehman Brothers, Washington Mutual and AIG continued the flow of famous bankruptcies, which sent the global markets into a backspin.

Today, we are at the beginning of the third quarter, 2009, two years after the credit crisis began, and also two years prior to the day in which China should have saved the global economy. Despite this, the main triggers of the credit crisis (housing market, default rates, over-leverage) seem far from over.

Banks still continue to file for Chapter 11 (read CIT, which would be the fourth biggest U.S. bankruptcy), and, low and behold, China has still not saved the global economy, albeit the analysts are still forecasting this would happen in the next quarter.

On what basis are these forecasts built? On the fact that the Chinese economy grew 7.9% in Q2, much more than expected? For most countries, such a growth rate seems almost mythical, but this is still far below the growth rate the Chinese economy saw the last ten years.

In addition, in order to keep the economy running, the Chinese Government, together with the central bank, run very loose fiscal and monetary policies. That loose, that the Chinese money supply grew by a massive 30% from a year earlier, while new loans increased by almost three times in just one year.

Economics 101 says that the money supply should expand at roughly the same pace as the economy (that is 8% in China’s case), anything bigger would spark massive inflation. Moreover, having new loans expand at such a strong pace raises some questions about the creditworthiness of some of the borrowers, and the defaults rate associated with them. Does this all have a familiar 2007 kind of tone to it, or are we just imagining that we have walked the over-leveraged, consumer fueled, path before?

On top of the inflationary problem, the question is how much time the Chinese economy can be developed while relying on internal credit, and how much can this help the global economy; China expanding internally does not help the global economy. The answer to this question remains in the hands of the international consumer, and their thirst and/or ability to obtain credit to start the consumption growth engine.

That will require lower interest rates, a lower value Usd, and by default a reversal of the ‘Strong Dollar’ policy that the U.S. administration is candidly trying to put out there as the message of comfort for holders of U.S. debt.

The China growth story will not unfold until the Fed deals with 10 year Treasury note yields; until they, and by default the Usd, are reduced, the China story may be more of a Fairy Tale than a Non-fiction Bestseller.

Trade Desk Thoughts: The Relationship Between Crude Oil And Cad

Written by A Forex View From Afar on Thursday, July 16, 2009

Historically speaking, crude oil and the Canadian dollar have had a very strong relationship, most of the time, the two assets having a high degree of correlation.

This can be explained by the fact that Canada holds the second biggest oil reserves in the world after Saudi Arabia. Moreover, a large amount of these oil reserves are pumped into the United States, making Canada the biggest energy source for the U.S. economy. Thus, investors focus on crude oil prices to gauge the Cad’s direction of trading.

The correlation between crude oil and Cad was pretty easy to exploit in time, but all this came to an end over the last few weeks as crude oil began to quickly drop while the Canadian dollar declined only a few basis points throughout the same period. Most likely, this happened because of two different fundamental drivers: oil dropped as the market was re-pricing the outlook of the global demand, while Cad traded mostly range-bound, together with the dollar index and the other major currencies, as it seems the financial market saw more dollar than it would ever need (thus the market stayed in risk-aversion mode only for a short period).

The attached chart shows how the cad and crude oil have behaved over the last 15 months (from 03.01.2008 to 07.14.2009), while the secondary chart shows the weekly correlation between the two. The green area denotes the periods when the implied correlation was between -0.5 and -1.0, which are the phases when crude oil can be used to forecasts Cad’s direction. As a note, the extended periods when Crude oil and Cad had no correlation or moved in the same direction - as the one we have right now, denoted by the fact that the correlation index swings between -0.5 and 1.00- happened only when the market reversed the prior trend.

crude oil vs usd/cad

TheLFB Team & The View From Afar Blog

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Fundies and Trading
There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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