A Forex View From Afar

The need for a bailout

The House of Representatives might have vetoed the Treasury’s plan to bailout financial institutions, but the market still sees a very strong need for a rescue package.

The market’s response as the news of the vote unwrapped, confirms that investor’s confidence is close to zero. Global equity markets tumbled the most in 21 years, while the major U.S. indexes posted some record declines.
If someone wants to look for any further evidence that the financial system needs a serious bailout plan, then just look at the number of banks recently bankrupted or were forced to “sell themselves” on both sides of the pond. Lehman, Merrill, AIG, Washington Mutual, Wachovia in the U.S and Fortis, Dexia and Hypo Real Estate in Europe are just the latest banks that can be added to the of credit crunch casualty list.

A new bailout plan with explanation and serious clarification on what the Treasury will do with the cash it receives might give it the potential it needs to pass the vote. However, till then, who can vote for a blank check with $700 billion on it that not too many know its clear purpose or effects?

Reports are just starting to appear with the effects of the credit-crunch over the real economy. Tougher access to liquidity and credit, weak consumption and small owners complaining about the business environment are just to name a few. If banks will not start to do what they are intended to do, lend, then this will be just the beginning as the whole economy is torn apart.

An alternative to the bailout plan would be for the Treasury to bankrupt every possible bank, until only one stands. Since Mr. Paulson has strong relationships with Goldman Sachs, it will not be hard to imagine which would be the last one standing. Moreover, since now they receive deposits, who really needs more than one bank??? Oh, let’s not forget that the U.S. still needs Bank of China to support its debt, but that would be another story.

To finish this article, who knows what a Wall Street bank is now? The answer is simple: a bank is nothing more than a future government entity.

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Wall Street Bailout and the Real Economy

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Trading the Canadian Dollar

The Cad has a unique trading style, moving only one third of the trading day, during the U.S. session. For the rest of the time, the pair tends to hover around a price level, be it the neutral pivot point, a moving average or a support/resistance level. Lately, however, the Cad has started to move during the overnight sessions as well, but the volume continues to be low and insignificant.

The daily chart shows little signs of dollar strength, even though the dollar has posted strong gains against its European counter-parts. This suggests the pair may not have too much room to run on the upside. The 1.0500 area may be a key resistance level in the future, as it has in the past, and long orders should come after this level is broken.

Regarding future short positions, the cad will first have to break below the 1.0300 level, which is an important swing point. At this level, the resistance area (which has now become support) held for over 9 months in which the cad was unable to close above. Having crude oil, the commodity that back’s the cad valuation, holding around the $100 level, we may see some additional tests below the 1.0300 level. The intra-day pattern of trading shows that it is better to avoid any short-term trades around the U.S. session open, when we often see a wave of orders hit the market.

This week, the only important news release coming out of Canada will be the GDP read for the third quarter. The market is expecting a 0.2% read, while the second quarter GDP was released at 0.1%. A read that deviates from market expectations will certainly move the market and test the closest support or resistance, depending on the news release.

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Wall of Shame The Bailout Plan

The bailout plan is the hottest topic around, let us examine some of the plan’s unique characteristics:

• The plan will require a blank check with $700 billion on it, minimum
• Although the plan is just steps away from being voted, no one can say for sure what it does or how it will be implemented
• The agency in charge of supervising the plan is still unknown.
• The plan presumes the toxic debt will be taken from banks’ balance sheets. It’s still not sure how it will be priced
• Toxic debt = packages of mortgage loans which are in a default phase. Most securities had been downgraded from investment grade to junk. This looks more like investors trying to scrap them, rather than the liquidity crisis that the Treasury claims.
• If the bad debt gets overpriced U.S. taxpayers will support the losses.
• If the bad debt is under-priced or priced at the current market value, it will not help the institutions who may as well offset it at fair value now. Banks can simply write down the bed debt and the same effect will emerge.
• The main reason behind the sub-prime crisis was the high default rates among homeowners and falling house prices. Injecting huge amount of cash into the financial system will not reduce mortgage rates, nor help interbank liquidity that impacts the taxpayer who is back-stopping the package. This looks like trying to cure the symptoms rather than the disease.
• Mr. Paulson is asking for full immunity when implementing the bailouts. To some, this says a lot, and to most it says it all. This smells.
• The plan has alternative names too: “The Swedish Solution”, “The Hanky Dumpty sat on the Wall (Street)”, “Bail-me-out Mae”
• The plan has no provision for financial officers of the failing business models to re-pay into the $700B any of the bonus checks issued since June 2007 downgrades of toxic debt, that is something maybe to consider. Check issued to “The U.S. Taxpayer” will start to cover things by all of those courageous enough to do the right thing and balance the investor’s book a little. The taxpayer foots the damage bill, as well as having their own investments stripped bare. The market’s job is to take the maximum amount of money from the maximum amount of people in the minimum amount of time. Well done on getting that done, but this really is turning into a Hall of Shame.

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Looking at the inter-banking liquidity

Usually, when a bank wants to make a loan for liquidity needs it has two options: either borrow money from the central-bank, through the open market operations, or call another bank to lend money at the LIBOR rate. The London Inter-bank Offered Rate or LIBOR is the reference rate at which banks lend money each other.

A major distinction between those two would be that banks need collateral in order to access money from the central bank, while there is no such need when accessing funds from a fellow bank. This would imply that money accessed through the LIBOR rate, would be more expensive (a higher interest rate) because the loans are not secured.

In order to measure the liquidity from the inter-banking environment, investors use the Libor-OIS spread. The index measures the spread between the costs of accessing money throughout the LIBOR rate on a three month loan and the overnight rate at which banks would access funds from the central bank. Usually, the spread is just a few basis points, less than 10 (or 0.1%), however, today the spread reached a massive 166 basis points (or 1.66%). This is the highest spread recorded since 2001, showing that there is a massive lack of liquidity.

The other alternative for a bank would be to access money from the local central bank. The recent open market operations held by the SNB and ECB showed that this is mainly what banks do. The ECB auctioned $25 billion yesterday with a maturity of one month, and received bids valued at $110. The average rate at which banks accessed the $25 billion was 3.75%, while the LIBOR rate with one-month maturity reached 3.20%. This shows that banks decided to have a rush at the central bank’s offer, despite funds from private banks being much cheaper. In normal market conditions (which these are not), the LIBOR would be bigger than the open market’s interest rate, since a LIBOR loan implies additional risk, requiring a bigger premium.

This does not have a direct effect over the currency charts, but it shows that banks are not lending to each other, fearing that bankruptcies may continue. Put head to head, it shows the financial system is a long way from recovering. As such, trade desksmay not be willing to take risk onto their balance sheets, meaning the high yielders (the plural from yielder) and the yen will just hover around the support/resistance levels on the charts. Assuming, of course, that no news hits the wires that cause a different reaction.

Quoting from an old London high street joke, the LIBOR is the rate at which bank’s do not lend to each other.

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Learning from the past

The Treasury proposal of a huge infusion of capital into the financial system and bank’s balance sheets had already been used by other countries, although the outcome was not always so bright. The plan proposed by Mr. Paulson is similar to the one used in Sweden the 1990’s, as we reported this week, in helping banks deal with the bad debt. However, the Swedish had a different approach to this solution; in exchange for the capital infusion Sweden asked for equity. However, Mr. Paulson’s plan only asks for the bad assets and nothing more in return.

The problem is how exactly these toxic papers will be valued. If they are overpriced, the taxpayers will suffer a huge loss, since the Treasury will pay for valueless paper, with little chance of forward redemption. If they are underpriced, or the Treasury pays the same price as their current real value, it won’t solve anything since banks can achieve a similar outcome just by writing-down the bad debt. From here, this appears that the U.S. proposal is loss-loss situation to the taxpayer, and maybe therefore to the Usd.

Even with the “Swedish solution” applied to the U.S. problem, the real economy may still have a hard time ahead. The Swedish economy recovered some 4 years later, in a period when unemployment rose from 2.1% to an incredible 19.9%. In Norway, a neighboring country that faced the same problem, unemployment also rose at a strong pace in the following years, but not as much as in Sweden.

Japan also had to deal with a huge asset bubble in the early 1990’s. The Japanese authorities had chosen a similar solution, injecting huge amounts of capital into the economy. The strategy was called “quantitative easing” and had no real effect over the economy. Actually, the only effect (counter-effect more likely) is that the Japanese economy has never fully recovered from the asset bubble, not even to this day. The Nikkei topped out around 40,000, dropped to around 7,000, and today trades at 12,000. Cash infusions do not always work, and in some cases just prolong the crippling effects of what would otherwise have been a painful but warranted natural reduction of those unable to perform in a changing financial arena.

The mountain of U.S. debt needs servicing, and this may be the cost of reckless borrowing. The U.S. economic outlook may not as bad as that of Sweden or Japan, just yet, but things are delicately balanced between imparting a reasoned argument to mortgage the future and the huge financial liability to the U.S. taxpayer of this creating another debt mountain that will never get repaid. The U.S. struggles with current debt payments as it is, managing to make the minimum payment when servicing its overseas commitment of repaying existing debt. A rise in unemployment and a drop in output are still expected over the next quarters, and that is not the environment that will make the dollar bulls feel warm and fuzzy, nor overseas wealth funds swoon at that thought of U.S. based assets dominating their books.

The U.S. is the economy that pulls the levers on the global scale, but we have asked our-self time and again recently whether 'The Global Player' may not become just another one of the 'Group of Global Players' in quick time. The BRIC (Brazil, Russia, India and China) group is watching the outcome closely. The BRIC’s are seen to be more than capable of forming an economic bloc, similar to the European Union, and have been studied to such a degree that the BRIC’s by 2050 could have a wealth and global dominance that eclipses the current Global Players.

The King of Currency has some suitors, and the World’s currency may now have to see some backing from the U.S. economic infrastructure being re-built on firmer foundations than the last re-balance, if the Usd is not to come under some valuation pressure.

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Usd supports new debt at a cost

The plan announced by Treasury Secretary Mr. Paulson, to buy $700 billion of bad assets (said to be illiquid) and another $400 billion to guarantee money-market mutual funds raises some question marks as to whether the dollar current valuation will be able to support such debt. In order to get the required funding to make the plan work, about $1 trillion, the Government will have to issue a new wave of debt. Such a massive sale will certainly add additional pressure to the Treasury yields, especially on the short-terms. Yields, in a very straightforward form are the cost of owning money. A lower yield equals a cheap currency; a higher yield denotes a strong currency.

U.S. yields are the second lowest in the industrialized world, only the Japanese yields being lower. Thus, a foreigner holding a dollar denominated bond would mean having to pay negative swap because of the high yield differential. Furthermore, the highly inflationary policy used now by the Fed adds even more downward pressure on the U.S. yields. The spread between the Fed Funds and the inflation rate, measured by the CPI, is now 3.4% the lowest since the 1980’s.

All this put together raises some questions as to whether the dollar does not need a re-valuation, again. On the daily charts, the dollar had already topped against the major currencies on very strong volume, suggesting the greenback will need a lot more momentum to break anywhere higher through the 80.00 dollar index resistance levels. Moreover, the major pairs bottomed when lower yields where not even in sight.

There may however be some light at the end of the dollar tunnel, it seems. As the global slowdown progress, reverse flux from emerging countries will soon start to appear, selling risky “emerging-assets” and heading towards the safety of the U.S. treasuries, (the very ones that pay a negative rate at the end of the month).

To draw a quick conclusion, the outlook for the dollar in the short to medium term lies to the downside, particularly until the Senate comes with a clear and concise text over the bail-out plan. Do not exclude a test of the 74-75 area on the dollar index over the coming period, until the market signals that they are buying into the noise coming from the ticker-tape parade. This took many years of relentless feeding on leveraged debt, there really is no easy, nor instant fix.

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Forex Correlation table

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Wall Street on Credit Crisis Street

Northen Rock
Bear Stearns
Countrywide Financial
American International Group
Lehman Brothers
HBOS
First Integrity Bank
IndyMac Bank
First Heritage Bank
Fannie Mae
Freddie Mac


....No further comments

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Central Banks step into the market

The world’s major central banks have made the decision to step into the market and help the financial markets ease some of the money market tensions.
Inter-banking liquidity had completely drained out in the last few days, as more and more financial companies come very close to bankruptcy. As such, the thee-month LIBOR rate, the rate at which banks lend funds to each other, had the biggest gain since 1999, advancing over 19% to 3.06%. Three month treasuries fell yesterday to the lowest level ever recorded, as investors look for safety.

Inter-banking liquidity can also be measured by the so-called Ted Spread (difference between the three-month Treasury bill and three month LIBOR rate), which widened by 0.84% to 302 basis points, almost a record. Readers should be aware that in normal market conditions, the Ted spread averages significantly under 1%. Not anymore, it seems.

Another way for a financial institution to access liquidity is by opening market operations from the “local” central bank. The latest open market operations held yesterday by the ECB shows just how starved banks are for liquidity. The ECB received a record €328b in bids for €150b. This clearly shows financial institutions are in great need for liquidity. Today, the ECB has received $101b worth of offers for the $40b auctioned in the TAF deal.

The Fed has authorized foreign central banks to use as much as $247 billion (although initially reported at $180 billion) in open market operations to shore up the balance sheets of financial institutions (or what is left from them). The ECB can use as much as $110 billion, from which it has already used $65 billion in two overnight repos. The Swiss national bank used $10 billion out of the $27 billion available in an overnight operation. Bank of Japan used all of the available $60 billion to add dollar liquidity to the Japanese based banks; the decision was taken in an emergency meeting. Also, the Bank of England and the Bank of Canada are now allowed to carry out dollar open market operations worth $40 billion and $10 billion, respectively.

The last time the central banks cooperated to add dollar liquidity to the market was back in December. The outcome in the currency market was initially a stronger dollar, but soon gave up those gains. Right now, the charts look like the market is trying to sell the dollar, as the prospects of another rate cut are increasing. This would be a hard hit to the dollar’s valuation; if we remember that just a few weeks ago the dollar was getting stronger because the market viewed the next Fed move would be a hike. Furthermore, analysts pooled by WSJ said this is more of a temporarily fix, since it still will not help bank’s avoid any more write-downs.

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The Fed, AIG and Lehman, or who is too big to fail?

In the last trading session, equities rose despite the Fed holding interest rates at the current 2.00% level, even though the markets’ view was that the central bank would cut 25 basis points to help the financial system.

At the same time, the Fed published a statement that closely followed the interest rate meeting, saying the conditions in the financial markets had deteriorated even further, while the credit crisis’ effects over the real economy will span for the coming quarters. The hold decision together with the statement should have made equities take (another) deep plunge, however the market rose and closed the session in positive territory. What helped the market ignore the FOMC, although a rarity was the rumor that the Fed and the Treasury will step in and bail out AIG.

Those rumors were confirmed later in the day. The Fed will provide an $85 billion loan to the insurer, and taking as collateral 79.9% of the company’s stock shares. According to RBC Capital Markets, losses from an AIG bankruptcy would have topped $180 billion, since the company provides insurance for $441 billion of fixed-income investments, from which $57.8 billion are securities tied to sub-prime mortgages.

Some voices have been raised saying the Fed should have taken the same measure in Lehman’s case. The Fed is walking a fine line between who is “to big to fail” and who is not. Nonetheless, Barclays, the company which abandoned talks for a takeover a few days ago, announced it will buy the Lehman’s U.S. unit, and announced they are looking for more of Lehman’s businesses. A Barclay’s official called it a “once in a lifetime opportunity”

In the meantime, there is more evidence that the inter-banking tensions is mounting. The dollar LIBOR, the rate at which banks access dollar funds, rose yesterday by 3.33%, the biggest gain ever recorded in history. In normal market conditions, the LIBOR trades somewhere slightly above the Fed funds rate.

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The Swiss National Bank Interest Rate Decision

The Swiss National Bank is expected to leave the Libor rate unchanged at 2.75% on Thursday. However, analyst opinions vary over what the bank will do over the longer term, with some expecting a cut, while others expect no change.

Unlike other central banks, the SNB influences the 3-month Swiss Franc LIBOR rate to implement its monetary policy. The London Interbank Offered Rate (or LIBOR) is the rate at which banks offer to lend unsecured funds to other banks in the money market. The SNB reviews its monetary policy at quarterly monetary assessments.

The latest report from Switzerland points out that the economy remains resilient to the global slowdown, to some extent. Furthermore, the economy is starting to give signs of deflation, now that oil is dropping.

In July and August 2008, the CPI showed price pressures are easing after inflation in Switzerland reached 3.1% year-over-year, the highest rate recorded in the last decade. Since 1996, the Swiss business environment has been characterized by a low inflation environment, averaging under 1% on an annual basis.

On Monday, a release indicated that the PPI slowed to 4.0% year-over-year from a 19-year high seen in July, just one month earlier. An important part of the inflationist pressure seen in the CPI and PPI was blamed on high-energy costs.

A further reason why the bank should keep rates on hold is that the Swiss economy seems to have withstood the credit crunch, even though the financial sector has the biggest percentage of the Swiss GDP in the world. First quarter GDP advanced 0.3%, while in the second quarter the economy grew by 0.4%. The Swiss unemployment rate is currently at 2.5%, showing an exceptional labor market that is a characteristic of a strong economy.

Against such a background, most analysts and economists expect the bank to hold rates at the current 2.75%, for the fourth time in a row.

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Markets driven by fear

The markets are now being driven by fear, jumping up one day and down the next, and traders move in and out of the treasury’s safety with every news story regarding financial stocks.

The mechanics behind the volatility seen lately may vary, but the main motive remains fear. Nowadays the market is driven by rumors about who will follow Lehman and who is next on the Fed’s “Merger and Acquisition” list. This has led to a strong rise in the CBOE volatility index over the past few weeks. On Friday, the CBOE volatility index (Vix) rose 5%, while today the Vix jumped 12% at mid session and is now trading at the highest point over the last month.

On Friday, the Euro and the Pound posted their biggest gains against the dollar in recent months. This occurred after both pairs were sold uninterrupted for more than a month. Just a couple of months ago, Fed Fund futures were pricing in a rate increase by the end of the year, but now, with Lehman’s failure, traders are starting to price in another rate cut, further reducing the yield differential.

Treasuries have had the biggest surge since January in the face of the financial crisis. Treasuries were bought in a flight-to-safety, as riskier assets are liquidated.

Another characteristic of the fear factor is the U.S. session becoming noticeably the most volatile session. This comes after the U.S. session had been as sluggish as the Asian session. The same thing occurred earlier this year, when the markets were trembling in the face of oil at $150 and the U.S. economy was staring at a recession.

When trading with a high leverage and with relatively small stop losses, as retail traders usually do, volatility becomes the biggest enemy. Whipsaw movements happen frequently and losses are logged that during other market conditions, would have been winners. If unsure about the next move, a wait and see approach might not be such a bad idea. Nobody can tell when the next rumor will hit the market these days or what the reaction may be.

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Recession in Europe Oh, really?

Recession in Europe Oh, really?

It has been discussed previously that the Euro-area does not have precise definitions of a recession. As such, analyst and economist have “imported” from the other side of the pond the rule of the thumb when it comes to declaring a recession: two or more consecutive quarters with negative GDP growth. However, NBER, the organization which provides the start and end dates for any recession in the U.S., defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. From that point of view, the ‘two negative quarters’ read is a little too subjective to call for a recession, especially in the current environment.

Judging from the official definition of a recession, the question may be how close the Euro-zone looks to be to having a recession. In the euro-area, unemployment has been in a clear downtrend for more three years, dropping from 9% to 7.1% over this period. Nevertheless, the recent releases showed a slight increase in the unemployment rate. The latest read, for July saw a 7.3% number, with the biggest rise in unemployment seen in Spain and Ireland, the areas famous for their housing boom and bust. This really points to a dynamic labor market, rather than a recessionary outlook.

The money supply numbers, the M3, is up over 9% from one year earlier. This year the growth rate had reached a little over 12%, the highest rate touched since the 80’s. Even if the growth rate has been tempered there is still very strong growth in money supply in the Euro area, a fact regularly cited in the ECB’s press conference and speeches. Going further, the investment rate of non-financial corporations is unaffected, remaining stable at 23.2%, and rising since 2003. Non-financial corporations’ profits share had reached risen almost 39%, slightly dipping from the end of 2007. These show corporations still are resilient to some extent to the global slowdown.

The trend for industrial production in the Euro-area has recently changed. At the beginning of 2008, industrial production topped and now the index has begun sliding lower. In July, industrial production fell 1.7% from one year earlier. This still does not denote a recession it is imminent, but it shows that production output has hit the apex. Overall, the “core” data still shows the Euro-area is far from in a recession. A drop of a little more than 1% from the previous year is nothing to be extremely concerned about in the context of global growth.

The problems in the Euro-area come when we look at the Expectations indexes and surveys. Most of them are near multi-years lows, while others suggest both the manufacturing and service sector expectations are contracting. This can be interpreted as normal because of the global slowdown, but, if things do not start to get on the right path soon those expectations will actually be materialized. Only then we will be able to speak of a recession; until this happens we have a slowdown, but a recession by the book’s definition? Not really.

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Economy For Sale

“Car For Sale. No brakes, no engine, lots of careful owners. Going cheap, all offers considered”.

Would you buy it? The central bankers are dealing with the economic equivalent of the above advertisement. "Economy For Sale....."

Monetary policy needs a transmission mechanism in order for it to be successfully implemented, and central banks know that the required mechanism is in the form of financial stability. Without it, a central bank can cut (read Fed) or raise (ECB) as much as it wants, because without an engine nor brakes the lever will not reach the real economy. The Fed can push as much as it wants the gas pedal and the ECB the brake pedal, but neither is going to get too far.

The Fed was born from the need for financial stability, bank crisis were all the rage at the beginning of the 20th century, and in that environment the Fed had spawned, and although managing to make the crisis cycles less frequent, they are now much more powerful.

In a simple form, financial stability can be described as the position in which the financial system can absorb shocks, avoiding any affects over the real economy. There would be no real point in arguing how strongly the credit crunch affected the real economy, not too many remain unaffected by it. The problem raised now is when financial stability can actually be achieved. Banks have taken massive losses on their balance sheets; sources say financial entities have written down a little over $500 billion since the sub-prime began. Adding to this, bank capitalization has fallen dramatically in the last period (the XLF had almost fell 50% in the year).

The LIBOR (London Inter-bank Offered Rate) shows that inter-bank “health” is rock bottom, while the default swaps market for financials’ debt is all but over.. In such a backdrop the financial sector may need a (much) longer period to stabilize than previously estimated, and thus the central banks may see their monetary policy inefficient over the short to medium term. The affect on this will likely be to empower the dollar more than other regions, only because it looks as though the Fed where the most pre-emptive of the major banks.

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The Challenges of an Emerging Economy

Not so long ago emerging economies were viewed as the areas that would support world growth, and were also to blame, (actually the speculators said this as they bid up the prices it seems), for high commodity prices.

Those times have quickly passed and the global slowdown has proven that the emerging economies have actually behaved in a very normal way as they too slow, and face the same problems as any other economy in this now global environment..

Emerging markets faces some well-documented problems, ranging from currency depreciation to unsupported deficit. Since the credit crunch began one year ago the emerging countries credit markets have suffered some of the largest declines recorded. The most famous may be the Chinese CSI 300, which practically lost almost 65% of its value in a little less than a year. Some currencies from the emerging markets are starting to feel a reverse money flow, investors taking money out of the country rather than investing. From the same problem, reverse money flows, the current account deficit starts to become unsupported, a big problem for most emerging countries. The reverse money flows comes usually when the world is facing a period marked by uncertainty. To some extend, it is similar to the carry trade un-winding.

The global slowdown had some advantages too for the emerging markets; Firstly, it allowed some economies to avoid overheating, something that is very dangerous over the long period (read boom and bust cycle). Secondly, it helped the BRIC economies reduce the large trade surplus numbers. Ironically, trade surpluses are known to contribute to inflation, and in an emerging country, inflation is a big concern.

Overall, at the end of the global crunch (when ever that may be) economist and analysts will have to draw a line and decide if the emerging countries actually have something to win from this period, since its pretty clear the developed economies had only to lose from it.

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Lower growth in Europe?

The Euro-area economy that was once looking resilient to the global slowdown, is now preparing for some hard times ahead, according to some analysts.

Continuing with the global slowdown, the ECB, last week, cut the growth outlook for the coming quarters. The growth forecast for the annual real GDP was trimmed down to a range between 1.1% and 1.7% in 2008 and between 0.6% and 1.8% in 2009. Today, the person responsible for the Euro-area Economic and Monetary Affairs, Joaquín Almunia said the European Union forecast for the following quarters would also be reduced, calling the outlook “unusually uncertain”.

Looking in the past at how wrong the central bank’s forecast has been (and this is not the ECB case alone, most central banks are in this category), the market starts to ask how close is the ECB to a recession? Technically speaking, it is still uncertain who will call the ECB recession, but probably Eurostat will take this role. One way or another, the currency market is in a deep re-valuing process, and until the Euro-area shows some decent signs of economic expansion, the selling will probably continue.

It was only a few months ago that most market pundits said the U.S. would be the only economy affected by the credit crunch, while global development will continue to be helped by emerging economies. Today, global development has suddenly changed into a global slowdown, while the emerging countries are being choked by inflation rather than prospering by strong demand. Just a personal thought; if the problems related to the credit crunch continue for longer than previously anticipated, the economies from the emerging countries will be affected by reverse money flows.

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The path ahead for the U.S. economy

With the recent economic news and releases coming out of U.S., it seems that the economy is back on track, to a slowdown, of course.

The unemployment number jumped 0.4% in August. This is the second biggest gain since the 1990’s, after May of this year when the unemployment rate jumped up 0.5%. House inventories are at an 11 month high; foreclosures are at 29-year high while mortgage rates are at the same level as when the Fed Funds were at 5.25%. Now, the Fed funds are sitting at 3%, but the mortgages are unaffected.

All this points to the U.S. economy growth rate slowing down once again in the coming quarters. Many have said the economy will resume the growth path after the strong second quarter read. However, it now looks like the main drivers behind the excellent number were the cash rebates, something the economy will not see again in the third and fourth quarters.

Analyst and central banks expect growth to pick up somewhere at the beginning of 2009, but if the U.S. and European economies do not start to show any signs of improvements, the recovery period may extend beyond expectations.

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All eyes on oil now

Crude oil is slowly becoming a very important factor for every central bank when setting its monetary policy. At the crossroads between inflation and growth, oil is becoming a traffic light.

Most central bank forecasts are based on oil remaining at the current price over the coming period. However, even though oil has dropped 27 percent from the record $147.27 reached July 11, some analysts are still saying the price of crude oil will go up once again, even faster than some may think. Arjun Murti, an analyst from Goldman Sachs who predicted even from March 2005 that oil prices will rise exponentially over the following years, still thinks oil has room to go up, to the upside, this year and into 2009.

If oil does rise, once again, then we may see another round of inflation. However, this time it will be materialized in second round effects. Furthermore, inflation will erode any growth signs the economy may produce.

Nonetheless, one should ask how likely is it that oil will spike up once again to $150? The theory behind this move is demand from emerging countries, mainly China, will stay strong in the following periods. The problem is that the Chinese economy is already showing signs of overheating, just like other emerging countries. It should be added that emerging countries have big problems when it comes to inflation. Due to the unique local market, a very dynamic wage setting behavior and low competitive business environment is not uncommon to see emerging countries running double-digit inflation.

Whatever the outcome may be, we can only hope we do not see another period like in the 70’s, characterized by stagflation (no growth and a high degree of inflation).

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The global slowdown and the yen link

The equity markets have taken a beating recently and the major stock market indexes are tumbling. The MSCI Pacific Asia index is off by 25% this year, of which 6% came in the last week alone, while the S&P has fallen 16% year to date.

Analysts and economists are starting to think the credit squeeze and the global slowdown will have a deeper effect on the real economy than previously expected. When the sub-prime crisis came to light, the fist estimates were that growth will pick up in the third quarter in the U.S., while the rest of the world would be unaffected (the de-coupling theory). Now, ahead of the third quarter, all the major developed economies have been affected, and some may even face a recession in the coming quarters. The U.S. situation is not too rosy either, since exports – what actually saved the economy from the brink of recession up until now – are going to fall with the global slowdown. Furthermore, some are even starting to suggest the slowdown will continue beyond 2009, as inflation will erode the economic growth.

Against such a background, the yen (Usd/Jpy) does not stand too many chances of going too far to the upside. Adding the political problems in Japan, the yen can only face hard times ahead as investors will take a wait and see approach until things normalize.

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What should the central bankers do now?

The financial world is now split in two over who is right: the Fed, which decided to cut or the ECB, which raised in front of the credit crunch and an imminent global slowdown.

At a time when the Federal Reserve has cut 325 basis points, the ECB has been bullish and finally decided to raise interest rates by 25 basis points. Over the same period, the Euro-area economy plunged, while on the other side of the Atlantic, things appeared to have bottomed.

However, even if the Fed and the ECB implement their decisions in the same financial markets (actually every central bank does this) they chase different objectives. The ECB’s objective is limited to assuring price stability over the medium term by way of keeping the CPI close to 2%. On the other side is the Fed, with a range of objectives from full employment to price stability and moderate long-term interest rates. From the academic part of central banking, there is a full range of research papers that say a central bank should exclusively focus on inflation targeting.

Since the two banks have different objectives, quantifying and comparing the two results is a little harder. Nevertheless, what is certain is that both banks have failed in reaching any of their objectives. The Fed has failed in securing the labor market, inflation is running wild and the economy is moving at a sluggish pace. The ECB has failed also, by not keeping inflation under control, having the CPI running twice as big as the target and second round effects are knocking on the back-door.

One of the things the two banks agree on is that growth will pick up somewhere in 2009, while inflation will moderate in the coming quarters. It will be interesting to observe if this comes true, as most of the banks’ estimates, until now, have notoriously failed. (remember “the credit crisis is contained”?). About who was right in dealing with the credit crunch, we will be able to judge only from the economic results in the following quarters.

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Getting To Know The Majors Forex Currencies

U.S.
Business Cycle: The U.S. economy is now in the Trough phase of the business cycle, after it experienced a steep decline in the last quarter of 2007 and in the first quarter of 2008. The economy was helped in finding a bottom in the second quarter of 2008 by the rebate checks and the strong exports, but the outlook is not too great either. The economy is expected to crawl into the second half of 2008 and find a decent pace of growth only somewhere later in 2009. In the first months of the contraction phase the global economy was resilient to the U.S. slowdown. As things progressed the global slowdown started to be felt by almost every overseas economy, while the U.S. economy had already bottomed. The issues over mortgage lending criteria, introduced in 2002 to stimulate another period of weak housing, came back in the form of bad debt, but now not just U.S. debt problem. Global Markets bought the U.S. mortgage debt, not really expecting a slow-down in the U.S. economy. That debt now needs servicing and if the sub-prime U.S. home owners decide that they cannot pay the bill, there will be a lot of Inter-Bank re-alignment of those holdings.

Swap Interest Rate: 2.0% is the overnight interest rate after the Fed cut 325 basis points over a very short period of time. Most analysts agree that the Fed will raise somewhere in 2009, before they look to cut.

Euro Area
Business Cycle: The euro-area economy contracted for the first time in its short history in the second quarter in 2008. However, the ECB officials called this contraction “technical”, citing the strong read in the first quarter, and have affirmed that Q1 and Q2, as Q3 and Q4 should be judged together. Analysts expect growth to pick up somewhere in 2009, lead by the German economy, which is seen as a powerhouse in the area. The Euro-zone has a much diversified economy that backs the strength of the Euro-zone business cycle. The Euro-zone economy is seen by many as the most diverse economy in the world, and therefore, is not susceptible to other individual region’s economic highs and lows.

Swap Interest Rate: 4.25% is the overnight interest rate, a strong rate that justifies the Bank’s objective of assuring price stability over the medium term (seen as 18 months)

U.K.
Business Cycle: Once a shining economy, but now near the edge of a deep recession is the U.K. economy. The U.K. economy has to pass through some tough times ahead, the housing market is declining at a very strong pace, the financial system is moving at a sluggish speed and inflation is way above the comfort zone. Recently, Chancellor of the Exchequer Alistair Darling said “The U.K. is facing arguably the worst economic crisis for 60 years". The recent business cycles have shown the U.K. economy likes to follow in the footsteps of the U.S., and this is what is happening now. The Service sector and the City of London –the financial headquarters- dominates the UK Business Cycle, while tourism is the main driver of economic stability in the region.

Swap Interest Rate: 5.00% is the overnight interest rate; a strong rate that was needed to control inflation was reduced by 0.25% in December 2007 and April 2008, to respond to the economic downturn.

Australia
Business Cycle: 26 years of uninterrupted growth characterizes the Australian economy. However, some suggest the economy has peaked and is heading toward the Contraction phase which is attributable to the global slowdown and its affect on the economy. The housing market, which was renowned in the financial world, recently slowed down the pace of growth, and consumers are affected by it. The Australian economy is based heavily on commodity exports and the recent selling of the raw material markets can only have a downward effect over the real economy.

Swap Interest Rate: 7.00% is the overnight interest rate that is paid to hold AUD Long, minus the rate of the currency on the other side. The bank recently cut the interest rate by 25 basis points to assure a reasonable growth.

Japan
Business Cycle: Japan has a very interesting and unique history, full of legend and fearless worries. At the same time, the Japanese economy is unique and interesting too, however, not in an encouraging economic way. The Japanese economy has been fighting stagflation (no growth together with inflation) for almost a decade now. Nevertheless, these days the stagflation era is slowly turning into a period of recession with a high degree of inflation. Consumers that are continuously saving and a cultural environment that has no peers could easily characterize the financial landscape. The real economy is not moving anywhere, and the Bank of Japan has its hands tied because the overnight rate is at a dangerously low level.

Swap Interest Rate: 0.50% is the overnight interest rate, the lowest in the world. The central bank and the Finance Ministry have repeatedly said that rates should go up, but until the real economy shows any signs of growth this will not happen. The markets look to go short the JPY currency Pairs to earn interest. For example: Eur/Jpy trade held Long equates to; buying the Euro Zone Interest Rate of 4.25% and selling the Japanese Rate of 0.5%, a net profit of 3.75%. Welcome to the Carry Trade.

Canada
Business Cycle: The Canadian economy had been expanding well over the course of 2007, however, the Canadian business cycle moved into the Contraction phase at the same time that the U.S. did. U.S. As Canada’s biggest trading partner, having the bilateral good trades reaching the equivalent of $1.5 billion a day, the U.S. is an important gauge of potential Canadian strength. Having such a background it is normal that the Canadian economy closely follows the U.S cycles.

Swap Interest Rate: 3.00% is the Overnight Interest Rate after the 0.50% drop in February.

Switzerland
Business Cycle: Switzerland has the biggest financial sector in the world compared with the size of the economy. In fact, the economy is based on the service side, and is renowned for the strength and confidentiality behind the Swiss banks. In the last quarters, the Swiss economy has showed it is resilient to the global slowdown, even if banks (one of the countries’ biggest industries) suffered huge losses from the credit crunch. The Swiss economy has two unique characteristics: the economy rarely suffers from “boom and bust cycles” and Switzerland has one of the highest costs of living in the world (which is offset by the taxes).

Swap Interest Rate: 2.75% is the overnight interest rate, only higher than the dollar and the yen. The Markets can be Short the CHF currency Pairs to earn interest. For example: A Gbp/Chf trade held Long equates to; buying the U.K. Interest Rate and selling the Swiss Rate, and netting the profit. The Swissy (Usd/Chf) is a strong indicator of intra-day US$ sentiment, it tends to move faster and to be more reactive to US$ changes than any other major pair. The Swiss National Bank is listed on the Swiss Stock Exchange (SNBN symbol)

New Zealand
Business Cycle: New Zealand has just passed the Peak of the business cycle, confirmed by the latest news releases. Inflationary pressures have built to an extremely high rate as imports flood the economy, but recent developments have lead to a reversal of such trend. The economy is largely based on the export of raw materials.

Swap Interest Rate: 8.00% is the overnight interest rate, the highest in the countries with an AAA (investor grade) bond rating. The bank recently cut the overnight rate 25 basis points, after it held at 8.25% for almost a year.

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