Weekend Update: Cliff Negotions Reach Nadir

Portfolio Composition

Short USD/MXN 16.667 Percent 

Long TRY/JPY     8.333  Percent

Cash                      75       Percent

I booked profits on my big short USD/MXN position on the New York close yesterday, not so much on the anticipation of Plan B going down to defeat, but more rising rhetoric from both sides on Thursday.  Furthermore, what appeared to be the low point looked like a harbinger to a Friday afternoon selloff, especially in riskier assets like emerging market currencies. Indeed,  USD/MXN has surged up to 12.95, a one day topside move of nearly 1800 pips.

Last night's Asian session was a bit less dramatic.  USD/MXN popped but then consolidated around 12.85, and I was probably a bit trigger happy when I got back in at that level.  However, it was a small position and I still have lots of firepower to take advantage of any overdone moves to the topside.  Many technical analysts think USD is already overbought, however, there remains substantial risk for further short term dollar strength on any sort of overzealous comments from Washington players or further entrenchment from either side.  I am looking add slightly to my USD/MXN short position at 13.  JPY was also quite volatile, and I was able to book a modest profit on an intra-session USD/JPY deal.

With the House gone until the 27th, all eyes are on any action the White House or the Senate might take to calm markets.  I plan to sell USD/MXN in small steps as the greenback gains strength on cliff fears.  I maintain my 12.5-6 mid 2013 target, for now.

     

Midweek Position Summary: Playing the Fiscal Cliff, Yen Weakness, and a non Mexico Growth Story

Portfolio Composition:

Short USD/MXN 50 percent

Long TRY/JPY    8.3 percent

Cash                     41.7 percent

Booked a handsome post-election profit on a long USD/JPY position over the weekend,  freeing up cash which accounts for my considerable reserve of unemployed funds.  I remain cautiously optimistic that the Mexican Peso will finish the year strong, and therefore maintain sizable short USD/MXN position. At the same time, I plan to keep at least 25 percent of my portfolio in cash to insulate myself against fiscal cliff driven volatility, or to take advantage of pullbacks caused by delays in the negotiations between the White House and Congress.

Playing the Yen weakness longterm, I have established a very small long TRY/JPY position.  Turkey's economy has considerable exposure to Europe, which is the destination for much of its exports.  While I expect Europe will slowly but surely walk away from the cliff and return to growth, the path will be long and volatile.  At the same time, Turkey has also diversified its exports, selling its products to booming central Asian and Mideastern economies.  Turkey is slowly consolidating its fiscal position.  The Turkish government has shrunk the deficit to 1.4 percent of GDP from the 2010 peak of 5.5 percent of GDP, albeit probably at the expense of considerable growth.  However, the normalizing of the economy has caused inflation, a major concern two years ago, to ease considerably.  Turkey's massive current account deficit, reaching nearly 10 percent of GDP, is a priority for both the government and central bank.  Turkey must import 97 percent of its energy.  However, Turkey is currently bringing a pipeline from the Caspian Sea online.    Turkey remains vulnerable to regional instability, with borders with Iraq, Iran and Syria.  Indeed, a Syrian rocket attack on a Turkish border town caused a sell off of Turkish assets last month.  The Lira regained its footing and then some however within days.  Despite these downside risks, Turkey remains a strong growth story that was brought to an untimely end by the 2008 crisis.  Turkey's own banks weathered the crisis fine, and it was only global external factors which drove Turkey into recession.  As the world recovery takes hold, I expect demand for Turkish assets and products to strengthen.  Finally the efforts by the central bank to shore up the current account deficit should also lend support to the Lira. 

In sum, opportunities exist for investors willing to do the work.  But as always, great care is required. 

Weekend Update: Where We Go from Here

Since this blog is ultimately about trading FX and making money, it is time to take a time out from the long nuanced commentaries of the past few posts and talk about trades again.  Specifically, what positions should one take, when should they be established, and when should profits be taken.  

News on the fiscal cliff was muted today due to the tragic shooting in Connecticut.  As a result, markets were able to consolidate and extend gains from Wednesday's Fed announcement.  The Euro reached an intra day peak against USD of 1.3173, the highest since May, before closing at 1.3155 in New York.  The Aussie dollar held gains as well, closing at a respectable 1.0556 versus USD.  Mexico's peso swung wildly throughout the day, plunging nearly 1000 pips against USD before regaining its footing in the 12.73-12.76 range.  The day's biggest mover was JPY, which experienced a bear market rally, closing up against all major peers.  The Japanese yen has been under tremendous pressure as the likely winner of Japan's December 16th elections has called for fiscal and monetary stimulus to boost a Japanese economy which has fallen back into recession. Former Prime Minister Shinzo Abe of the conservative Liberal Democratic Party is poised to return to power after unexpectedly resigning in 2007 less than a year into his term amid string of foreign policy failures.  Mr. Abe has now built a campaign around reviving Japan's stagnant economy.  The candidate has openly criticized the Bank of Japan, and has called for "unlimited stimulus" and an inflation target of at least two percent.  LDP has dominated post-war Japanese politics, ruling continuously from 1955 to 1993, and 1994 to 2009.   

With polls predicting an overwhelming win for LDP over the center-left Democratic party headed by PM Noda, speculators have been establishing a huge short yen position since mid November.  According the Commodities Futures Trading Commission, the market has massed a 14.3 billion dollar net short position on JPY, the largest since July 2007.  While it is not certain if this development represents a true pricing in of Japan's weak fundamentals, or a speculative move by traders to profit from the elections, the evidence points to the latter.  Japan's massive debt levels, loss of comparative advantage, chronic deflation problems, and aging population couple with a closed door immigration policy have been festering for decades.  Only extreme external risk aversion, which has pushed some investors into the yen due to its historic role as a safe haven, has allowed the currency to achieve post war highs in the face of deteriorating internal fundamentals.  In sum, the Yen, despite the considerable structural problems facing the Japanese economy, is most likely oversold in the short term, with speculators looking to make quick profits over the weekend.

As such, I expect to see USD/JPY reach 84.10-20 levels Sunday night stateside, and then sell off as the yen bears ring the cash register. Where the yen ends up after the profit taking is over will be good indicator as to the degree to which the 'conviction trade' has pushed the yen lower.  Specifically, it will be very interesting to see if the yen holds its gains from the rollout of the Fed's new easing program on Wednesday.

Considering these facts, shorting the yen now with plans to take profits on Sunday, or buying AUD, CAD, or USD against the yen after the post election dip are both very attractive options.  Europe also appears to be finally uniting.  The best play to profit from this is to sell USD/NOK or USD/SEK on rallies.  The Scandinavian economies have some of the strongest fundamentals on the Continent, well capitalized banks, and a sturdy and well regulated financial system.  The Scandies also offer modest yield; NOK and SEK yield 150 and 125 bps respectively.  Currently, I am short USD/SEK with a longterm target of 6.3 to the dollar.   Finally, USD/MXN remains a sell on rallies, though one must be cautious as MXN is especially sensitive to news (good or bad) about the fiscal cliff.  Any dip in the peso back into the 13 to 13.20 range would be a very attractive opportunity to establish or add to any long peso position.  

  

             

Commentary: A Clearer Picture Emerges on US Monetary Policy

The Federal Reserve System made news yesterday with two announcements. The system will more aggressively expand its balance sheet in the coming months, purchasing an additional 45 billion in US Treasury securities on top of the 40 billion in monthly MBS purchases announced in September.  The Fed has also announced specific thresholds for when it might stop easing-- until unemployment is below 6.5 percent and/or inflation is above 2.5 percent.  From this news, a clearer picture has emerged as to outlook for US monetary policy.  First, the System's balance sheet will almost certainly reach 4 trillion dollars.  This confirms the expectations of many analysts, and will mean that the unwinding of the Fed's balance sheet will take even longer than originally expected.  Secondly, on Wednesday Bernanke tacitly acknowledged during his post meeting press conference the fact that rate increases won't be possible until the Fed sells enough securities to soak up the mass of excess banking reserves.

" It is worth noting that the goals of the FOMC’s asset purchases and of its federal funds rate guidance are somewhat different. The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases. Moreover, as I have discussed today, the decisions to modify the asset purchase program and to undertake rate increases are tied to different criteria."

Bernanke cannot directly state that the Fed could not raise the Federal Funds Rate today, for fear of undermining the central bank's credibility.  However, we are beginning to see the contours of what the exit strategy will look like.  The Fed will cease asset purchases, the Fed will maintain its zero interest rate policy for a time, the Fed will slowly sell securities to soak up the mass of excess reserves, and finally, the Fed will undertake rate increases.  This process will take at least five years.  In short, along the roadmap to monetary tightening, one can see many of the signposts recently pointed out by your humble analyst. 

News: Fed Expected to Expand Bond Purchases This Week as Incoming Pena Nieto Administration Submits Balanced Budget

Markets this week are expecting the US Federal Reserve System to announce an expansion of its new bond purchase program.  Currently, the Federal Reserve is purchasing 40 billion in mortgage debt in an effort to boost the housing market.  The financial press is currently speculating about the how the Fed will implement the expansion of its so-called QE3 bond purchase program.  The Fed could augment its purchase of securitized mortgage debt up to 80 billion.  The Fed may also purchase a further 40 billion a month of treasury securities.  This possibility would ease the Fed's task of implementing an exit strategy when it needs to withdraw the unprecedented stimulus it has provided to a sagging economy, since selling treasuries is easier to implement than selling securitized mortgages. 

Meanwhile, talks over the looming fiscal cliff continue to grab headlines as the White House and Congress struggle to hammer out a deal.  South of the border, the incoming Pena Nieto administration in Mexico has submitted a balanced budget for 2013.  Mexican law requires a balanced budget, a restriction that can be removed by an act of Congress.  The conservative PAN coalition had received approval to run deficits in 2009 as Mexico sought to support its economy in the wake of the financial crisis.  Mexico has been slowly shrinking its deficit since then, running a deficit of only 0,5 percent of GDP in 2012.  The new government will close the lingering shortfall by seeking out efficiency savings in the federal government and allowing income tax cuts for top earners to expire.  Under the plan, Mexico's top tax bracket will rise from 29 percent to 30 percent after the first of year.  Mexico also hopes to reduce it borrowing cost if rating agencies decide to reward Mexico's actions with a sovereign upgrade.  Mexico's Peso opened higher in Asia this evening at 12.835, up from Friday's 12.875 New York close. 

Commentary: It Could be 2020 until the next US Rate Hike

The Federal Reserve System has taken unprecedented action since the financial crisis and the ensuing recession to ease credit conditions across the entire money market, from interbank lending to home loans.  For the record, I believe that these steps were absolutely necessary to both preserve a functioning financial system and accelerate the recovery from the resultant business contraction.  Putting the merits of these actions aside however, I wish to examine how the Federal Reserve will implement a normalization of policy. 

The Fed's pre-crisis balance sheet totaled 820 billion, while the banking system in aggregate had a mere 1.5 billion in excess reserves.  As of this month, the Fed's balance sheet has grown to 2.8 trillion, and will continue to grow larger as the Fed's new mortgage bond purchase program is implemented.  Excess reserves now stand at 1.6 trillion.  While the tripling of the Fed's balance was has drawn both praise and ire, the 1000 fold increase in banking reserves has been largely ignored by the financial press.  It is crucial to note that the Fed sets the Fed funds rate by augmenting or decreasing the aggregate reserve of the banking system by buying or selling securities on the open market.  The 1.5 billion in excess reserves could be easily augmented pre-crisis with the sale of a tiny fraction of the Fed's total balance sheet.  It is conceivable that in such a scenario a the Fed funds rate could be raised by selling under 100 million in securities. Today however, with banking reserves at 1.6 trillion, the Fed may very well have to dump hundreds of billions or even a trillion worth of securities onto the market in order to raise its target rate.  Executing these trades would take years, not weeks or days.  In short, the System could not raise the Fed funds rate today even if it wanted to. 

The communication of the Fed to maintain a 'highly accomodative' policy until mid 2015 has been interpreted by most actors as forward guidance for the timing of the first rate hike.  However, in order to raise rates in 2015, the Fed would need to have already begun quietly unwinding its balance sheet so that it could execute the trades in 2015 that would actually affect a change in the Fed funds rate.  On the contrary, the Fed is still expanding its balance sheet.  It will certainly surpass 3 trillion, and may even reach 4 trillion if current asset purchase programs are continued or expanded. 

In sum, the Fed probably won't be able to raise the rates in 2015 either.  The mid 2015 date is most likely the point when the System will begin to sell off its treasury and mortgage holdings.  However, the sheer size of the excess reserves, and the reluctance of the Fed to shock the markets by dumping trillions of debt in one shot, will mean it will be years before the unwinding causes rates to rise.  In sum, it is not at all unlikely that the Fed will not be able to swiftly and effectively target the Fed funds rate until 2019. 

As the Fed has intervened in unprecedented ways to provide stimulus to the economy, it will also take non traditional methods to withdraw this stimulus at the appropriate time.  Powerless to rapidly change the Fed funds rate, the Fed will be forced to attempt to quarantine excess banking reserves by raising the rate of interest it pays on deposits at the System's twelve banks.  This may tightened credit conditions, but it is uncharted territory.  It must also be mentioned that this policy essentially entails paying the banks to withdraw credit from the public.  This could become a political problem for the Fed, considering that Congress only just granted the Fed the power to pay interest on deposits in 2008. 

No matter which way you look at it, the Fed's exit strategy will be a long and highly complex process that will take years to execute.  With the mind boggling growth of the monetary base, and the impracticability of selling trillions of dollars worth of securities all at once, 2020 is a reasonable estimate for the first increase in the Fed funds rate. 

Mid Week Position Summary

Short USD/MXN

Got lucky for once in a long time and booked a modest profit at the psychological level of 12.9, only to see USD/MXN surge back up to 13 in late afternoon trading, presumably over fiscal cliff concerns.  The Peso had surged Sunday night in Asian markets, only to give back everything and then some once traders stateside got a chance to put in their two cents.  If anything, the heated rhetoric between President Obama and Speaker Boehner might not have as much an impact in non-English speaking markets.  I plan to re-establish my short position, selling in quarters at 13.05, 13.15, 13.2 and 13.29.    My target will be 12.95.  Meanwhile, I will keep a segregated small short position for the interest income and the Q4 target of 12 flat.      

Commentary: Keynes, Moneterism, and the Fiscal Cliff.

I am indebted to Dr. E.K. Hunt for his wonderfully insightful and elucidative book, History of Economic Thought.  Some ideas here are his; reading his book also helped me to organize and understand my own thoughts in meaningful and important ways.  Dr. Hunt, your work has changed my life, and for that I am grateful.   

The budgetary adjustment facing the United States on January 1st, 2013 is no long coming fiscal reckoning.  The capital markets continue to eagerly lend to the United States government, as evidenced by record low yields on federal securities.  There is no debt crisis; the US treasury continues to make interest payments on outstanding debt, and finances budgetary shortfalls via the sale of bonds and bills.  If anything, the US has the opposite of a debt crisis.  The federal government has lower borrowing costs and better access to financing than at any time in history.  So the fiscal cliff is not the result of decades of Washington recklessness.  Rather, it is an artificial deadline, imposed by a dysfunctional and insane Congress on an embattled President.  Now that President has managed to get re-elected, despite the best efforts of the insurrectionists in the US House of Representatives who threatened to bring down the federal government and destroy its credit worthiness simply to win an election.  If anything, President Obama's win last month was a victory for builders over destroyers, and a stinging defeat for those who would burn down the house rather accept the will of the majority of its occupants.  But I digress. I wish to examine the fiscal situation facing our country from a historical perspective that begins long before the rise of the tea party, the ascension of Barack Obama, or the passage of the Bush tax cuts.  For this, we must look back at a century and a half of economic thought and industrial history.  For the current US fiscal outlook did not begin with cutting taxes for the rich, or two unfunded wars, though these events are certainly symptoms of the status quo.  Rather, the situation we find ourselves in is the direct result of the slow but steady evolution of social, industrial, economic, and monetary structures, the understanding and elucidation of which is the only way possible to understand (and ultimately escape) our current predicament.  In this paper, I intend to do just that.

The Great Depression of the 1930s was undoubtedly the biggest economic crisis of the past 100 years.  As late as 1939, unemployment was as high as 20 percent.  Apart from being an economic crisis with untold human suffering, the Great Depression represented a crisis for economic thought which until the 1930s had been dominated by the neoclassical school.  Importantly, the neoclassical economists' theory of employment, wages, and income distribution held that involuntary unemployment was impossible, and that unemployment was the result of workers refusing to accept a lower wage.  This conclusion rested solely upon the idea of the value of marginal product theory of income distribution which held that:  1.  Each successive unit of output resulted in lower returns in terms of value for society.  2.  Each successive worker to enter the labor force then resulted in a lower marginal return on the output of their labor.  3.  Competition between workers caused the wage rate to fall to the value of the last successive unit of output.  In other words, the wage rate equaled the marginal value of the product of labor.  These three postulates also necessitate the conclusion that as competition drives down wages to the value of the marginal product of labor, profits must rise for the entrepreneurs by an equal amount.  Or in macro-economic terms, as the wage rate falls, the interest rate on capital rises by an equal magnitude.  We must therefore conclude as output and gross employment rises, the distribution of income necessarily becomes more unequal.

The conditions on the ground during the 1930s however struck at the very foundations of this elegant theoretical edifice which had been meticulously developed over the past half century.  First, as industrial output plummeted wages for workers who remained employed fell sharply, while neoclassical theory predicted they would rise as the less output meant that the marginal value of the output of each worker lucky enough to keep his job would rise as well.  Secondly, many unemployed workers were willing to work well below prevailing wage rates, yet no opportunities existed.  Large masses could then be said to be legitimately 'involuntarily unemployed,' which directly contradicted neoclassical dogma.

For John Maynard Keynes, a British economist brought up on the neoclassical school, the Great Depression was a fascinating challenge.  On the one hand, Keynes essentially agreed with the neoclassicists that both households and firms were rational maximizers whose interests were in harmony when the market was in equilibrium.  Keynes' major contribution to economic theory were the following insights.  1.  Interest on financial capital was the reward for parting with liquidity, not a reward for delaying consumption as held by neoclassical theory.  2. A large component in the demand for money was the so-called speculative motive.  For example, when the market expected interest rates to rise, investors would be reluctant to hold bonds with long maturities for fear of a sharp rise in interest rates.  It was always good to hold a significant amount of liquid cash to take advantage of a potential rise in the rate of interest.  3. While the rate of interest was the equilibrium point which balanced savings with investment, it was possible for there to be so much excess savings in the market that to bringing into equilibrium with investment would require a negative rate of interest.  It was these cases which Keynes sought to understand better.  Keynes essentially believed that when savings and investments could be brought into equilibrium by a rate of interest above zero, the simple prescription was for the central bank to create enough money to lower the rate of interest sufficiently to its equilibrium level.  When this was impossible because the market demanded a negative rate of interest to make savings equal investment, another solution entirely was required.

Before proceeding, it is crucial to reiterate that Keynes, like his neoclassicist predecessors, believed that total income in the economy must equal total spending.  For example, expenditures by households on consumption goods were income for firms. Likewise, the investments one firm made on machines to make goods was income for the firm which constructed the machines.  Thus, total output must also equal total spending, since firms would not produce goods they could not sell.  Keynes expressed this concept with the equation A = I + C + G, where A is 'autonomous spending,' I is investment, C is consumption, and G is government spending.  We will revisit this equation shortly as we discuss the principal policy recommendation for Keynes' analysis, deficit spending by government.

Keynes' theory of interest essentially stated that excess savings as compared to investment drove down the rate of interest.  However, the equilibrium rate of interest at which investments and savings were equal could be below zero.  In practice, savers would never lend out their money at negative rates.  In such cases, Keynes advocated that governments become the borrower of last resort by issuing bonds to finance large deficits. The government therefore was essentially providing an investment outlet for all of the excess savings in the economy.  The government would then spend these borrowed funds to increase spending in the economy and therefore total output.  Keynes advocated the initiation of 'useful projects' such as the construction of schools and roads.  It should be noted however that Keynes saw the government's ultimate role was to soak up and spend the excess savings for which private investors could not find profitable outlets.  For this reason, Keynes believed that spending money to employ men to dig ditches and then refill them would be nearly as effective as building bridges.

The problem of excess savings has its origin in two places.  First is the lack of profitable investment outlets.  This can be solved by the issuance of government bonds which pay a fixed rate of interest, as these securities are essentially seen as risk free. And as discussed above, investment can be stimulated by a lowering of the interest rate by the monetary authorities.  But only when the equilibrium rate for savings and investment is above zero.  A second and perhaps more important cause of excess savings is the gross and ever increasing income inequality which the neoclassical theory predicts is the inevitable outcome of capitalism.  As a small but powerful class of absentee owners gains a larger and larger share of the national income which it cannot possibly consume or invest profitably, total spending drops (and savings rises) and therefore output falls.  Is it any wonder, therefore, that as wealth has become more and more concentrated, government debt has soared and deficits have exploded?  As more and more excess savings is socked away in the hands of the few, the government has been forced to provide the investment outlets (ie, issue more bonds) so that spending and therefore output does not fall.

The Keynesian prescription  has necessitated the creation of incredibly intricate and fragile networks of creditors and debtors.  Banks and financial firms become creditors of governments, while simultaneously being indebted to their depositors, investors, and shareholders.  Inevitably, some of the excess savings has found its way into the hands of households in the form of bankcards and other forms of consumer credit.  This enhances demand for the products and services of the entrepreneurs, who in turn issue bonds to finance capital investments to keep pace with growing consumer spending.  The result is that nearly all actors become both large creditors and debtors.  This elaborate network of debt knows no national boundaries, and any possible default at the government, firm, or household level could bring down the entire system.  

Such a possibility explains the extraordinary action taken by central banks after the collapse of Lehman Brothers in 2008.  The failure of such a large debtor to make good on its obligations threatened the capacity of many of the firm's creditors, themselves debtors, to meet their respective obligations.  The potential ripple effects threatened to bring down the entire economy. We need not examine in detail the government response to the 2008 crisis.  Suffice to say, this time, the worst seems to have been averted.  However, the growing disparity of income become rich and poor, which has become worse still since 2008, will continue to put ever increasing stress on the financial system and central banks as economies are forced to create ever more elaborate and complex credit relationships to re-inject into the economy the huge sums of excess cash held by a super elite class of mega capitalists.

In sum, while it is indisputable that the massive government spending during the second world war and the post war reconstruction ended the great depression and brought on a two decades of relative global prosperity, I fear that long term sustainable growth will never be attainable without a more equitable distribution of income. Our present course which does not nothing to address income inequality will lead to a cascade of financial crises, growing in scope and complexity, as banks and financial firms are forced to create riskier and more interdependent credit relationships between households, firms, and a plutocratic elite.  Meanwhile, central banks will come under ever increasing pressure as they are forced to constantly ease credit conditions to spur sidelined savings into profitable investment outlets.  Central governments will become even more indebted as they try in vain to soak up all the excess savings by the endless issuance of bonds to both fund new projects and refinance old debt.  The seas appear to be calming, and a debt deal in Washington seems likely.  However, steering around the fiscal speed bump in January does nothing to change our trajectory towards the ultimate day of reckoning.     
     

Commentary: Dry Powder is a Powerful Thing

Those of you who read this blog probably have figured out two things.  First, I really like the Mexican peso, and plan to hold it for the long to medium term.  Another strongly held conviction I have, second only to the potential for MXN, is that the Japanese Yen must depreciate.  Japan remains a safe haven despite its weak internal fundamentals underscored by chronic deflation problems, a rapid aging population which will soon struggle to replace itself, and a general sense of stagnation and malaise.  While the Japanese may be able to fix their animal spirits and come out of their melancholia, the BOJ and the national government are probably useless at fixing their deflation and demographic crises.  The BOJ does not have the courage to enact an aggressive enough asset purchase program that would cause above target short term inflation but finally end the decades of deflation which have resulted in tens of trillions of Yen in lost growth.  The national politicians on the other hand will never stand up to voters and enact a sensible immigration policy which welcomes immigrants from other parts of Asia to replace Japan's dying population.

Those of you watching the markets this month saw the dip in the Peso followed by its recovery, and a surge in the Yen, followed by its collapse to seven month lows.  So did your humble analyst reap handsome profits from the realignment of the short term trends with the long term fundamentals?  Alas no.  When the panic earlier this month over the fiscal cliff came, I had already initiated as many positions as I had felt comfortable holding.  I had a huge long MXN position and had no exposure to the Yen.  When the big peso pullback came, I was unable to buy the dip for fear of getting over leveraged.  I was simply forced to ride out the losses.  The excessive risk which comes with excessive margin also stopped me from shorting the Yen as it popped during the run up to the election.  In sum,  even when you have fundamental beliefs in your positions, keeping a little dry powder is always a powerful move.  There is a huge opportunity cost to giving up all liquidity and going all in, even when the long term fundamentals are with you.  This is especially true when major market events are on the horizon.  Such was the case in October, with coming US elections and the looming fiscal cliff.  In retrospect, despite my confidence in the time in the Peso, and I'm still confident, keeping some cash on the sidelines would have enabled me to take advantage of the inevitable volatility.     

Weekend Update: Fiscal Cliff Weighs Heavily on Markets

Mexico missed on GDP last Friday, growing at a 3.3 percent YoY basis for the third quarter for 2012, slightly below analysts expectations.  Markets didn't care though, and the Peso closed up nearly 1000 pips from the 13.25-29 lows, ending the trading day in New York at 13.15.   Press conferences held by US congressional leaders had an upbeat and optimistic tone about an early resolution to the fiscal cliff.  The news buoyed the Peso, which sells eighty percent of its exports to the US.  The fundamental story in Mexico is still positive, despite this recent miss.  The events of Friday make it clear that the fate of the Peso, as long as Mexico is stable, is tied to external factors like Europe and the US budget talks, and not internal factors like Mexico's growth rate.  I remain cautiously optimistic, for now. 

Commentary: Why the US Won't Go off the Fiscal Cliff

Since the US presidential elections earlier this month, markets have been under considerable downward pressure over fears of the fiscal cliff.  Equity markets are posting red across the board.  The Dow Jones has experienced several 200+ point sell offs in the recent sessions.  On Fx, markets are expressing the general risk off mood by running to 'safe haven' assets like the USD and JPY, while selling off riskier currencies such as MXN, TRY and ZAR.  AUD and CAD have shown some resilience, but both are off their highs.  AUD is objectively the most 'respectable' high yielding currency.  Australia is the only advanced economy whose central bank is not implementing very low interest rate policies.  

The fiscal cliff undoubtedly presents the greatest macro-economic risk to the global recovery, and policy makers in Washington would do well to craft an agreement as quickly as possible to calm jittery markets.  The going off the cliff would tighten fiscal policy by cutting the deficit by roughly 800 billion.  This would be achieved by spending cuts and the repeal of all the Bush tax cuts.  Currently, the deficit is roughly 1.2 trillion; an unprecedented sum for an unprecedented slowdown.  Those concerned about the fiscal cliff are falling back on the economic dogma developed by John Maynard Keynes in the 1930s, which established that in the short run, the amount of production in the economy equaled the amount of spending in the economy.  A crucial part of that spending is deficit spending by government.  

The obvious plan is to allow fiscal policy to tighten slowly over time so that the consumer and investors can pick up the slack as the government deficit falls.  This may call for say 50 to 100 billion is deficit reduction for 2013, with more reductions throughout the decade as the recovery takes hold.  The composition of this reduction, ie, how much is achieved through cuts and how through tax increases is probably largely irrelevant, and Obama knows it.  100 billion dollars in a 15 trillion dollar economy is just not that big a deal, even with Keynesian multipliers.  Obama will push for tax increases on the rich in order to achieve a post election political victory.  To me, this seems a waste of hard won political capital, since again the total deficit reduction only should be about 100 billion at max, and the Bush tax cuts for top earners (250,000k+) is only 80 billion a year.  A much more significant longterm policy achievement would be to reform immigration or pass the Dream Act.  Both would spur growth by removing artificial barriers to the movement of human capital.  

Thankfully, there are many vested interests who want to maintain the status quo.  This includes voters who will not willingly accept that their taxes should go up, as when as innumerable industries which rely on government contracts.  When all is said and down, the groups that experience the most pain when the deal is struck later this year will be those groups with the least clout in Washington and the least organized lobbying efforts.  

   

Weekend Update: Bracing for the Week Ahead

It's Sunday night in the US and the coming weeks have many of us who have placed risk on bets nervous.  The uncertainty as to the resolution of the so-called fiscal cliff spooked markets last week, causing big sell offs in currency and equity markets.  On FX, the market ran to the USD and JPY, both posting big gains for the week.  USD/MXN kissed 13.25 before closing at 13.2 Friday night.  While I remain bullish on the fundamentals, as do the analysts, the short term volatility has certainly raised my blood pressure.  I can only take solace in my 'capital firewall.'  The USD/MXN could hit 14 again and I would not be forced to close my positions.  I am currently raking in about thirty percent annually in carry, and remain confident that I can liquidate at a tidy profit in the neighborhood of 12.8.

The long term trend for USD/JPY remains bullish, and traders would be advised to look for spots to get long.  USD/INR is probably overbought in the short term, and the long term outlook may improve as both the RBI and the central government push market oriented reforms. Scotia Bank sees a retest of the 51 level for USD/INR in the coming quarters.  I will be watching the situation closely, for now however, my fate lies entirely with the Peso.  The key will be not to panic even if the Peso continues to dip as Washington rhetoric heats up.  Once it becomes clear that the US is not going off the fiscal cliff, the Peso will resume its mid to long term upward trend.  

    

Mid Week Position Summary

Short USD/MXN @ 12.93

Capital Ratio: 12.66

Still sitting tight and earing carry off my short USD/MXN position, after booking a modest profit on a USD/INR short position Tuesday night.  No changes in the fundamental picture.  On election night, the Peso soared in Asia and Europe then gave up all its gains stateside as risk off sentiment overwhelmed markets.  Many believe that it was due to fears over the 'fiscal-cliff,' but profit taking most likely was a significant factor, at least with the USD/MXN shorts, since this is the second time in a week the peso has failed to consolidate big gains.  

On Asian FX, watch USD/INR which may make a further run at the summer highs if fears that post-election paralysis will send the US off the cliff continue to weigh heavily on markets.  On the fundamentals, Prime Minister Singh continues to push liberalization reforms, and the RBI remains more concerned with inflation than growth.  That said, the reserve bank would certainly begin to cut rates aggressively if inflation eases.  This seems unlikely however if the Rupee continues to depreciate.  The much more likely scenario is the attempt of the central government to spur Rupee appreciation via reforms aimed at boosting India's competitiveness.  Such a scenario would certainly take the enormous pressure currently on the RBI and give it more room to maneuver on the monetary policy front.      In sum, I remain a cautious seller of USD/INR on rallies in light of a probable deal on the looming US fiscal adjustment.  I look to initiate a small short position at 54.75, and hopefully earn some nice carry over a month or two.  My target will be the early October lows of 51.05.   More commentary on India to come.   

Doing the Rounds: Markets Largely Sideways before US Elections, Greek Debt Vote

Markets were largely sideways today with little activity of note.  EUR/USD and GBP/USD consolidated last week's losses, closing at 1.2792 and 1.5980 respectively. On the Pacific front, AUD/USD and USD/JPY were also little changed, with both pairs closing within a few pips of where they were on Friday.  On emerging markets, USD/MXN traded in a tight range, bouncing around between 13.02-13.05.  The market is clearly looking for direction.  However, as long as the fundamentals remain strong, the Peso should still have legs with which it can continue its run.  USD/INR and USD/TRY were the only significant movers today.  USD/INR surged overnight in Asia after a typical bout of risk aversion that traders have become accustomed to.  Turkey's Lira traded higher, breaking through the 1.78 level versus USD after Fitch upgraded its sovereign debt.

The key risks events for this week are definitely the US presidential elections and the Greek parliament vote to implement its austerity plan.  Stateside, markets see the race deadlocked, but abroad most actors are pricing in an Obama victory.  US equities may get a slight bump if Romney pulls off an upset.  However, any post-election moves ought to be transitory in nature, and given that market expectations are very hard to pin down, difficult to forecast.  Finally, most objective analysts don't see the election having much impact on the fundamental growth trajectory for the US.   

Progress in Europe might give the Euro a welcome rally, and would certainly help it consolidate the gains in has posted in the last three months from its July 31 low.  However, this event will almost certainly be over shadowed but the aftermath of the election, so caution is advised.       

Commentary: USD Higher on Better than Expected Jobs

A week ago I opined about how the USD will begin to trade higher on good internal numbers coming out of the United States.  I also stated my belief that such an event will portend the return to a dollar bull market as investment comes home, and foreign investors turn to the US as the most promising growth opportunity within the advanced economies.  I was not expecting to be posting this so soon, but today, we saw the first signs of shift towards market conditions I outlined a mere ten days ago.  Jobs numbers surprised to the upside today, and rather than trigger a flurry of indiscriminate risk buying which would ironically ding the dollar and buoy everything else, the market chose distinct winners and losers today.  To start off, EUR/USD got hammered today which makes sense.  The strong jobs reports signals a US led recovery, while Europe remains mired in uncertainty as it slowly works through its sovereign debt crisis.  Under this scenario, it is perfectly reasonable for the market to expect capital flows from Europe to the US and reprice EUR/USD accordingly.  Cable, was also down today, off its 1.6130 highs of earlier this week.  Again, the British economy stands to fair worse if the US (rather than Europe) leads the recovery among advanced economies.  AUD/USD was down too, not so much a loss of confidence in the Austrailian economy, but more of "pressure release" as the dollar rose against EUR.  The dip in EUR/AUD confirms this hypothesis.  Floundering emerging markets like South Africa got whacked on the job news too.  The RSA is experiencing internal labor unrest, and relies on Europe for the majority of its exports.  Finally, JPY was a huge loser today.  Bought as a safe haven asset, the mid to long term economic  prospects for Japan are shaky at best.  Expect to see further weakness in the Yen as the US recovery picks up steam. 

The winners today were, not surprisingly CAD and MXN, economies which stand to gain the most from robust US growth.  USD/CAD traded back below parity.  USD/MXN was under some significant pressure and dropped down to 12.9272.  It was unable to gain a foothold however, and was pushed back to 13.03 where it started the trading day as actors booked profits.  This suggests that USD/MXN is already a crowded trade, and it may take some sustained and clear real money flows to Mexico for the Peso to break through.  Watch remittances in dollar terms (they are down big in peso terms mainly due to peso appreciation!)  and flows on export demand and tourism.  The local bond market is also a place cautious investors will seek yield as the Fed has signaled that it will continued to keep interest rates low until 2015.  A sovereign upgrade, a rate hike, or a large acquisition in Mexico by a US firm would as be very supportive of the Peso.  I continue to hold my large long peso position, but I now realize that it will be a slower grind towards my 12.55 target than originally anticipated.  

In short, we may in in for a dollar bull market as investors around the globe turn to the US as the dog with the least amount of flees.  I am still bullish on Mexico, but funding buying MXN against JPY rather than USD just got much more attractive. 

Mid-Week Position Summary

Short USD/MXN @ 12.93

Capital Ratio: 12.62

I continue my bullish stance on the peso despite a slight pullback into the 13.04-13.1 region.  I increased my position by 25 percent last Thursday at 13.05.  Sandy, and nervousness over the jobs numbers and elections coming up have been weighing on risk sentiment.  If anything, the internal fundamentals in Mexico have strengthened, with Mexico registering an above 4 percent YoY GDP growth rate for Q3, and a hawkish policy statement coming out of the Banco de México.  I will be watching the ADP and BLS jobs numbers closely, and may take profits if good news causes a euphoric pop in risk appetite.  That said, the peso's excellent yield, and along with my strong capital position make sitting tight an attractive option as well. 

Doing the Rounds: USD Grinds Higher Amid General Risk Aversion

The US dollar has been grinding upward against its major peers today as markets are met with a general mood of risk aversion.  EUR/USD appears poised to make another run at the 1.28 handle, though only a sustained break below this key psychological point would reestablish a mid to longterm bearish trend.  Likewise, cable traded lower today in the 1.600-40 range.  Conflicting signals from Bank of England officials have also weighed on Sterling.  Again, watch a break below 1.60 for clues as to the midterm trend.  USD/MXN spiked up to 13.1087, missing my sell order by a measly 13 pips, before heading back down towards the top end of the 13-13.07 range where the pair has spent the majority of the last few trading session.  The Canadian Dollar continued its slide, with USD/CAD trading back above parity.  AUD/USD was also dinged this morning, trading down roughly 30 pips from Friday's 1.0360 highs.  Finally, it is interesting to note that the less liquid pair USD/PEN has also seen its biggest daily gain in nearly four months.  Peru's Nuevo Sol has been appreciating as the South American country has maintained some of the strongest growth in the region as the result of sound macro-economic policy.  This, despite the central bank's intervention to smooth out the appreciation of the nation's currency.  USD/PEN traded above 2.6 for the first time since September after closing at 2.5910 last Friday.

In general, market conditions have not changed.  Look for bargain hunters to come in to position themselves for Friday's jobs report.     

Weekend Update: Corporate Earnings, Jobs Report in Focus

The week to come is choke full of data points to be priced in by the market.  Many big names report quarterly earning throughout the week.  Right out of the gate on Monday Baidu(BIDU) and Burger King(BKW) report, after and before the close respectively.  Tuesday the 30th sees Eaton Corp (ENT) and Deutsche Bank (DB), and BP(BP) report, while General Motors (GM) will host its conference call before the open on Wednesday morning.  Exxon and Chevron report on Thursday and Friday respectively.

The flurry of corporate names reporting should set the tone for risk sentiment going into the all important jobs report, expected to come in at 145k, released at 8:30 AM EST on Friday.  Considering all this, and with the specter of an ultra close US presidential election weighing on some market participants, we're in for a volatile week. 

News: Banco de México Stands Pat, for Now.

Mexico's central bank held its key interest steady at 4.5 percent today in an announcement released at 10:30 AM central time in Mexico City.  The five member board headed by Austín Carstens has kept its target rate, the rate at which banks lend to each other overnight on an unsecured basis, at a record low since May of 2009, though has maintained a "neutral monetary policy," in the words or Mr. Carstens since then.  Mexico's relatively strong economic performance during the global recovery has caused the nation's central bank to refrain from further asset purchases or rate reductions for three years, even as its counterparts in both advanced and emerging markets have stepped up efforts to speed growth through monetary stimulus.  Both the Federal Reserve and the Bank of England have recently expanded their respective QE programs, while this quarter has also seen surprise rate cuts from emerging market economies like South Africa and Thailand.

Mexico's decision to hold its rate at 4.5 percent was widely expected by most analysts, however, the statement of monetary policy provides new insight into the overall stance of the Banco de México's board of governors.  While the growth outlook was somber, and warned global macro risks such as the so-called fiscal cliff in the US and the ongoing trials and tribulations of the Euro-zone, the bank appears to be losing its patience with inflation.  Inflation in Mexico hit 4.77 percent last month, outside of the central bank's target of two to four percent.  While the bank in its statement attributed the rise in general inflation to supply shocks in both food and energy, noting that core inflation has stayed steady, it expressed the will to act even if it judges risks of higher inflation are only due to short term spikes in the price of oil and/or agricultural commodities.  Of particular concern to the bank is the possibility that above target general inflation may skew inflation expectations in the real economy upward, even if the rise in CPI is mainly due to price increase in items excluded from core inflation, rather than a general rise in prices across all sectors.  The bank therefore strongly hinted at possible rate hikes in the near future to "consolidate currently low inflation expectations, prevent 'contamination' of the process of price formation in the rest of the economy, and not compromise the bank's commitment to achieving a longterm inflation target of 3 perent."

Furthermore, Carstens has stated publicly on several occasions that volatility in global financial markets has resulted in overselling of emerging market currencies, particularly the Mexican Peso.  He has continually characterized the peso as "clearly undervalued" and has stated that further appreciation back towards 11 MXN per USD would be a welcome relief to both Mexican consumers and businesses which have been squeezed by higher import costs.  That said, Mr. Carstens has also insisted that any kind of peso appreciation must come from strong fundamentals and economic performance rather than any specific or set of central bank policies.

This morning's announcement failed to move the peso which bounced around in a range today and closed in New York at 13.02 per USD.   

Commentary: The Week Everything Changed in USD Land

I remember watching CNBC on September 15 2008, hours after failure of Lehman Brothers.  Markets were panicking and chaos reigned. But looking back in my memory of the jumbled mess of swirling rumors, idle speculation, and fear driven hypotheticals, one image remains burned into my mind's eye.  To this day, I remember the words "US Dollar Sharply Weaker" popping up in the text box above the stock ticker as it cycled through various headlines.  To those of us who have stayed in the market since then, this simple historical fact may come as a shocking revelation.  Indeed, for the better part of four years now, any bad news, inside or outside the US, has been met by investors around the world running to the greenback.  Bad US jobs reports, surging dollar.  Weak German consumer confidence, surging dollar.  China growth concerns, surging dollar.  What is most striking is that even disappointing economic news out of the US seems to be good for the dollar, as market participants assume that a weak US economy means a weak world economy, and they run to the safe haven asset of choice, ironically, the US dollar itself.

However, during the week after the collapse of the once venerable Lehman Brothers, the data shows that people, of all place, ran to the Euro.  Below is a figure of the daily exchange rates for EUR/USD in the two weeks following failure of Lehman.

EUR/USD during the two weeks following the collapse of Lehman Brothers.  The bad news of the failure of a major US firm at first sent the Euro higher versus the greenback as US fundamentals appeared to be the weakest in decades.  The following week however, as the the market digested the depth of the crisis and its global impact, investors raced back into the dollar as a safe haven despite the fact that the crisis had its origins in the US.  The Euro would continue a massive slide all through October and would not find a bottom until April of 2009 at 1.20 USD per EUR. 

The fact that the Euro surged and then fell tells a story that has been slowing unfolding over the past few decades since before the dot-com bubble.  From 1980 until the 2001 recession, the United States had been generally seen as the best opportunity for growth in the world.  All through the 80s and 90s, the dollar rose with domestic equities as the United States was leading what many around the world saw as a secular bull market.  But by the start of the new millennium, the 4.5 percent growth of the nineties was replaced more measured 2.5 percent growth of the early 2000s. For the first time in nearly two decades, the market looked outside the US for the biggest opportunities for growth, and the dollar got hammered.  The biggest beneficiaries were both in vogue emerging markets like Brazil, but also well established economies like Austrailia and Canada.  Both of these countries have seen their dollars push past parity with their American counterpart.  (They crashed during the 2008-09 crisis but have since recovered)

So for that one week after the fall of Lehman, the market had interpreted the failure of the largest US investment bank as just the latest chapter in the overall story of a secular US decline.  Accordingly, major actors continued US divestment.  But as we know now, within a matter of days, investors would be fleeing back into the US dollar as global growth concerns moved to the fore as the crisis deepened.  It wasn't just another failure of a big US firm which was sending signals that the best days for the US were behind it, the entire world financial system was on the brink, and now the amazing story of growth seen in emerging markets was unraveling.  The dollar now traded differently.  Any bad news, US or international, sent it soaring, while even good domestic numbers would cause it to fall as more risk was bought.  In a mere two week span, everthing had changed in USD land.

Today, and as global heads of state, finance ministers, and central bankers continue their quest for growth, the USD stands at a crossroads.  It could continue the trend of trading lower on good news and higher on bad news, as investors seek to continue the pre-2008 emerging bull market which was brought to a screeching halt by the financial crisis.  On the other hand, with the mess in Europe, the US may be poised to lead the world recovery.  In the latter scenario, the dollar would begin to trade higher on good domestic numbers as investors moved into US equities and corporate bonds.  Eventually, the world demand for US debt would rise even more as investors bought T-bills on the speculation that the dollar would appreciate.  If a strong US jobs report ever sends the dollar higher instead of tumbling against emerging market currencies and EUR, it would represent a major shift in the psychology of the market and may be clear indication of a new secular bulls market for both the USD and US equities.

For those of us still interested in emerging market currencies, it may be time to consider switching to a cross rather than buying them against the US dollar.  One idea I have been toying with is switching to the Yen as my funding currency for MXN purchases.  For those of you interested emerging markets like India, South Africa, or Turkey. I would recommend buying ZAR/JPY or TRY/JPY instead of selling USD/ZAR or USD/TRY respectively.  If your broker does not offer these crosses, try buying USD/JPY on dips (I am looking to get long at 79) to hedge against the eventuality of a stronger dollar based on stronger US fundamentals.              

Mid-Week Position Summary

Short USD/MXN @ 12.9000

Capital Ratio: 10.08 percent

I am all in on the peso after booking some modest profit on long GBP/USD positions earlier earlier in the week. Order filled right before a slight pullback to 12.98.  The longterm tread remains bearish with many investment houses upgrading their outlook on Mexico's peso.  The fundamentals remain strong with a growing Mexican economy, strong foreign demand for peso denominated assets,  sound fiscal policies by the central government, and a hawkish central bank.   The trade has nice positive carry and I intend to hold this position even if there is a large  short term pop in light of my strong capital position and ability to ride out losses.  I will target the 2011 low of 12.55 in the medium term (1-2 months) and look to get short again for the one to two year target of 11 pesos to the dollar. 

Commentary: Will the Outcome of the US Presidential Election Move the FX Market?

Markets watch US presidential elections.  All the way back in 2000, the uncertainty around the result caused a large sell off of stocks on Wall Street which sent the Dow plunging.  (The dot-com bubble had also burst in March of 2000)  With the country charging towards the edge of the fiscal cliff, and the prospect of a lame duck Congress having to fix it, all eyes are on Washington.  Furthermore, slow growth, and overhang from Europe is weighing heavily on investor sentiment.  Here at FX-Fusion, it is our opinion that actors across the entire economy are still weary from the crisis of 2008, and for the past few years investors have been slowly wading back into the market.  Households are still deleveraging by aggressively paying off non-mortgage debt, and young people are renting because they are still afraid to enter a recently beaten down housing market.  The economy is growing, but despite this, the market is still looking for a clear signal which will either turn the bulls loose or bring in the bears, both of whom have spent the summer and fall waiting with baited breathe for any major news out of Europe .  So in this uncertain, directionless environment, market events matter more than ever.  Finally,   Mitt Romney has been pushing the "China is a currency manipulator" meme for months now, so I think that it is quite appropriate for me to share my thoughts on how the election next month may impact the FX market. 

What About China?

As President Obama correctly pointed out, USD/CNY has appreciated substantially since 2010.  The chart below illustrates this point.     

The Managed Appreciation of  the Chinese Yuan.  The People's Bank of China (PBOC) held the exchange rate with the US dollar constant for decade from 1995 to 2005 before allowing significant appreciation.  It reestablished the peg in 2008 to help its exports during the Great Recession.  In 2010, after significant nudging from the Obama Administration, China again allowed its currency to appreciate. 

 So the Reminbi (aka Yuan)  has already been allowed to rise against the dollar.  Sell USD/CNY, its a great carry trade with significant chance for further Yuan appreciation.  But as important as flexible exchange rates are for preventing trade and capital flow imbalances, it should be obvious to anyone that even if the Yuan were at parity with the dollar, it would still be attractive to ship jobs there because labor costs are so much cheaper.  In short, the only way to compete with China without bringing down real wages stateside (an adjustment that would take decades) is for US workers to gain more education and training so that they are many times more productive that their Chinese counterparts.  I am not the first or hundredth person to point this out, but it definitely bears repeating.  Labelling China a "currency manipulator" won't solve the massive trade imbalance.  Furthermore, since China is already allowing its currency to appreciate, doing only serves to antagonize the third largest economy in the world.    

Will a Romney Win Result in a Stronger Dollar? 

A well respected fund manager recently opined that an inevitable Romney victory will result in a stronger dollar on the speculation that Romney would appoint a more hawkish Fed chairman.  This very thought had crossed my mind a few weeks ago, back before the polls had tightened.  More hawkish language from the Fed, or the prospect of a tightening of monetary policy may cause temporary dollar rallies, but speculating on the election is foolhardy.  First, with national polls virtually tied and a slight Obama lead in the electoral college, the contest between Mr. Romney and President Obama is basically a coin flip.  Furthermore, a Romney victory may very well not move the markets because Ben Bernanke's term does not expire until 2014.  The prospect of an unknown Fed chairman being installed two years in the future is hardly a clear data point for the market to price in.  In short, spec plays based on the election are probably just gambling.  But if that is your thing, let me suggest going short AUD/USD on th prospect of further rate cuts from the RBA and the corresponding monetary tightening that would come with a new Fed Chairman.  

Parting Shot:  China is already letting its currency appreciate.  Speculating on  the election is foolish because the polls are tied and it is a distinct possibility that the result does not move the market.