Commentary: Fed in the Driver Seat as Markets Await Bernanke Testimony

Conflicting signals from top Fed officials continues to drive equity and FX markets this week, although now in the opposite direction.  The last week and half have been all about rumors of the Fed 'tapering off' its bond purchase program before the end of the year, stoked by comments by San Fransisco president Williams.  Williams, who earlier in the year had affirmed his support for continued asset purchases, suggested last week that he was open to a winding down of Fed's 85 billion dollar monthly bond purchase program as early as the end of the summer. Such talk had sent stocks lower and the greenback higher during Friday trading, capping a week long dollar rally that had resulted in fresh highs for USD/JPY. 


On the other side of the table, Chicago Fed president Charles Evans was keen to reassert teh dovish tone at the Fed in what may or may not have been an attempt to walk back the Williams' speech.  Evans acknowledged that the US economy is performing 'quite well,' relative to other advanced economies, Evans, arguably the most dovish FOMC member, stated that bond purchases were here to stay given subdue inflation and historically high unemployment. Evans comments have been met with fading of the dollar rally, indiscriminate of local fundamentals.  Despite a slowing economy and lower intra-day stock market, USD/MXN traded lower on the news, sliding to 12.27. 

Fed Chairman Ben Bernanke is also set to testify before Congress this week.  While his testimony is always a significant market event, this week's two day affair before House and Senate committees appears to be of particular significance, especially for the FX market.  Specifically, market participants will be looking for a clear direction from the central bank's chief as to the pace of any winding down of asset purchases.  Markets will be hoping for Bernanke to 'break the tie' between the conflicting statements put out by FOMC members recently.  Bernanke, whom  Evans called a "spectacular chairman," may calm markets by reaffirming the Fed's intention to continue its QE program well into 2014.  More likely, Bernanke is will stick the thresholds set by the Fed in late 2012 and stress the Fed's dual mandate of maximum employment in a context of price stability.  Asset bubbles, a major downside risk to cheap credit, are likely to be a theme, but 1.2 percent headline inflation and 7.5 percent unemployment leaves the door wide open for more stimulus.   

News: Good Data From Abroad Fails to Crimp Dollar's Style

The USD has continues to climb higher today, rising against everything from JPY to MXN.  The Euro opened down nearly 50 points, despite better than expected car registrations, suggesting that auto-sales on the Continent may finally be picking up.    USD/MXN also extended its recent rally, pushing as higher even as Mexico posted higher than expected growth for Q1 or 2013.  Analysts had been expecting 0.3 percent YoY growth, in light of slowing manufacturing sector.  While a slowdown did occur in the industrial sector, Mexico's service sector grew fairly robustly, or 1.9 percent on a YoY basis. The manufacturing sector shrunk however, by 1.5 percent YoY, consistent with March's dismal IP data.  The primary sector grew at a 2.8 percent YoY pace, mainly due to increased crop yields.   The manufacturing sector, the engine behind Mexico's booming exports, seems to have been hurt somewhat by US fiscal consolidation.  Belt tightening occurred south of the boarder too.  The Mexican government has been diligently working to eliminate its small budget deficit.  Mexico's deficit in Q1 2013 was fifty percent smaller than its was this time one year ago. On the bright side, the Mexican consumer seems to have filled the spending gap somewhat, as evidenced by steady PCE data. 

Data is great, but the broader theme here is a buoyant dollar that appears to be overwhelming internal fundamentals of both major and exotic currencies.  Indeed, GBP, CHF, AUD, ZAR, INR, THB, TRY and a host of others are all way down for the week.  Some of these country's central banks have taken action of late, and some haven't.  The feeling in the air though, is the the Fed may be preparing to wind up its QE program while around the world other central banks are just getting starting.  

  

 

News: USD Pushes Higher, Mex Q1 GDP Looms

The US dollar has reasserted itself once again on the back of last week's surge in USD/JPY.  USD now appears to be firmly anchored above JPY 102, after bouncing off this key support level earlier this morning.  Buy the dip seems to by the story with pair, as USD/JPY sales are met with fresh buyers.  

But its not just the Yen which is the dollar's latest victim. While much talk is afoot about the 'realignment' of AUD, the Aussie dollar's dip below parity has coincided with broad dollar gains against majors and exotics alike. EUR/USD has dipped below 1.29 and its now settling into a 1.28-50 range.  Sterling is on the back foot again, but appears to have found short-term support at 1.52.  USD/CHF is trading in concert with EUR/USD.  Many expect a retest of .99 or even parity.  

On the EM front, USD/ZAR is pushing higher, and appears poised to test the crucial 9.30 level which was the peak of the last rally.  Further labor unrest and low commodity prices is also weighing heavily of ZAR.  Asians are down with the Yen and AUD.  USD/INR is trading higher in the 54.50-80 range.  USD/THB, which plunged earlier this year, is back near 30.  Finally, KRW has been under heavy pressure on speculation that the BOK, which cut rates along with the RBA last week, may intervene on FX markets to protect Korean exports against a weaker Yen.     Finally, USD/MXN is pressuring 12.30, especially in light of the low expectations for Q1 GDP due out Friday. The finance ministry expects annualized GDP to come in at a paltry 1 percent.    

In short, the greenback is consolidating its gains against everything.  While I am tempted to pat myself on the pat for buying USD/ZAR last week, it appears that the real theme is strong USD dollar.  Virtually any long USD is well in the green for the week.  A win is a win, but broad dollar strength, not internal fundamentals of individual currencies, appears to be setting the tone the FX market. 

Commentary: Talks of Tapering Probably a False Alarm

The Fed Rumors continue to swirl that the Federal Reserve may 'taper off' its bond purchase program before the end of the year. The market response has been soggy equity markets, a rally in Treasuries, and broad dollar strength. Specifically, the Fed is concerned that communicating the exact timing and nature of its implementation of its exit strategy may cause chaos in the Treasuries and MBS markets with participants rushing to front end any policy action by shorting these securities. This may make the Fed's promise to continue its open ended commitment to purchase 85 billion in Treasury and MBS, so long as unemployment remains over 6.5 percent and inflation under 3 percent, a tricky proposition. Should the BLS report high inflation or unemployment outside the Fed's stated targets, traders may begin to short Treasuries and MBS in anticipation of the winding down of the Fed's asset purchase program. 

One fact must be considered however. Even if the Fed decides to 'taper off' its purchases, such a move not represent a tightening of policy. Rather, it would only represent a reduction of the pace at which further liquidity is injected into the financial system. Hence, actual trades by the central bank won't come into play. Instead, the market will only have to rediscount the changed pace of liquidity injection. In other words, assuming that the price of the USD, stocks, bonds, or other securities already factors in the factor that the Fed will pump in 85 billion per month of fresh liquidity, how would actors re-adjust price expectations if the Fed cut its purchases by some modest figure, say 15 billion? 

I'm not sure, but I doubt a modest reduction in new liquidity being pumped into the economy will crush risk sentiment and result in falling stock prices and a resurgent USD. True, the USD may strengthen on the news, but knowing the Fed, any winding down of the Fed's QE program will be accompanied by good economic indicators which means that the broader economy can support higher rates. (Or rather, less accomadation, since rates are unlikely to rise until the Fed raises the rate paid on excess reserves or sells securities) In other words, expectations of higher returns will make risk takers willing to pay higher rates to obtain financing. For this reason, especially with rates near their zero bound, the unwinding of the Fed's balance sheet will probably be accompanied by increased loan demand, spurred on by a growing economy, and in spite of rising rates. A resumption of robust credit growth will be highly supportive of stock prices, housing prices, domestic consumption, and growth. 

 On FX, credit growth will affect the USD in two ways. Stronger growth in the US vis-a-vis other major economies will be highly USD supportive, even if this is obtained largely via increased leverage. However, as we saw in the 2000s, credit growth can also be USD negative, especially if US or foreign firms borrow in USD but invest abroad. However, this scenario seems unlikely to repeat itself. US firms will shift their focus towards North America, especially if the United States continues to lead the global recovery among advanced economies. Furthermore, firms abroad, especially in Europe, will be able to obtain cheaper financing in Euros, especially since it remains clear that the ECB has left the door for further easing wide open. True, European capital markets don't have the depth or liquidity of the US, but this will only be a factor for very small firms. Finally, we are seeing some US firms issuing Euro denominated bonds to obtain lower rates. DirectTV floated a five hundred million dollar eurobond today. In sum, whether the special place the US has in the world economy makes the USD the financing currency of choice as the credit cycle ramps up, despite higher rates than EUR or JPY, will be the key driver of the dollar in coming years.

Weekend Update: Opportunities Abound

It's been an exciting week and the time has come to prepare for the week ahead.  This week saw USD/JPY breach the 100 handle in dramatic fashion, surging up to 101.60 by New York close Friday afternoon.  Nearly all Asian currencies are down with the Yen.  USD/THB continues its rise, closing in New York at 29.77.  USD/INR is also up, closing at 54.65.  Two other movers have been AUD and KRW, whose central banks both cut rates this week.  AUD/USD breached parity, before popping back up to 1.0024.  USD/KRW, which had fallen back as low as 1082 as tensions cooled on the Korean peninsula, surged back above 1100 to 1110.7 after the BOK delivered a surprise rate cut.  

On the other side of the world, EUR/USD was soggy, as EUR has been unable to maintain is recent rally on strong German data.  I am still neutral on this pair. I still see a chance for a slow recovery back towards 1.40, but many commentators who I greatly respect have year end targets in the 1.20 to 1.25 range. 

USD/MXN gave up recent gains on profit taking and lower than expected industrial output for March.  Analysts had expected a drop, in light of the Easter holiday, which fell in March this year.  However, the 4.9 percent year on year drop was a big surprise to the downside which had some worried about a possible Mexico slowdown.  The rate outlook remains mixed, as Banxico struggles to manage capital flows and rising inflation.  I am looking to sell USD/MXN at 12.20. I remain cautiously optimistic.  The February's drop in IP was couple with weaker exports.  March saw robust export demand, with exports near all time highs.  Next month's data point should confirm whether or not the recent slowdown is indeed seasonal.  

Finally, USD/ZAR is probing higher, presumably on profit taking on any short USD/ZAR positions initiated on last week's post jobs euphoria.  The fundamentals remains weak, and the overall market tone is extremely gloomy.  I look to buy this pair on rallies. 

In short, opportunities abound. Asian currencies are getting cheap as the Yen continues to get hammered.  I may elook to get long THB or even INR should frantic yen selling push them even lower.  However, selling AUD and JPY as momentum trades or buying USD/ZAR on dips remain my preferred strategy for next week.  MXN is a mixed bag, right now, though I look to cautiously expand my position.  I will look to sell at 12.20, but more importantly, I will be laser focused on Mexican economic data for the foreseeable future. 

 

Commentary: Warren Student Loan Proposal is a Disaster

Senator Elizabeth Warren (D-MA) has proposed opening of the Fed's discount window to student borrowers, albeit indirectly.  The plan would mandate that the Federal Reserve lend to the Department of Education via the discount window so that it could charge students the same 0.75 percent rate that banks pay for emergency short term financing from the Federal Reserve.  To the uninitiated, this plan sounds great.  But it is nonsense, a disaster, and a disgrace that such a radical proposal would come from a sitting US Senator.    

Since my critics will no doubt accuse me of being a defender of the big banks, or a call me a fat-cat plutocrat, let's get some background out the way.  I voted for Barack Obama in 2008, and again in 2012.  Both times my support was enthusiastic.  I have generally supported Mr. Obama and his economic policies.  I am a strong supporter of a quick and easy path to citizenship for undocumented workers, and I believe in free universal healthcare.  But if my fellow democrats don't kill Ms. Warren's proposal immediately, I will be ashamed of the capital "D" after my name. 

 So what's wrong with the Students Loan Fairness Act.  In a word, everything.  But let's go through the details just so there isn't any doubt. 

The Fed lends money to banks against collateral, typically US government bonds or other highly rated securities, on a very short-term basis, usually overnight.  The purpose of such loans is not to enrich the banks or enable them to speculate.  It is a mechanism by which the banks can temporarily convert their loans into cash to meet withdrawal demands.  Without this safety valve, banks with a sudden surge in withdrawal requests would be unable to pay depositors, since it is not possible for them to "call" loans made to other customers.  

Furthermore, the Fed takes full custody of the pledged collateral, and earns all interest accrued during the term of the loan.  The bank is also still on the hook for the 0.75 percent for borrowing from the Fed.  So the bank is not only stuck paying interest on the loan, it also must forfeit the income generated by the collateral.  The result is a big net cost to the bank.  
 Banks would much prefer to borrow on the interbank market, where rates are lower and no collateral is pledged. 

Finally, the discount window is a boon, not a cost, to taxpayers.  Since 2008, the Fed has issued over 30,000 loans via the discount window, all fully repaid on time with interest.  The result has been over 300 billion in profits remitted directly to the US Treasury.  During its entire history, due to its ultra stringent lending standards, the Fed has never suffered a default.  

So where does this leave us with Ms. Warren's proposal?  

To start, because the Fed's awesome power to print money has great potential for abuse by politicians, the Fed was intentionally walled off from the rest of government.  The Fed never funds the government.  This sacrosanct rule of central banking is key to the Fed's credibility and that of the United States.  Countries which have resorted to money printing by the central bank to fund the government have suffered calamity after calamity.  Two recent examples include Zimbabwe in the 2000s and Argentina in the 1980s.  

Despite the lessons from history, Ms. Warren's proposal engages in overt money finance, or economist jargon for printing money to pay the government's bills.  She would direct the Fed to provide financing to the Department of Education to fund its Stafford student loan program.  While the goal of helping students is laudable, the means represent a dangerous crossing of the Rubicon which cannot be ignored. 

But perhaps worst of all, Ms. Warren's rhetoric in promoting her bill reminds of the cynical, rank, pandering usually employed by the Right.  Comparing central bank loans to banks, which are secured by firm collateral and usually last days, to student loans secured by nothing but the student's character and repaid over decades is the kind of despicable dumming down of issues that makes getting an education so important in the first place. 

Ms. Warren has made her career going after the excesses of Wall Street and helping to regulate the financial system.  She helped stand up the CFPB and assisted with overseeing the TARP bailout.  I therefore find it hard to believe that Senator Warren does not understand the basics of discount window loans or how it differs from loans made to consumers or students.  The fact that she would take advantage of the public's ignorance of an obscure but crucial function of government to score political points is shameful.  And ironic, since the objective of this whole exercise is supposedly to promote higher education.  Perhaps Ms. Warren should remember who exactly she is trying to help.          

News: USD/JPY Zooms Past 100, focus on 105

Sentiment on USD/JPY has turned firmly bullish as the pair surges over 100 for the first time in four years.  Techs and strategists alike are gearing up for a further leg upward in coming days and weeks.  News wires have talk of USD/JPY testing 102 as early as tomorrow.  Clearly from a technical perspective, 100 represented a major barrier, as evidenced by several failures to break above the 99.9 level in past few weeks.  Despite the take breach of this major level of technical resistance, don't look for a wave of short covering.  Per CTFC futures data, speculators were already long at about a five to one ratio.  Corporates continued to hedge their bets, piling up big Yen long positions.  Its unclear whether this is Japanese names "protecting" dollar denominated receivables, but this divergence in trader activity highlights the differing objectives of the participants on the FX market.  Corporates aren't concerned about the money they lose hedging on the futures market, so long as earnings from operations are "protected."  Furthermore, many companies always hedge, regardless of the fundamentals.  Therefore, corporates will stay long JPY for the foreseeable future, out of an unwillingness to take FX, or an inability to the work necessary to take said risk.  The as long as the specs continue to happily sell puts to the corporates, its up, up, and away for USD/JPY.