Friday April 8, 2005 - 10:41:04 GMT
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Black Swan Capital - www.blackswantrading.com
A dollar story
Miss Gulch: Mr. Gale, I want to see you and your wife right away about Dorothy.
Uncle Henry: Dorothy? Well, what has Dorothy done?
Miss Gulch: What she's done? I'm all but lame from the bite on my leg!
Uncle Henry: You mean she bit you?
Miss Gulch: No, her dog!
Uncle Henry: Oh, she bit her dog, eh?
Miss Gulch: No!
The Wizard of Oz
Editor’s note: A little known secret is that the exchange above was initially patterned from two Wall Street experts talking about the bond market.
We saw a swift reversal in the dollar mid-day during the US session yesterday. Was it simply an overreaction to an overreaction in the bonds, after some Fed speak? Or was it something more? Is the market again realizing the potential for a widening dollar yield differential? Was it a coincidence that crude and bond prices fell together? Do they reinforce each other? There are many questions, as usual. Unfortunately, there are never as many “good” answers—only conjectures, expectations and guesses.
The sharp drop in bond prices yesterday seems to be attributed to Fed speak. It just so happens that Mr. G’s minions were out on the circuit in force and they seemed to be reading from the same sheet of music, let’s call it Fed-inflation talking points (FITS). First, in Philly, Federal Reserve President Anthony Santomero said the Fed is behind the curve and the market shouldn’t focus on the jobs report to determine Fed policy, inflation is where the action is. Later in the day, FITS were reiterated by Federal Reserve President William Poole—he said the US economy faces some “pretty obvious” risks of inflation.
If we find a wave count to fit the inflation theme, the timing looks pretty good. Just maybe FITS is the catalyst to drive long bonds “where they should be,”—a lot lower (according to those who believe you can only fight the Fed so long, but sooner of later the Fed wins):
Okay, so what, bonds reversed a little; it’s purely a technical move, you might be thinking. And you might be exactly right with that thought. But it’s interesting we got the bond move and crude move at the same time yesterday.
Crude was looking “toppy”, so maybe it was just technical too (I always loved it when Dorothy said to the good witch “Toto too?” didn’t you. And yes, Mr. Greenspan aka Dr. Marvel, would be cast as the great and power Wizard.)
Back to the charts…
Ok, so what if oil falls? Well, I think if oil prices fall, whether it be for technical reasons or because of a slowdown in demand (maybe due to higher interest rates)—who knows at this point—it frees the Fed to hike more aggressively and catch up with the inflation bogey man that has produced FITS. (Some would say the inflation bogey man is just an excuse to reining in some of the asset bubbles created by the Fed. But I would never be that cynical.)
Oil above $50 bucks was considered an “energy shock” that could push the economy into recession according to the experts.
“Last summer, one-third of economists who participated in The Wall Street Journal Online's economic forecasting survey said a recession would follow if crude-oil stuck in between $50 and $59 a barrel -- exactly where futures prices have traded since late February,” according to The Wall Street Journal this morning.
(As an aside: What is interesting too, is the morphing of the expert views. Asked the same question in April of this year, of where oil prices push the economy into recession, zero, zip, nada, of the experts said crude at $50-$59 barrels would push the economy into recession. Ah, hindsight is still 20-20!)
A look at bonds and crude oil on the same chart…
Two points that I draw from the chart below:
1) The two series tend to track more closely than I expected. But it makes sense because higher bond futures prices equals lower interest rates, which in turn supports faster growth and greater crude demand. And vice versa as bond prices fall…
2) And this is the guesswork part: it seems there comes a point where the market believes the Fed cannot afford to hike aggressively, precisely because higher crude prices act as a blanket on growth i.e. the energy shock thing the experts talk about.
Chart: crude vs bonds
Keep in mind the Bank of Japan, Reserve Bank of Australia, Bank of England, and the ECB all decided to pass on rates. And, if crude breaks, it frees the hands of the Fed to hike more aggressively—catch up to the curve/normalize rates/locate that elusive neutral level etc. And if that is the case, it means the dollar’s positive yield differential widens faster than thought before crude oil broke.
So that is today’s story. And a reason for the dollar’s swift reversal yesterday. But at this point, it’s only a fairy tale.
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