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Wednesday June 8, 2005 - 11:12:56 GMT
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Day 3 of dollar "correction" as conundrum intensifies


“Financial markets are fast-moving, continually oscillating, reflections of the processes of transformation and change. They cannot be defined by static concepts and linear relationships. The practical value of economics is therefore limited to providing background forecasts against which to judge the current trends in markets.”

Tony Plummer, The Psychology of Technical Analysis

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Warning: This morning’s ramble is a bit more confused than usual as we once again swerve into “conundrum land.”

“Fed officials have said in every way except via the language in the policy statement that they're more concerned about accelerating inflation than slower growth. Given their focus on wages as the driver of inflation, the news last week that unit labor costs in the non-farm business sector rose at a 4.3 percent year-over-year rate flashed yellow on their radar screen,” writes Bloomberg’s Caroline Baum.

Question: Are traders again underestimating the Fed? And will the dollar once again turn and rally sharply once again once “underestimation reality” is back in the market? Or are long-rates telling a story that will soon gain the Fed’s attention? If so, maybe there is something to a coming disappointment on dollar interest rates that is driving the dollar correction day three.

By any stretch, it would appear long bond prices are ahead of themselves given short rates.
At least that is how we have been viewing it. But on second or third or fourth…thought, it could be that higher short-term rates logically become self-fulfilling for historically low long-term interest rates that may go even lower.

If GDP growth is more closely linked to lagged short rates (higher short-rates and lower growth as the Fed takes away the punchbowl analogy), coupled with what The Economist sited recently: “In the 1950’s and early 1960’s, at time of relatively low inflation and robust economic activity, yields were well below nominal GDP growth rates.”, then this could be a long bond buying opportunity—a la the message that Bond King Bill Gross has been singing for a while, as he racks up more and more gains—they call him the King for a reason.

So maybe long-rates are not “ahead” of where they should be in the current growth environment, especially if the Fed continue to hike the funds rate. And as Ms. Baum points out, there is little reason to believe the Fed won’t do just that.

How is that for perverse! It’s the kind of thinking that transpires when one attempts to rationalize a conundrum.

So as we said on Monday, maybe traders and commentators who we suspected would start to use the “slowdown in the Fed” to justify a dollar correction are right for the wrong reasons? It would be no matter. The dollar is sinking for day three and in the end, to paraphrase Mr. Livermore: In trading it is better to do right than it is to be right.

In the end, this little perversity we laid out (which just dawned on us about six months after it did the Bond King), if true, will probably not stop at the borders of the US—rates globally should follow a similar pattern. If so, that could put all the players back in the same rate boat sooner or later. And then, it will probably come back to the strength of the economy. For now, the US still looks to win on that measure.

So, the correction we are seeing, and expected in the beginning of the week, may have some legs—but over the intermediate-term, we haven’t changed our view that the dollar resumes its rally against all comers. Of course, only the market will tell us if and when.

Jack Crooks
Black Swan Capital


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