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Friday November 4, 2005 - 11:53:17 GMT
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It's still all about yield


“It ain’t over till it’s over.”

Yogi Berra

FX Trading

Jobs report Friday. It usually means fireworks. Be careful out there. Retail sales in the US surprised on the high side yesterday. Hmmm…

Bonds continued to edge lower even after Mr. Greenspan told us again the Fed isn’t too worried about inflation. This time he pointed us in the direction of the structural reasons i.e. a massive global workforce being unleashed in China and India. Makes sense! Or does it? No matter if it does or not, the bond market is the final arbiter in our book.

Today we attach a recent piece we wrote on October 30th about yield as the driver—most of the stuff is still fresh, some stale, but the logic we think still applies.

It’s still about yield!
Next stop 1.16, on the way to 1.10…

No doubt US Federal Reserve Chairman Alan Greenspan has a lot on his mind, he usually does. Besides the rising inflation expectations, it seems the Maestro is growing increasingly concerned he may be remembered as “Mr. Bubble”—the man that erred on the side of asset bubble creation, instead of sound monetary policy, to drive the US demand engine.

“The Maestro has dropped his baton. In a series of stunning about-faces, Federal Reserve Chairman Alan Greenspan has just recast his perceptions of the critically important relationship between monetary policy and asset markets. Not only does he finally own up to the perils of America’s housing bubble, but he now concedes that speculative froth in asset markets may well have been a direct outgrowth of the Fed’s policy stance.”

Stephen Roach (30 September 2005)

“I didn’t do it. You didn’t see me do it. You can’t prove anything,” was the lament of Mr. Greenspan not too long ago when quizzed about asset bubble creation flowing from the Fed’s rather liquid monetary policy. Now, he seems to be voicing a very public confession from the hallowed halls of the Fed: “I created an asset bubble in real estate, at least. It is a danger. And it’s time to deal with it.”

We think Mr. G has shifted into “legacy-thinking-mode.” If so, the market could be surprised by the aggressive language, if not by an outright unexpected move higher in rates during the remainder of the Maestro’s tenure—draining air from the bubbles and taming inflation are self-reinforcing reasons to up the ante.

Many economists are expecting a 4.5 percent Fed Funds rate by the time Mr. Greenspan leaves office—others a bit less. Beyond that, market hawks are looking at possibly one more 25 basis point hike soon after Mr. G leaves the building, so newly appointed Fed Chairman Bernanke can show off his inflation fighting prowess. Even the hawks may be underestimating the Fed.

Recently, San Francisco Fed President Janet Yellen said the “neutral rate” may be as high as 5.5 percent. If we are reading the tea leaves correctly, yield is still the driver for the dollar and the height of the dollar yield differential will soon exceed current market expectations. As a result we expect the next stop for the euro/$ exchange rate will be somewhere near 1.16, on its way to 1.10.

It always has been, and continues to be about yield…

We became dollar bullish very early in 2005. Why? Because despite all the talk of the dollar’s demise based on the ominous structural concerns—read current account and budget deficit—we believed it was about interest rates. Or more precisely, yield differential. We got that one right.

By December of 2004, the Fed had already hiked rates five times—pushing short-term benchmark yields from 1.0% to 2.25%; a quarter of a point above the European Central Bank benchmark interest rate. And there was no sign the Fed had any intention of stopping there.

The weekly chart below shows the movement of the Fed Funds Futures (inverted) compared to the US $ Index. One important thing to discern from this chart is the lag between the time the Fed began hiking, and when the dollar responded. It was approximately six months. We saw a similar period lag back in early 2001, as the Fed began cutting interest rates. It took approximately six months before the dollar began to breakdown. We think this price action lag is part and parcel to the fact that currencies tend to overshoot and undershoot because it takes time for bullish and bearish sentiment, respectively, to be shaken out of the market.

In the case of the dollar, as the euro was peaking near 1.36, it coincided with a speculative sentiment extreme which said the dollar could go only one way—down. Players who were riding a very nice self-reinforcing price trend created a whole host of reasons why that trend would continue. They failed to see the real reason it wouldn’t--yield.

Old hands in the market will tell you, prices stop going up when there’s no one left to buy. And in the case of the euro-$, all the buyers were in the market.

As the price trend began to change, the market began to focus on the one consistent long-term driver of currency movement—yield. (US economic growth was, and still is, another powerful element of the story, but for now we will stick to yield.)

Why are we reviewing history? Because the game has changed, just as the dollar overshot on the downside—we think the aggressiveness of the Fed, driven by…

1) The newfound concern over asset bubbles
2) Rising inflationary expectations

…will lead to the capitulation of even the most ardent dollar bears to the trend—on the yield story and that will lead to an overshoot in the dollar to the upside. That’s why we think our estimate of 1.10 on the euro by the first quarter of next year is conservative.

Besides underestimating the Fed, the market is overestimating the European Central Bank.

ECB will likely just jawbone

There is much talk about the potential for a rate hike by the European Central Bank (ECB), sooner, rather than later. We think it is much ado about jawboning. The risks to growth trump inflation concerns at this state—we believe. We have already seen earlier this year hopes of Euro-zone economic revival quickly dashed.

And we aren’t the only ones in that camp that says ECB talks but doesn’t act, despite the rising expectations for a move in the market. Our view coincides with the reasoning in this excerpt from a piece by Morgan Stanley economist Stehpen Jen [our emphasis]:

“If I’m right on ‘stag’[stagflation], then it is unlikely that the ECB will turn their currently hawkish rhetoric into aggressive action on interest rates. Don’t get me wrong: I believe that the ECB is truly worried about upside risks to inflation emanating from the energy price shock, which pushed headline inflation to 2.6% in September. I also believe that the ECB worries genuinely about the build-up of excess liquidity and its impact on asset prices. However, as long as there no clear signs of second-round effects (read: an acceleration of wage inflation), and as long as the tough rhetoric suffices in anchoring inflation expectations, the fear of a renewed relapse in growth is likely to keep the ECB on hold, in my view. My guess remains that the majority of the ECB Council will want to see at least two quarters of GDP growth (Q3 and Q4) at or above trend before raising interest rates. Just imagine what would happen if the ECB raised rates in December and growth faltered yet again: several governments in Europe would seize the opportunity to make monetary policy the scapegoat for everything that’s wrong with Europe.”
We couldn’t have said it better ourselves. Thank you Mr. Jen!


Mr. Greenspan’s public admission the Fed has created bubble trouble, coupled with a real concern on the inflation front suggests the Fed could not only continue to hike, but do so in a way that surprises the market. And if the ECB plays wait and see, the yield on the euro is going to look mighty meager relative to the dollar.

If yield is still the primary driver, as we suspect, the dollar could move sharply higher against the euro in the weeks and months to come as the conversion flow to the yield story, in the minds of the market players, morphs into a stampede.

Jack Crooks
Black Swan Capital
30 Oct ‘05


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