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Thursday June 29, 2006 - 10:34:09 GMT
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Rate ruminating


“I wish I had an answer to that because I'm tired of answering that question.”

Yogi Berra

FX Trading – Rate ruminating

Where are rates going? No clue! But it’s time to get ready to rumble!

We think it’s about liquidity. For a lack of liquidity at the margins, and a perceived further tightening, will likely lead to the ongoing flow of dollars back home from far-off places that once appeared as a one-way bet with little in the way of volatility—Goldilocks morphs into the Big Bad Wolf and it tends to support the dollar.

However, an objective measure of liquidity is hard to define in an environment where credit is doled out by financial intermediaries across such a broad spectrum and with ease. But, sooner or later it all comes back to interest rates and omnipotent central banks.

We noticed rates are going higher, evidenced by bond prices going lower. They peaked in June ’03—THREE years ago. That should be enough lag for flow-through into the real economy, don’t you think?

The 10-yr Notes are sitting bang on the 62% retrace level going back to the low in early 2000:

Below is the same 10-yr Note chart with the US $ Index (inverted) superimposed; we invert the $ Index prices so you can see how the two series have moved relatively. And based on the weekly chart, the two series have tended to move together (when the $ Index inverted line goes down, it means the value of the dollar relative to other currencies is increasing). But in early April ’06, that’s where the two series began to diverge:

Interesting in retrospect, but does it tell us anything? It might suggest, if we stretch our imaginations, the currency crowd began reflecting the theme the Fed was close to done in early April—and the bonds proved more prescient. If so, it would suggest that today’s Fed language, accompanying today’s “assumed” 25 basis point rat hike, is much more important for the currency crowd than it’s been in a while.

But there’s a real problem with this type of simplistic analysis in general, even if we can actually glean some truth from it:

1) We can’t forecast interest rates; if we could, we’d be trading bonds and living happily ever after on our private island instead of worrying about currencies.
2) Even if we could forecast interest rates, the relationship between the $ and rates, as you can see with the gift of hindsight, is not always direct i.e. the recent divergence we just talked about.

So where does it leave us? It leaves us with no choice—or I should say, with our only choice—watch how today’s Fed announcement plays out against ongoing expectations. Surprisingly, the non-commercial open interest (this reflects mostly punters) is only slightly weighted to the long side in the 10-yr Note contract, 569 K long vs. 507 k short, as of June 20th. And it’s fairly evenly split on the commercial side too.

This isn’t exactly a crystallized sentiment extreme. We seem to have more talking bond bears than acting bears. That in turn suggests there is plenty of firepower on the sidelines. The dollar sentiment is mixed too. There are a healthy number of euro and C$ bulls that are balanced by yen and Aussie bears. Looking at these numbers is why we titled our piece on Tuesday—Coin flipping and bone throwing? This market is more confusing than usual, and that’s saying something.

Push come to shove, we are long the dollar on the view that additional euro sentiment might need shaking out. But dollar bulls, that have been happy of late, have to be careful, as a whole new theme is starting to take shape, we will likely hear its outline later today: Has the Fed gone too far? If so, it becomes a whole new ball game and 10-yr T-Notes may have nothing to do with it.

Jack Crooks, Black Swan Capital
Black Swan Subscription-based Service


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