Wednesday August 23, 2006 - 18:22:54 GMT
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Forex: Summer Musings
In the truth-is-stranger-than-fiction category I have a few "true" stories to add to the list that includes Fabio killing a goose with his face while riding on a roller coaster at Six Flags. By the way Fabio came out of it scathed with a badly broken nose. Firstly, is the allegations of Osama bin Laden's former sex slave in a new tell-all book alleging that the "sheik" was infatuated with Whitney Houston in the 1990's and wanted to have Bobby Brown killed so he could marry her. And secondly, since it is election season the French Conservative Party (UMP) led by Nicolas Sarkozy, who has presidential ambitions, is staging a "beach campaign" by handing out condoms and flip flops with the logo of the party printed on the handouts.
The funnier side of life aside, the bond and FX markets continue to suffer from a propensity to bet on a sustainable trend (higher for bonds and lower for the dollar) with the reality that one-sided trades make the directional bets painful. Increasingly the markets share an opinion expressed here before that September offers dollar bears anyway a reasonable chance at a significant run lower in the dollar as the cyclical and structural themes unite forming a substantial downtrend for the dollar, not unlike what was seen in April and May.
The critical event is the mid-September (15-16) G7 and IMF meetings in Singapore where the imbalances theme will again be flushed out and little evidence that policy is being adequately addressed to ensure an orderly adjustment in global imbalances. While this message was delivered to markets by the G7 and IMF in April, the level of urgency should be elevated in light of the lack of movement on policies that would aid the adjustment process. Moreover, it is widely assumed by officials and academics if not market economists and participants that the longer the adjustment process goes unaddressed the greater the risk of a disorderly adjustment (dollar crash). Acting as the new world FX cop, the IMF will very likely garner more market than ever before in capital markets as it takes up the adjustment process monitoring and remediation from G7. And it is no mystery that the IMF believes a broad dollar decline is a necessary, if not sufficient, condition for adjustment.
The turning point in the cyclical theme happened when the Fed announced a pause in tightening August 08. While upside risks to inflation are predominant, the Fed's decision to pause was predicated on the notion that 325bps of tightening are likely to slow growth and inflation with the latter responding with a long lag. The idea that another 25 to 50 bps in tightening will make or break inflation is preposterous. I am not ruling out more tightening, but simply argue that the Fed's decision to pause was taken with in mind that the long period of removing accommodation is far more determinant in where future inflation goes than 25 to 75 bps on top of the 325bps already in place. It smacks of fine tuning. If anything the Fed may have to hike rates again to address inflation expectations, but TIPS spread show little evidence of inflation expectations getting out of hand...same for the University of Michigan consumer sentiment index's inflation expectations survey.
Furthermore, even if you believe the Fed could move one or two more times and then pause for a considerable period of time, the market could view the additional rate increases as elevating the chance of a hard landing and sell dollars. So not much relief for the dollar in the Fed inflation hawks shoe-horning in another one or two rate increases this year, especially when it will be matched or raised by the ECB and even the BoJ.
Perhaps Bernanke will clear the air a little Friday when he speaks at the Kansas City Fed Jackson Hole Conference. Otherwise we have a week more of failed breakouts until the US July PCE price data, ECB press conference and US jobs data hit the wires.
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