Forex Investment and Currency Trading

The financial market environment over the last 9 months has been turbulent to say the least. We have seen this turbulence reflected across all corners led by credit but also in Equities, Commodities and FX. 

In the recent months the market focus has been particularly focused on the credit scenario, health of financial institutions, ability to raise capital etc. etc. 

This problem has been correctly seen to be primarily a problem for U.S. financial institutions with other pockets of stress overseas (U.K. and Europe in particular). 

One thing financial markets hate… actually 2 things they hate are uncertainty and inaction. We certainly have had both of those as on one hand the market got increasingly worried (As evidenced by inverted yield curves, liquidity concerns and various degrees of financial market concern). Added to this was the ever-growing perception that the FED was behind in its reactions. Since then we have had quite a sea change from the FED. This is particularly true on the liquidity provision side reaching its crescendo with the Bear Stearn’s episode. In the U.K. and Europe as well as Canada etc liquidity measures have also been addressed.

But it is not just on the liquidity side that we have seen a sea change. The Fed has totally switched to focusing much more intently on the health of the economy, consumer, and housing. As a consequence we have seen 300 basis points in Fed cuts since September last year. While that has not sent one of the favorite measures where we would like it, it is going in the right direction.  
 
The Fed funds minus 2-year yield spread inverted over 140 basis points as we entered September last year. This was only the third time that this had happened in the last 20 years. Prior to then the periods were June 1989 and December 2000. Sure enough in both those instances as in September last year this was soon followed with an aggressive rate cutting cycle.

This time, however, despite the rate cuts the curve inverted even higher than the levels seen in September last year. This is something that did not happen in 1989 or 2001. Why this time? 

The inversion of the 2’s 5’s yield curve to more than 20 basis points in November 2006 and the sharp downturn in housing since early 2006 were the primary reason.

Both of these indicators suggested that the Fed was behind the curve. Then as they started cutting they adopted a gradualist approach- cutting small, talking of pauses, inflation rhetoric etc.  As a consequence financial market/economic concerns started to grow and 2-year yields inverted to 196 basis points below Fed funds in January this year.  This is the point that the lights were switched back on at the FED. On Tuesday January 22nd as the DJIA sat on its 200 week moving average in pre-open (Just as the NDX had been sitting on its 200 week moving average on 02 January 2001) the FED surprised with a 75 basis point interest rate cut. (On 02 January 2001 the FED came through with a 50 basis point inter-meeting cut).

This was really the first big positive Fed surprise and they cut another 50 basis points at the January meeting just like in 2001.  This looks to be the first time that a perception started to creep in that the FED was getting serious. The level of inversion seen before that surprise cut has never be seen again and while not yet in positive territory the inversion is now only 41 basis points.  In addition it has finally broken the up trend seen since June 2004. This suggests that the market final believes that the Fed is treating the situation with the seriousness it deserves. This has only been further validated by the various innovative liquidity measures that the Fed has adopted.  

There remains no doubt that further cuts are going to be necessary and looking at the last 2 easing cycles you see that the low in FED funds in both instances was lower than the low print in 2 year yields.

So a FED funds as low as 1.25% in this cycle could well be a danger.

The economic data is soft and likely to remain so and bouts of “bad” news will likely get a strong reaction given the overall nervousness that exists.

However the Fed has finally got its head around this and will pretty much stop at nothing to get the financial markets and the economy back on an a even keel.

While concerns, write downs, re capitalisations are likely to be around for some time to come (and are likely to create further angst) market price action is about perception. The price action in interest rate and equity markets, while not suggesting that everything is o.k., are for the first time showing signs that there is a belief that that a resolution will ultimately be found.

The focus is going to switch more and more towards the real economy and how to get it back on track. Interest rate cuts will be an important part of this dynamic. When you look back to 1990 (housing crisis) and 1998 (credit crisis) and the falls of more than 20% in the DJIA, the equity markets turned long before there was an all clear in the underlying environment. In fact if you look at the DJIA In the 1989-1991 period it returned over 40% as it did in the 1998-1999 period.

It is therefore that going forward more and more focus will be on the economy. While the news is not likely to be too good there are potentially 2 pieces of good news.

1. This would be a more traditional environment for the Fed/ treasury to operate in terms of getting the economy back on track. While the economic outlook is not great this scenario would likely be less volatile as people pulled all the various pieces of information together. This contrasts sharply with the financial market “icebergs” of the last 9 months.
2. Let us be honest though. It is not only the FED that underestimated the feed through to the underlying economy of this financial crisis.

• For most of this financial crisis market commentators have been underestimating the deterioration of U.S. economic data at the same time as they have been underestimating the strength of non- U.S. data.
• This double “under estimation” has lead to the sharp deterioration in the fortunes of the USD as can be seen. Why has this happened???

One would guess that while commentators on one side were of a similar viewpoint that this was a financial event not an economic one they also expected much more financial fallout to develop outside the U.S. Overall this did not materialise except in a few pockets.

So where does that leave us??? Without a doubt the epicentre of these events has been the U.S. and the U.S. credit markets. The unanswered question is whether the financial fallout does not exist outside the U.S. or simply has not yet been fully realised? Certainly there have been further disclosures from institutions outside the U.S. in recent days that suggest the “Jury remains out” on this one

One thing we certainly do not believe (Rightly or wrongly) is that the Global economy outside the U.S. (Which is still the World’s largest economy) is immune to a significant U.S. slowdown. Neither do we think that commodity markets, which have been booming, will go unscathed. While it is very feasible that Commodity markets are in a significant bull market going forward it is hard to square the idea that this last leg is driven by Global demand when you see markets move in multiples over short periods of time (Crude up over 100% since early 2007 and the CRB index is up 46% (low to high) between August and March with many soft commodity markets multiplying in value..