Forex Investment and Currency Trading

Fed shifts towards neutral…
The minutes from the April FOMC meeting indicated that the Fed believed that the risks to the economic outlook were becoming more balanced. The summary of policy-makers’ discussions opined that the policy easing already undertaken had diminished the threat to growth. Furthermore, the
Committee added that “future policy adjustments would depend on the extent to which economic and financial developments affected the medium-term outlook for growth and inflation”. Some members went so far as to argue that further easing would be inappropriate unless there was “significant weakening in the economic outlook”. Indeed, Kevin Warsh expressed exactly that sentiment in a speech this week regarding the Fed Funds rate, urging that the Fed should resist calls for more rate cuts even in the face of slowing growth because of the rising inflation threat.

… amid balanced, but growing, risks
The Fed’s central tendency forecasts showed markedly worsening shifts in the outlook for growth, unemployment and inflation. The GDP central tendency for 2008 was lowered from 1.3-2.0% as of January to a tepid 0.3-1.2%, which could represent a low since 1991. The unemployment central
tendency was increased from 5.2-5.3% as of January to 5.5- 5.7%, potentially a high since 2003. Finally, the core PCE inflation central tendency was boosted from 2.0-2.2% as of January to 2.2-2.4%, potentially a high since 1994. Subsequent data very tentatively support the Fed’s shift from its dovish
stance. The yoy change in the core PCE deflator unexpectedly ticked up to 2.1% in March. In contrast, the first estimate of Q1 GDP growth came in as-expected at 0.6% saar, but the latest trade data suggest that growth could be revised higher towards 0.9% next week. Furthermore, other data point to
upside risks to the call for Q2 GDP to have fallen at a 1.0% annual rate. As to unemployment, the April report showed a surprise decline to 5.0%. All this, of course, has encouraged the yield curve to flatten.

Treasury supply will weigh on bonds and curve
The Fed has continued its permanent open market operations, and it most recently (May 21) conducted a $5bn outright coupon sale of Treasuries maturing in 2011 and 2012. Furthermore, supply will remain an issue next week, with the Treasury scheduled to auction $30bn of 2yr notes and $20bn
of 5yr notes. The 2yr auction (May 28) will be offset by $22bn of maturing notes, somewhat dampening the negative effect on this sector of the curve, but, the 5yr auction (May 29) is not offset by any maturing debt. The April auctions were roughly similar in size ($8.4bn of net 2yr issuance on Apr 23 and $19bn of 5yr issuance on Apr 24). In that instance, the 2yr auction had little price impact, but the 5yr auction caused yields to rise generally.

Yields, curve trapped in channels – for now
Finally, the price action supports the assessments of the fundamental and supply situations. Yields have been trapped in an upward trending channel since troughing around the time of the Bear Stearns crisis in mid-March, while the yield curve has been following a flattening trend since early March, when the Fed began permanent open market operations. For the 2yr yield, the uptrending channel provides support around 2.34%. Resistance lies at 2.81%, but the yield would first have to break above the recent high of 2.59% (May 14). For the 10yr yield, the up-channel provides support at 3.77%. Resistance from the up-channel lies at 4.02%, although as with the 2yr yield, the 10yr yield would have to break above the May 14 high (3.97%). Regarding the 2s10s curve, resistance currently lies at 146bp. Down-channel support lies at 123bp, although price action would first have to breach support around 135bp (rough double-bottom during May). This price action remains consistent with the view that the economic backdrop will likely improve in coming weeks due to the tax rebates as well.
Eventually, market believe that the economy will sag again under the weight of rising commodity prices, falling house prices and continued banking impairments, but that theme will only develop several weeks, if not months, from now.