Forex Investment and Currency Trading

Fading the market’s hawkishness
The retained view is that the current headwinds - to the banking system, consumer borrowing, housing prices, real personal income, and consumer net wealth - provide a formidable argument against the Fed hiking – at least anytime soon. With the market still pricing an almost certain Fed hike by September (92.8% of between 25bp and 75bp of hikes) but beginning to show signs of doubt, look to establish long eurodollar exposure via options to position against the market’s overly hawkish stance.

Priced hiking retreats despite inflation’s roar
Yields pulled back this week despite developments suggesting ongoing price pressures. Continuing on from last week’s worse-than-feared import price and CPI reports, overall PPI during May spiked to 7.2%y/y, the 3rd highest reading since the 70’s and early-80’s. Furthermore, the floods in the midwest continue to wreak worsening havoc with the crop yields, sending the price of corn to yet new records. Against these inflationary developments, there are signs that policymakers are taking steps to dampen the prospects for a “Super Spike” in the price of oil. Saudi Arabia has noted it might agree to increase production to help alleviate supply concerns, even though leaders there do not believe pricing accurately reflects fundamental supply/demand concerns and so doubt that increased supply of oil will do much alleviate spiking prices.
For its part, the US could be on the verge of moving to alleviate supply concerns, with President Bush calling for renewed drilling for oil off the coasts, particularly of Florida and California, although any such initiative will meet strong resistance and take years to implement.

Looking through strong retail sales?
The decline in yields and paring back of Fed hiking expectations also developed despite strong retail sales reports. Tax rebate checks began going out in May, and retail sales for the month spiked 1.0% overall (double the 0.5% consensus) and 1.2% ex-autos (well above the 0.7% consensus). Samestore sales data for the first week of June showed further strength, with the Redbook series jumping 2.3% y/y, a high since last November, and the ICSC series rising 2.1% y/y, the 4th-highest rate of the year. Perhaps the market was
discounting this strength as temporary due to the stimulus of the tax rebate checks. And consumer sentiment continues to sag under the weight of the housing depression and high energy prices, with the U. Mich. sentiment for Jun unexpectedly falling to 56.7, a low exceeded only three times (during the 1980 recession) in data back to 1978. Indications from the manufacturing sector suggest continued softness, as
the Empire Manufacturing index unexpectedly fell to -8.7, signalling a resumed weakening trend, and industrial production unexpectedly fell 0.2% m/m in May, due in part to declines in consumer-goods manufacturing.

Or sensing renewed problems in financial system?
Another reason for the market to retreat from its hawkish stance is a sense that banking/financial system problems are resurfacing. Signs of this lie in the 2yr swap spread, which has traded recently in the 90-98bp range, a wide exceeded only during the worst periods of the crisis (’07 yearend liquidity crunch fears during Nov-Dec’07, Bear Stearns implosion in March, Libor concerns in April). 1mo into 2yr implied annual vol is 195.30 bp, also above the wides at the various crisis points mentioned above, and the S&P investment bank and diversified financial services indexes remain near the 3-year low registered at the height of the Bear Stearns crisis. One reason for the tenseness could be that eight CDO’s worth $5bn are being liquidated, and these likely represent merely the tip of the iceberg as defaults continue to rise. Liquidation of the CDO assets could cause banks to have to mark to market assets that had been sheltered as Level III assets because there had been no market. In turn, the banks might then turn to bond insurers to cash in on purchased protection, which would likely put further downward pressure on these already-stressed
institutions. Such developments could spiral out of control and present another spectre of financial meltdown. This new meltdown would result not from a liquidity crunch, as happened with Bear Stearns, but from actual loan defaults and the leveraged security losses stemming from the way the loan exposure was replicated and spread among multiple derivative securities.