Coaches Blog

By Harold Fretheim

The theme of Sunday night’s trading room was increased FOREX market volatility: A volatility caused by the steady increase in the crosswinds of market fundamentals.

It was actually kind of cool to open up the Wall Street Journal and find – on the front page of the “Money and Investing” section – a story on the FOREX market that could have been written from notes taken in Sunday evening’s room. It is kind of cool to think that our trading room was a day ahead of the Journal.

The question now though is simply this- is this going to continue to be true? No one has a crystal ball for trading but one of the values of fundamentals is that it can help us to anticipate when a market may be about to change its nature- to move from ranging to trending, from volatile to smooth. We might be at such a clarifying moment.

After being roiled by the Fed’s decision to embark on QE2 the world has woken up to 4 essential facts: First, as Alan Blinder reminded us in the Wall Street Journal yesterday, the Fed is not incompetent and will not continue QE if inflation begins to kick up. Second, that the Asian economies continue to expand. Third, that Europe is still in trouble. Fourth, that the US economy also continues to expand- although slowly but with a greater chance of picking up speed now that the Republicans will have a solid majority in the House of Representatives.

Core producer prices for the US showed an unexpected decline of .6% for last month- even as Europe showed an unexpected increase of 1.1% year over year in the same measure. This follows a string of good news for the US in both ISM reports, Non-farm payrolls, the weekly jobless claims, retail sales, etc.

Given the fact that US savings rates are rising and consumer credit falling – with consumer deleveraging running ahead of schedule, it now seems that QE2 is an act of real wisdom by the Fed- a necessary measure to keep the American economy from suffering a liquidity crisis during a period when a necessary major rebalancing is occurring in the American economy- one where the American economy shifts from emphasizing consumption to more emphasis on production and saving. As the core producer prices show- in such a shift deflation becomes a real threat. QE2 is a program designed to combat that threat.

In contrast, Europe is back on the front pages. Ireland is being told that is must seek a bailout. The Greek deficit was bigger than initially reported. Portuguese bonds are in trouble- the spread over German Bunds has become too high. There are suggestions that both Portugal and Ireland will need to tap Europe’s emergency bailout fund at the same time.

And Spain’s situation continues to be painful- could they eventually be in the same boat? The Euro is now falling, and falling for a reason even as the US dollar appears to be stabilizing. There may still be reason for the US dollar to fall against the Yen- with a bottom being reached next summer or fall according to some experts. But there is no longer such good reason for the dollar to fall across the board although not yet a good fundamental case for it to rise, except in the event of a need for another flight to safety. As this mornings somewhat lower than expected TIC report showed (net purchases of US securities dropped to $80 billion last month), there is not yet an increased demand for safety.

Which means that for the time being it might be a good idea to be paying more attention to the Euro/Yen pair. At least here we may see a short term bearish trend develop as the Yen remains stubbornly high while the Euro tanks on its troubles. However, in the event that the Germans come up with more support for the Euro, this could then reverse, giving us the final piece of a reverse head and shoulders pattern.

By Harold Fretheim

I was so involved in trying to report the upcoming events for this week that I forgot to mention that there is now a near perfect Symmetrical Triangle on the EUR/USD hourly chart. 

This triangle has formed since the EUR/USD hit a high of 1.4157 on 10/15/2010.  It has a technical target of 450 pips. right now the pair is dropping in what an elliotician would call the fifth internal wave. 

Given that the Core PCE just reported out at 0% (the FOMC wants it to move up to .2%) and that the US House of Represeentatives is about to pass into Republican hands (but not the US Senate – although the Democrat majority will sink to only 51 or 52) this triangle makes a lot of fundamental sense.

By Harold Fretheim

This week the world will have its eyes focused on the United States. Major announcements, the FOMC meeting and, above all, the midterm elections.

But it would be foolish to ignore what is going on elsewhere: The Bank of Japan, The Reserve Bank of Australia, the European Central Bank and the Bank of England will all also be making major rate decision or quantitative easing decisions. The effect may be rather jarring as the market, while otherwise fixated on the American drama is suddenly, from time to time, forcibly reminded that there are other economies, markets and political actors outside of the US.

Before turning to the US let us see what may happen elsewhere -

The Bank of Japan

First, the BOJ will meet this Thursday, a week ahead of its regular schedule, and possibly announce that will add the purchase of Japanese Real Estate Investment Trusts (no, I am not kidding) and exchange traded funds (again, I am not kidding) to its asset buying program.

It had previously announced purchases of lower graded (BBB or above) corporate bonds and commercial paper (A-2 or better) at its previous meeting. In doing this the BOJ is attempting to do an end run around the banks in order to prevent the added Yen from doing no more than add to the excess reserves of the banks.

Even though the amounts are not large, the signal being sent is straight forward: Sending your money to Japan to invest in Japanese stocks and bonds may mean that you risk bidding against the BOJ: In an auction like environment do you really want to compete with a major central bank? This may not be classic currency intervention but it has a similar effect. The market may view such an action by the BOJ as very Yen bearish – but perhaps only momentarily.

The Reserve Bank of Australia

The RBA, which will meet on Monday, may elect to do the opposite. There is a strong possibility that weak business credit will force them to leave interest rates unchanged but there is also the possibility that Australia’s mining boom may persuade the Reserve bank of Australia to raise interest rates now to head off inflation later.

Since very briefly hitting parity on October 15, the AUD/USD has swung back and forth in a sideways correction for the last two weeks. At least for the moment the possibility of a rate increase has it moving up (it stands at .9880 as I write this) but what happens if the RBA decides NOT to raise rates? We get to find out tomorrow evening.

ECB and BOE

The ECB and the Bank of England are not expected to make big changes at this point- they may be anticlimactic. Although there is some thought that the BOE may increase its purchases of British government bonds, which would be pound bearish.

USA

Which brings us to center stage: The United States of America. This may be the Year of the Euro, but it is the American Week. Start with Monday morning, when we first get The Core Personal Consumption Equivalent index (which is constructed by comparing the current and the previous month’s Core Personal Consumption Equivalent Price Deflator [a very long string of decimal numbers which can be found in the Statistical Abstract of the United States – I may be the only person you know who has every actually looked up these numbers – and that was over a decade ago]).

The thing to remember is this: To the Federal Reserve the Core PCE Index is the real CPI – it is the only one that they actually look at. And this fact has gradually begun to penetrate the consciousness of the market in recent years.

FOMC Announcement

Now and in coming months it may assume a knew importance because when the FOMC releases its Statement on Wednesday afternoon they are expected to announce a different kind of Quantitative Easing – one where instead of a single large and fairly rapid purchase of government bonds they instead institute a program of incremental purchases on a smaller scale – one where purchases can vary in size depending upon perceived need – a measured, flexible buying program in the words of Morgan Stanley.

Which means that the relative size allowed will be a balance between core inflation (as measured by the Core PCE index) and economic growth. So the Core PCE will, in a sense, be part of what will determine the growth, or lack of growth, in the US money supply and therefore become a big factor in whether the dollar should strengthen or weaken. The question on Monday may simply be this – has the market realized this yet – or not.

The other significant announcement for Monday will be the Manufacturing ISM purchasing manager’s index – which may disappoint this time.

Which leads me to the main event for this week – the US elections. Yes, I realize that we have the Non-manufacturing ISM on Wednesday and Non-farm payrolls on Friday but these for once fade to comparative insignificance when compared to the midterm elections. At this point the best projections appear to show the Republicans gaining 8 Senate seats and as many as 70 seats in the House of Representatives (or as little as 50).

This means that the lower house will now have a Republican majority. Such a result may significantly alter the business climate in the United States. Remember – even if a House majority cannot repeal Obamacare it has the power to Defund it – meaning that every part of the new health scheme that requires the expenditure of federal funds may find itself without money to spend or even to hire or retain staff. The same can be said for the financial services bill (you know- the one that forces those of us in the US to bring our trading funds home from the City).

As the results come in the market will be sorting out what he practical meaning is – and this process will not be over in one day. We may be weeks actually getting a feel for what a changed Washington will mean for the market but in the short term a good rule to remember is this- markets sometimes simply react bearishly just to change itself- even if the change is later long term bullish.

So expect volatility over the coming week or even beyond.

By Harold Fretheim

Update – Maybe my initial assessment of the rate decision by the Bank of Japan was a trifle harsh.

While it is true that most of the 5 Trillion yen in additional quantitative easing will simply go to purchase Japanese Government Bonds (3.5 trillion yen) what is different is the decision to put aside 1.5 trillion yen to purchase a combination of commercial paper, exchange traded funds (I kid you not) and real estate investment trusts (again, I kid you not).

BOJ Struggles

Clearly the BOJ is struggling to find a way to get maximum bang for its Yen without using too many Yen.  The Tokyo stock market liked it (Hey – they have a new customer!) and in fact the Yen did weaken against many of its counterparts – at least a little. 

Of course, the Yen strengthened against the US dollar – but this has to do with a market that is generally dollar bearish sine the FOMC officially announced that US inflation might actually be too low and they may need to do something about.

By Harold Fretheim

Last night showed us the value of fundamentals in trading. That value does not consist in providing a crystal ball – which no trader has- but rather in providing and understanding of what is happening and why a technical set up is no longer valid. 

AUD and the JPY

Yesterday there was a bull pennant showing on the AUD/JPY- but in fact that pattern did not end up delivering. Why? Because the Bank of Japan did not expand its commercial lending program as expected (and as would have made sense) and instead will pursue a smaller program of Japanese government bond purchases – while at about the same time the Reserve Bank of Australia (much more wisely) decided not to raise interest rates after all. 

A wise trader would have understood that the Bull Pennant on the AUD/JPY was a perfectly valid chart pattern – but once these decisions came out he also would understand that the reason for that pattern had just evaporated. And right there is the value of fundamentals – it gives early warning of market shifts.

Of course, when the fundamental news confirms a trend it can also give a trader greater confidence as well. For instance, oil has just climbed well over $82 per barrel – and the USD/CAD continues to break down out of the large triangle that had formed over the last several months. 

Which is exactly what one would expect based upon the news about oil. If you are in that trade you may now have moved your stop loss into profit but you probably are not in a hurry to close it.

Europe

Moody’s says it is likely to downgrade Ireland’s credit rating – because the cost of the Irish bank bailout looks like it will equal one third of the Irish GDP.  To put this in perspective – what if in the US the TARP program had been $4.5 trillion rather than $700 billion? 

Obviously such a burden is an economy crusher – and Irish economic growth has been reduced massively as a result.  How long before the market starts to look at the European bailout fund and begins to ask – is even $750 billion dollars enough?

By Harold Fretheim

The Euro went up even though Moody’s downgraded Spain. 

Why?

Three factors: 

First, there has been a lot of press about new rules being negotiated that would enforce budget discipline in the Euro area.

Second, there continue to be world wide signs of a slowed but continuing economic recovery, and third, China has pledged to buy Greek bonds and other Euro area bonds. 

Why would China do this? It is actually quite simple – Because the Renmimbi is still essentially pegged to the US dollar (although it has strengthened 1.74% in the last month or so) when the Euro drops against the US dollar so does the Renmimbi – which makes Chinese goods much more expensive in Europe. 

Given the recent scares coming from Europe  (such as the Portuguese budget deficit, the downgrade of Spain by Moody’s, etc) the Chinese perceive a significant threat of a major trade shift if the Euro drops again.  Most likely they got burned badly last spring and do not want a repeat performance. But for how long can a drop be prevented? 

Perhaps we got a hint on Friday of just how skeptical the market is in the form of an article from the Independent (UK):  It seems the Citigroup recently staged a conference call for 200 to 500 institutional investors to listen to the Irish Finance Minister talk about the Irish budget and Ireland’s bailout of the Anglo-Irish Bank. 

Not to put it to bluntly but it seemed that Mr. Lenihan was actually heckled during the call (comments such as "sell Ireland" and "Dive, Dive" were heard). Last week it looked like Rising Wedges were forming on both the EUR/USD and EUR/JPY pairs. While these now seem to have been spoiled by the more positive news it remains to be seen how long the Euro can continue to rise.

US and Canada

While private sector employment may show a slight rise in the US on Friday that rise will not be enough to keep up with the entry of additional workers into the labor force – so the unemployment rate in the US is expected to rise. 

Still, the slight rise reported Friday in spending and income in the US – when combined with the expansion of Chinese manufacturing- did send the price of oil over $80 per barrel.  As a result the USD/CAD may have now broken downwards out of a triangle pattern that has been forming since April 21.

Australia and Japan

There appears to be A Bull Pennant (or at least an ascending Triangle) on the AUD/JPY.  And with good reason- Both the Reserve Bank of Australia and The Bank of Japan will make rate/policy decisions tomorrow evening- the announcements will come within perhaps an hour or so of each other. 

The RBA appears to be itching to raise interest rate, although the economic recovery in Australia is in fact much weaker than it looked two or three months ago.  On the other hand, the BOJ definitely needs to increase quantitative easing, and the Japanese government may need to do a further round of actual currency intervention soon. 

If the two banks do what it appears that they want to do then logically the AUD/JPY should indeed rise. But, a caveat – agricultural commodities were taking a nose dive at the end of last week due to improved corn harvests in the US plus better prospects for Russian winter wheat.  This could effect the AUD – and there is no guarantee of the RBA rate hike either.

By Harold Fretheim

Since to you I realized that I mis-spoke about the time frame for the 500 pip rise of the Euro vs the Yen – it actually took 36 hours, rather than 24. But that is still a very strong and fast move. 

Of course, since then the Euro has retreated against the Dollar and the Yen – both – largely on renewed banking fears spawned by continued worries over Ireland and its attempt to reorganize the Anglo-Irish Bank.  There are fears that Ireland may not be able to handle this on its own, requiring in turn that the ECB may have to step in with rescue funding – spreading a widening loss across the European Monetary Union. At this point the Euro has dropped over a hundred pips against both the Yen and the US dollar.

Also – there has been a surprising change of heart with the Bank of Japan. After the government intervened to weaken the Yen many folks assumed the the BOJ would act to ’sterilize’ that action by draining the additional Yen out of the Japanese economy. 

They have announced that they will not do this – which means that for the first time the BOJ is acting in a manner that says that the now take deflation seriously instead of worrying excessively about inflation.  They are leaving the additional Yen out in the economy. Just in case this is really the case I plan to watch the AUD/JPY and the CAD/JPY as possibly good candidates for a bull move.

By Harold Fretheim

So Mr. Kan hung on to the Prime Ministership of Japan- but just barely.

In politics – in any country – survival under such conditions requires the ability to make a deal and stick to it. What was the price paid by Mr. Kan?

We got our answer within hours as Japan announced that it was intervening to weaken the Yen. The last time the Japanese intervened was in 2003 and 2004- a period that lasted for months. Given how Japan reached the policy decision to intervene it is quite likely that this will again be the case. That opinion is reinforced when you remember that a weaker Yen is the surest way of defeating deflation.

European Banks

Meanwhile Basel III was announced- to the great relief of the European banks who had feared that the new capital requirements would be even worse than the final agreement. Common equity will still have to more than triple to 7% – but the banks were given until 2019 to reach that goal.

Although European banking stocks retreated (in anticipation of a coming dilution of share value) the news was otherwise seen as positive, or at least as a reprieve for Europe.

Currency Movements in Yen Pairs

The combination of Yen intervention and Basel III made a EUR/JPY buy a great deal. We saw a spectacular 500 pip rise on this pair over a single 24 hour period.

But to me the most significant move was the one on the AUD/JPY – where a good triangle pattern had formed on the daily candle chart starting on May 21. Instead of dropping out the bottom and giving us a move with an 800 pip technical target this pair has burst out of the top – moving up.

Of course this can be credited in part to the Yen intervention and in part to reports of a large Winter Wheat crop – coming at a time when the failure of Russian the wheat harvest means that Australia gets to sell a lot of wheat in a sellers market – but the real significance lies in the information which this move gives to us:

Just over 2 years ago a similar failure of the triangle pattern on the EUR/JPY gave us a 3 week warning of the coming financial tsunami – if we had only understood what we were seeing. Now we may have just received a similar signal of a fundamental market shift – though this one should be in a happier direction.

By Harold Fretheim

This is still the Year of the Euro – it is important to remember that much of the turmoil in the world economy – including the apparent U.S. ‘growth recession’ (a slow recovery with little or no job growth, resulting in an increase in the unemployment rate) is directly the result of the European sovereign debt crisis (Starring Greece but with Spain, Portugal and Ireland all definitely contending for Best Supporting Actor). 

Now comes word that the recent, apparently successful, ’stress tests’ of the European banks may have very significantly understated the vulnerability of at least some of those banks to government debt risks.  The immediate market response – stock market turmoil and the EUR/USD dropped over 200 pips in less than 24 hours – erasing two-thirds of the ground it had gained over the previous two weeks.  

It did not help matters that German factory orders were off as well- adding fuel to that fire. Of course, the Euro also fell against the Yen – it is has now effectively erased about 90% of the gains it had made against the Yen over that same time period.

Meanwhile, Ms. Gilliard persuaded the final two independents to support her Labour party bid to form a government – giving her the 76 seats that she needed to (just barely) hang on to power as Prime Minister – but undoubtedly at a very high price indeed. 

The market reacted by sending the Australian dollar down (including against the Yen).  From a technical trading standpoint: has anyone else noted that the AUD/JPY has formed an almost perfect symmetrical triangle since May 21 – one with an over 800 pip technical target if the AUD/JPY drops out of it in a further decline?  

Chart patterns are very effective at showing us what the market is set to do if the fundamentals do not change. 

Meanwhile in the U.S. the administration has announced a plan to push for a small amount of ‘targeted’ tax cuts to support business plus an additional modest infrastructure construction plan as the bold measures which surely stimulate the economy into moving again.

In addition the President has announced that there is absolutely no way he will support an extension of the Bush era tax cuts- even though serious economists, like Mr. Berner at Morgan Stanley, point out that failure to do so will shave about 3/4% off of what already appears to be shaping up as very modest growth for 2011. 

The market has not been impressed with this. As a result of all of this- and some somewhat better but still disappointing economic news in the U.S. – The US dollar continues what Bloomberg reports as the ’slow downward grind of the US dollar vs the yen’.

Did I mention that the New Zealand dollar has fallen against the Yen due to the recent earthquake there?.
There is a theme here- the Yen is strengthening across the board.  And the Bank of Japan met this week and did nothing. 

They did not even take the normal amount of time to do nothing.  I was shocked to read of the Bank of Japan’s decision yesterday morning-  In my experience the earliest that the BOJ has ever reported out from a meeting.    In its statement it acknowledged that deflation is a significant problem – "The bank recognizes that Japan’s economy faces the critical challenge of overcoming deflation"  but then, in the second half of the very same sentence the BOJ spoke of  "returning to a stable growth path with price stability,". 

Translating from Economese this means that the BOJ is still more scared of inflation than deflation- the phrase about deflation is still largely window dressing.   Of course, it is also true that the BOJ just had an emergency meeting last week and expanding their short term lending facility to provide liquidity assistance to Japanese companies.  But these are very short term (3 to 6 month) loans- carefully calibrated to have the least possible effect if the intent was to change the strength of the currency.  But deflation is a serious danger to an economy- and it has become a political danger to both the Japanese government and the BOJ itself.  

The refusal to take realistic steps to weaken the Yen may soon come back to haunt the BOJ- perhaps as early as next week.  On September 14 (the afternoon of September 13 on this side of the International Date Line) the Democratic Party of Japan will be holding a party conference.  At that conference Mr. Ichiro Ozawa (who created the DPJ) is challenging Prime Minister Naoto Kan for the leadership of the party (in a Parliamentary system this means that Mr. Ozawa would replace Mr. Kan as Prime Minister). 

The centerpiece of his campaign: A promise to take strong measures to directly intervene to weaken the Yen.  Mr. Kan may have enough votes to fend off Ozawa without needing to promise similar action- but what if he doesn’t?  What if the price of staying Prime Minister is a promise to take strong measures to weaken a too strong Yen?  

And why would he not make such a promise when he too has noted that deflation is a serious problem- and that weakening the Yen is probably the quickest way of solving the problem?  He might want to bow to the feelings of the board of the the BOJ? Why, when arguable they have just humiliated him with their half hearted response?  

This is still the Year of the Euro (and we will no doubt be hearing more from Europe soon) but Monday evening I plan to be looking for news from Japan- and I would strongly encourage others to do so as well. 

By Harold Fretheim

And so, as the world watched breathlessly, Governor Masaaki Shirakawa, that bold and valiant leader of the Bank of Japan rushed home from Wyoming an entire day early in order to hold an emergency meeting of the board of the BOJ.  I will let the folk’s at MarketWatch give you a description of what happened next:  

"Japan’s central bank agreed at an emergency monetary-policy meeting to take new steps to rein in the soaring yen and pump up the slumping economy, in the latest sign of currency worries rippling around the world.

The Bank of Japan’s decision to expand a special low-interest lending facility is part of a concerted effort, through words and actions, by Tokyo’s policy makers to blunt the yen’s moves."

Give the folks at Marketwatch high marks for professionalism- because they somehow managed to restrain themselves from inserting the word ‘grudgingly’ between the words ‘bank’ and ‘agreed’.  In fact, all that the bank did was to expand the emergency loan program by 50% – adding the equivalent of $116 billion dollars to the credit line.  

I was not impressed and neither was the rest of the market.  Whether you are looking at the EUR/JPY or the USD/JPY the result is the same – a rise over the day or so prior to the announcement followed by a retracement to the starting point of that rise after the announcement was made. 

The Yen is as strong as ever.  Mr. Shirakawa might as well have stayed in Wyoming and gotten in some more trout fishing.

Of course, 2 things have to be remembered here: First, thanks to the extremely low inflation followed by deflation in Japan compared to the modest but higher inflation rates in Europe and the US the USD/JPY would actually have to be all the way down to 55.00 on the USD/JPY  in order to be equivalent to the low achieved in April of 1995- this means that Japanese exporters are not actually in the same position that they were in back then. 

And, second, given the sheer size of the Japanese national debt the BOJ lives in abject terror of any significant form of inflation which would drive up interest rates on that debt to a point where interest would largely swallow the government’s budget.   

So the BOJ is always, at least subconsciously, battling against inflation.  This is the reason why their response to government pressure was a largely symbolic one- A sort of ‘intervention lite’ that depended for its effect on the drama of an emergency meeting followed by an announcement of SOMETHING.  

And, unfortunately, because that something is a short term lending program (The new money is for loans of 6 months or less) it has even less impact than it might otherwise have had- in central bank speak the short terms of the lending are said to "sterilize" the monetary impact.  The problem with such thinking is that "sterilization" leads to sterile impacts.  As the market has already demonstrated.

But it would have been foolish to expect more than this in an opening shot.  As I noted above the BOJ has reasons to worry about the impact of inflation.  The problem is that they do not yet appreciate the destructive power of deflation.  At this point the Prime Minister and the Minister of Finance actually do- or seem to anyway.  It is important to remember that the real reason that the yen needs to weaken is NOT so much to assist exporters but rather to defeat deflation.  So this struggle between the BOJ and the Government will continue.  And we should expect to see yet more rhetoric between now and the next regular meeting of the BOJ- which is only about a week away.