Thursday, July 20, 2006

Bernanke the Dove Saves the World

EUR/USD 1.2626 / 29 Hi 1.2632 Low 1.2587
USD/JPY 116.69 / 73 Hi 116.93 Low 116.54
EUR/JPY 147.35 / 39 Hi 147.40 Low 146.97

Ben Bernanke just changed the world. At least that's what financial markets seem to think. His dovish comments yesterday came at a time when the market was expecting hawkish guidance. They didn't get it. And timing is everything. While the market sits back and rethinks the chances of an August 8 rate hike in the States, it's worth taking a look at what Bernanke actually said.

First, he noted that a moderation in economic activity is under way in the States. After 17 rate hikes and counting, that is hardly a surprise. Second, he noted that even if inflationary pressures continue, weaker domestic economic growth should see inflation contained in the medium term. Third, he noted that the second round inflationary pressure, namely rising wages, would likely be absorbed by companies, given that softer demand would not allow price rises.

What he is saying is that while profit margins are now high, they will be eroded by rising wages and weaker growth. Bernanke is not only calling the peak in rates and economic activity but in profit margins. Stocks missed that.

While it remains to be seen if softer demand can do the job the FED won't, namely contain inflation, what Bernanke did do is open a window of opportunity for USD bears. And they took that opportunity.

But the USD and capital flows were ignored by Bernanke. Bernanke's assessment focused almost exclusively on domestic factors. The U.S.'s very large external deficit figured nowhere. And the Federal Government Deficit also didn't show up on his radar. So the two greatest risks to growth in the U.S. were absent. This is not a good sign. The U.S. is not a nation which can tranquilly assume that offshore capital inflows, necessary to fund domestic consumption and the massive Federal Government Deficit, are a given. It can not assume that a substantial USD sell-off, and resultant inflationary consequences, is not a risk.

Bernanke is factoring in the best of all possible worlds: inflation contained by softer domestic demand, oil prices which remain steady, wages pressures absorbed by companies, a steady inflow of offshore capital and plain sailing on FX markets with USD fluctuations having no impact on inflation or Treasuries. It is in that environment, and only that environment, that the FED can afford to hold a dovish view.

For now the market is buying the best of all possible worlds scenario. But it will take only one shock to wake them up. We have a lot of potential shocks out there: the Middle East (Iraq, Iran, Lebanon, Israel, Syria), and Oil to name just two.

With the Bernanke FED unlikely to hike rates steadily, the USD sell off is expected to continue with the USD/JPY leading the charge, given the current stratospheric level of Eur/JPY. Stock market bulls will have to hope that USD selling does not scare stocks. Longer term, however, that is the big risk. Bernanke has not changed the world he has just given the market a very benign assessment of current risks.

OIL 72.87
GOLD 643.00

Bernanke was also rather dovish on the OIL outlook. Taking his cue from futures markets, he suggested that future OIL price rises are not expected to be substantial. If this is his assessment of commodity price risk and the associated inflation risk, then we are in trouble. Anyone who assumes that futures predict the future obviously hasn't ever traded futures.

GOLD is still on a winning streak and given the type of economic land political leadership coming out of the States at the moment, it seems fair to expect that trend to continue.

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