Tuesday, August 01, 2006

To FED or Not to FED - That is the Question

EUR/USD 1.2737 / 40 Hi 1.2783 Low 1.2719
USD/JPY 115.27 / 31 Hi 115.39 Low 114.48
AUD/USD 0.7606 / 10 Hi 0.7667 Low 0.7596
EUR/JPY 146.85 / 89 Hi 146.91 Low 145.89

And suddenly there are doubts. Will the FED keep rates steady on August 8 after all ? Today's inflation numbers have shaken the market out of its complacency. Perhaps the FED will move after all ? There is no doubt that economic activity in the States is slowing. What is in question is if a slower economy will bring inflation down without any help from the FED. Bernanke, in recent testimony, more or less suggested that this will, indeed, be the case: Demand will slow in response to the rate rises that have already taken place; given weaker domestic demand, U.S. Companies will be unable to pass on price increases related to rising costs and, therefore, inflation will slow. Bernanke's entire analysis is based on the happy idea that there is no outside world. If the U.S. was isolated from the outside world and did not rely on foreign imports, foreign savings, foreign OIL, foreign commodities and did not export to foreign markets, his analysis would be close to the mark. Because the U.S. is not a closed economy (though admittedly less open than many others) his analysis sucks.

In the real world there are lags and dangers which can see activity slow while Price Pressures remain high. STAGFLATION by any other name ?

Dangers ? Like what ? Like for instance rapidly rising commodity prices, record high OIL prices and higher import prices as the USD comes under pressure. Global commodity prices have gone through the roof, OIL prices are at record levels. So far we have not seen all that much pressure on the dollar. Despite its massive external funding requirement, its abysmal trade deficit and the less-than-popular Foreign Policy of the Bush Administration, for the time being the USD is only hovering NEAR to recent lows against the EURO and the JPY. There have been no signs of panic selling.

But the risk is still out there. Which is why U.S. Treasury Secretary, Paulson, has started making noises about a strong USD being in the interest of the U.S., INDEED. Paulson What he means is that the U.S. needs to keep those capital inflows coming.

So what is the FED to do ? In this environment the prudent policy maker would move to hike. To complicate matters there are Congressional Elections on November 7. And there are three FED meetings before then: August 8, September 20 and October 24/25. Political considerations suggest that an October hike is off the agenda. That leaves only August and September, and September is touch and go. So, should there be any doubts that the inflation is a risk, or that offshore investor confidence in the USD is falling, then a move in August makes sense. Later would get complicated.

The market, though, had all but factored in a DEAD FED. Which is why today's inflation numbers have taken such a toll. (The Numbers) Out of nowhere - well not really out of nowhere, but the market was happy to play along with Bernanke's rosy picture - there is suddenly the idea that the FED may be forced to keep hiking even while economic activity slows. Oh dear. And yes the market is on to something here. 'Cause that is the most likely outcome of the present policy dilemma. The U.S. can't afford a currency crisis. In fact, right now the U.S. can't afford anything much at all. More downside for stocks is on the way. And they still haven't solved the conflict in the Middle East.

What's more there is simply no sign that the Bush Administration's agenda is anything less than an escalation in current hostilities. Iraq is a mess. The Israeli attack on Lebanon is broadening with tacit U.S. support and massive U.S. arms shipments. There are signs that the conflict will spread to Syria soon, even in the face of Israeli reluctance to attack Syria. Iran comes later. And the U.N. has never looked more powerless or pointless.

Escalation in the Middle East is not going to be good for inflation. And although the current situation may well force the FED to hike, that does not mean that the USD bulls can return to the market. What we are seeing is some short term position squaring. Anyone with a longer term view should take this opportunity to short the USD. The USD is still in trouble. BIG TIME.

Oil 74.70
Gold 649.50

With the neo-con plans for the Middle East proceeding unimpeded, OIL is hovering just under its recent record. All the signs point to plans for increased hostilities on the part of the Israelis. BBC The Hizbollah and the Syrians are expected to respond in kind. I'm not sure exactly what the longer term objectives of the neo-cons are, but in the short term higher OIL prices are a given. Geopolitical uncertainty, rising inflationary pressures and the big question mark about the USD will see GOLD continue to benefit.

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