Thursday, September 07, 2006

Scramble for the Exits

EUR/USD 1.2730 Hi 1.2831 Low 1.2725
USD/JPY 116.25 Hi 117.08 Low 115.98
AUD/USD 0.7616 Hi 0.7685 Low 0.7615
EUR/JPY 148.02 Hi 149.83 Low 147.86

Well Bush just lost another member of the Coalition of the Willing. They may have been willing but it looks more and more like they chose the losing team. Blair is trying to finesse his exit. He started out suggesting another 12 months, that morphed into May 2007 pretty quickly, he'll be lucky to see the end of the year as Prime Minister of Britain. He's an unpopular, out-of-touch, pro-War Prime Minister and his support is withering by the second. Wonder how the Lebanese Prime Minister is going with his attempt to get him tried for War Crimes by a Scottish Court? That would make an interesting corollary to the New Labour political experiment. The U.S. electorate will have to wait another 2 years.

The Central Banks of the world are talking, but no-one in FX-land is listening. Labour Cost numbers released last night in the States showed Labour Costs rising and Productivity falling. Suddenly inflation is back on the agenda, at least on the Street. The FX market went with the data and the view that more rate hikes in the States are possible. There were even signs of USD buying as the old (very old and very tired) interest rate differential story got dragged out AGAIN. Meanwhile the FED seems pretty relaxed about costs, and inflation. The FED's BEIGE BOOK, also released last night, noted that "manufacturers found little ability to pass through higher costs into prices of manufactured goods" and that the slowdown would "create slack in the job market". This is NOT a hawkish FED. This is a Central Bank more concerned with slowing economic activity and the bursting of the housing bubble. These are not inflationary VIGILANTES talking.

Across the pond, though, the real inflation VIGILANTES are talking. And in FX-land no-one is listening. ECB officials have been talking until they are blue in the face about the need to exercise EXTREME VIGILANCE regarding inflation. Weber suggested that rates in the Euro Zone could continue to rise into 2007. The market didn't listen. The view on the street is that weaker economic conditions in the latter half of the year will force the ECB to change tack. Short term rates are expected to peak around 3.5%. Of course the assumption is that the U.S. economic slowdown will worsen in the second half of 2006 and impact on growth in the Euro Zone. How the market manages to reconcile this view with the view that the FED isn't done yet is one of the many market mysteries. The power of the carry trade has mesmerized traders.

Meanwhile the BOND market is listening. Treasuries remain under pressure and European Bond markets are bid. The idea that the FED has just embarked on the first leg of its attempt to reflate the U.S. economy is bad news for Treasuries. It is also bad news for the USD, but the FX market just can't wean itself off attractive interest rate differentials. YET.

With the whole market short the lowest yielding currency (the YEN) though market action can be volatile. All it took was a teensy, weensy comment from the German Deputy Finance Minister today to get the entire market scrambling to exit short YEN positions. Mirow noted that YEN weakness would be discussed at the next G-7. Which means the Germans are not happy. A bit of a change of point of view since May. Anyway the PRICE ACTION following his comments certainly underline where market risk lies right now. YEN shorts are reportedly at record levels. U.S. economic fundamentals are weak, the market is sitting one way, YEN bears should exercise EXTREME VIGILANCE.

The scramble out of EUR/JPY longs sent the EUR/USD lower today. Markets are chattering about a possible test of EUR/USD 1.2630 from here. Longer term players should buy EUR/USD under 1.2700. Although today was driven by YEN short covering, the underlying weak economic fundamentals in the States can not be ignored. Follow through selling on the EUR/USD is likely to be limited. EUR bears would be better advised to sell the EUR/JPY than the EUR/USD. The market has been making a one-way bet on this cross for way too long.

Stock markets are also taking a pounding and the only real explanation is the scramble to exit positions across the board as markets reassess risk in the light of an expected global economic slowdown in the second half of 2006 and into 2007. Volatility is extreme and more volatility is likely. We are dealing with a highly leveraged market and the potential for sharp moves is extremely high. The outlook for global stock markets is dim. More selling is expected.

OIL 67.74
GOLD 641.10

GOLD continues to benefit from its status as the ultimate safe haven. After all for the Japanese there isn't even much in the way of cost of carry. And the Japanese just announced that their reserves hit a RECORD of $878 billion in August, which is just short of the RECORD Chinese reserves of $954 billion as of end of July. More market volatility will enhance the attraction of GOLD.

OIL has softened slightly. The Israelis have announced that they will be lifting their siege of Lebanon. The Iranian situation is on the back burner, Merckel announced yesterday that Germany will oppose any military intervention in Iran. For now GEOPOLITICS is not making front-page news and that means OIL can be expected to remain capped.

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