Thursday, October 19, 2006

Monetary Policy Fixation

EUR/USD 1.2556 Hi 1.2561 Low 1.2528
USD/JPY 118.57 Hi 119.03 Low 118.56
AUD/USD 0.7569 Hi 0.7575 Low 0.7540
EUR/JPY 148.90 Hi 149.24 Low 148.88

There are a couple of things which we know: the FED is not going to hike rates at its next meeting and the ECB is hell-bent on hiking another 25 points by December. What's more there doesn't appear to be much chance that the FED will hike or do anything at all THIS YEAR. Bernanke is in "wait and see" mode. There is an off-chance that the FED might ease by the end of 2006, but it's a very SMALL possibility and would require the U.S. economy to run off a cliff very soon. Economies don't do that. Growth or economic disaster are played out in slow motion.

Meanwhile the ECB is still trying to out-Bundesbank the Bundesbank so "extreme vigilance" might not be on the agenda right now, but it's lurking. Maybe that's what Rumsfeld meant when he talked about "Old Europe". Out here they have a hard time letting go of past glories and tired ideas. So in the minds of some, notably Trichet, the Bundesbank was a raging success. I think he admired their dress sense because it CAN'T BE the state in which they left the German economy which gets his heart a-flutter. But then Trichet never really had to deal in person with the consequences of recession. He has always had a nice safe, public service job with all the trimmings. What they need in Europe is a little of Clinton's "Can we move on?". But no, in Europe we can't and won't, and if you're not careful we might start waving around lace hankies.

Despite what is known about interest rate policy in the EuroZone and the U.S.A., and despite the rumblings out of Japan about more rate hikes coming, the market INSISTS on pouring over every little bit of data. And what they are trying to divine is the nuances in inflation and growth which just might change the monetary policy outlook. This is a pointless exercise. But it does mean that with every little bit of information the market acts like an idiot savant with bi-polar syndrome and no medication. While ranges hold and volatility is relatively contained the FX market becomes a proxy for interest rates. Interest rates differentials are driving FX Markets, not flows, but short-term speculators.

While everyone is looking at the consequences of CARRY trade, DIVERSIFICATION marches on, pretty much unheeded by the market. A couple of days ago the Russians announced yet more diversification of their Foreign Exchange Reserves. This means they want to hold LESS USDs. Now, in addition to Euros and Sterling, they want to hold the YEN from a YEN base of what is believed to be zero circa. Official figures are hard to come by, but the estimates out there suggest that the Russian currently divide up their Foreign Exchange Reserves as follows: 45% USD, 45% EURO and 10% Sterling. Russia's Reserves are estimated to be around USD 268 billion, with USD 181 billion held in Foreign Currencies. This makes Russia the Central Bank with the largest Reserves in the world, after Japan and China.

Russia's Reserves have risen enormously over the past year and there has been a marked shift out of USD holdings. According to some sources USDs made up circa 70% of FX reserves a year or so ago. The longer term trend towards diversification continues. And this is not good news for the USD bulls. And that is the longer term trend, regardless of what the bi-polar, short-term market would have you believe.

In the short term, however, data released yesterday suggested that the U.S. didn't have any trouble attracting capital inflows. After seeing capital inflows fall to just USD 32.9 billion in July, Foreign Capital inflows to the States surged to USD 116.8 billion in August. This was way more than the USD 56 billion the market expected and slightly more than the U.S. requires PER MONTH to meet its funding requirement. Most of the money coming from abroad is heading towards the U.S. Treasury market. Indeed, foreign investors now hold around 44% of the Total U.S. Government Debt on issue. Now that's an Achilles Heel if ever there was one. And whereas once the Foreign Holders of U.S. Treasuries were compliant people like the Japanese, now we have Russia and China. Neither have quite the same attitude to the Americans.

The USD is currently in the process of putting in a top against the JPY and the EURO. The November 7 election might muddy the waters a little, but that is what is happening. Anything above USD/JPY 119.15 is a sell. Anything below EUR 1.2500 is a buy. And the top for the EUR/JPY has been made.

OIL 57.90
GOLD 592.20

GOLD is trapped in a range. While the Carry Trade supports the USD, further significant upside is unlikely. The longer term prospects for GOLD depend entirely on the shift away from holding the USD as a global reserve currency. So, according to your point of view, the bullish case for GOLD is a slam dunk.

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