Sebastian

The euro will still have the advantage even if the ECB pause, because with the respective rates at 4% and 5.75% respectively, there is far more scope for a shift downwards in UK rates than in euro rates.

Interesting article. The pound may indeed be doomed but it is for reason's of the UK economy's making, rather than an Amercian conspiracy. Sterling has appreciated significantly since the spring of last year at the same time the country had a widening current account deficit. From a long run fundamental perspective, it does not make sense that a currency gains in value on one hand, while having to produce more currency on the other to pay off its deficit. It means the system is awash with pounds. This is fine when all is well, but investors that bought into the pound for its high interest rates will run quickly to the exits as soon as the outlook for the UK economy and the currency begins to become more uncertain. This will pull sterling down sharply and in particular lead to a major and sustained decline against the euro (the euro area has a balanced current account). Underlying currents in the UK banking sector right now suggest all is not well and given the economy's overall reliance on the financial services sector, the Bank of England will be forced to reduce interest rates, possibly as early as next month. This will undermine sterling even in the short to medium term and we could start to see a real sterling decline in the coming weeks. Sterling has got something of a temporary respite in the past few days as risk aversion has dissipated in the wake of last week's Fed interest rate cut. Once the euphoria of this event is finally exhausted, markets will begin to look around again and may be less than comfortable with hat they see in the UK.

Canada has been the teflon currency of the past 6 months and the subject of a major speculative bubble. While it hit parity today, I for one would not be surprised if it ends the year closer to 1.10. It has appreciated 5.5% since the start of last week alone and is now trading more like a commodity than a currency. It's amazing to see a currency manipulated in the fashion the CAD has been this year, but with a rather clueless Central Bank, we should not be too surprised. Some of Canada's major banks have been parties to the manipulation by synchroninsing the timing of M&A fund flows to deliberately influence the currency's price.

The Bank of Canada made a fatal error when raising interest rates in July. At the time they knew that the recent rally in the CAD had a smell coming from it, which could not be explained by the fundamentals. In addition, their projections for inflation have been proven to have been completely over-stated after only a few months. As bizarre as it might seem, Canada is now more likely to hit a recession earlier than the US and the Bank of Canada can take some of the credit for that. Canada's Finance Minister seems to be in the kindergarden group when it comes to understanding the underlying fundamentals that make the Canadian economy tick and someone needs to tell him that CAD's recent appreciation comes from something more than a plummeting dollar. The CAD has gained 10% against the euro since March and many analysts think the euro is over-valued as it is. What does that say about the CAD?

It has not risen against the dollar because when liquidity becomes more plentiful, funds flow into higher yeilding assets and currencies. The yen is used to fund flows into the likes of the Aussie and Kiwi dollars and the 'safer looking' euro. A mass flow of funds out of the yen is going to have it depreciate across the board, including against the US dollar. 1. Interest rate cuts increase liquidity. 2. The Fed don't seem to believe inflation should go up in the US (if they did how could they justify a 0.5% rate cut) and neither do the markets. They may both be proven to be wrong.

You need to keep an eye on earnings of the financials as they are released over the next few weeks, to see whether we are going to be told any truths about real losses owing to subprime. These 'losses' may well be hid on balance sheets for some time though as banks/brokers 'struggle' to calculate their exposure. And in any event, if you were the CEO of a major bank/brokerage, would you at this time declare exposure as a real loss? The Banks themselves will know the extent of the problems though and it will play out as a continuing or worsening credit crunch problem in financial markets, with a few more Northern-Rock-type cases. Another point that may be of relevance though is that volumes traded in most equity markets have been significantly down in recent weeks, so maybe many investors sit on the sidelines and wait, believing this has yet to play out fully. These investors may also be the ones that have flocked to commodities, to grossly inflate prices in that market.

The Canadian dollar is grossly overbought and in danger of a very sharp reversal, which will come, soon. CAD has rallied from 1.1870 against the US dollar to 1.01 in the past 6 months. Such gigantic moves by any currency are not sustainable. The CAD is the only currency that has not retraced in the past 6 months (we can ignore the moves during the volatility in August). 80% of Canada's exports go to the US and since 40% of Canada's GDP is attributable to exports, one can begin to see how major competitive problems are going to start reeking havoc within the Canadian economy in the coming months. And the argument that higher oil prices will continue to help the CAD don't stack up. Higher oil prices in a slowing US economy means lower US consumer consumption and a sizeable fall in Canadian exports which in turn will lead to a slowing Canadian economy. Also, higher oil prices are currently converting into less Canadian dollars because the CAD has risen faster than oil prices. CAD is soon to be the sale of the year in my view (against the USD and the euro), because the speculators and manipulators that have driven the currency will bail out as soon as the magical parity level has been met. The CHF could prove to be the best currency to trade against sterling because it is still very much under-valued against most of the majors and the SNB maintain a tightening bias and in terms of rate differentials going forward, the CHF stands out - as it is already coming from a very low interest rate base.

The markets don't really want to know about subprime, the credit crunch, slowing global growth, and a housing sector disease simply because bulls are not interested in bad news and given that we have had a bull market for the past 4 years, bears are the tiny minority and like morning mushrooms they quickly get stamped on every time they raise their heads. If the Fed are to be believed (given the shock and awe of a 0.5% rate cut) the US economic outlook is far from rosy and markets should be questioning, pausing and probably selling. But markets think Bernanke is playing Father Christmas and that the gifts he has left are for free. Markets have chosen to ignore recent troubling data in Japan, the euro area and the UK in favour of the belief that global economic boom is unstoppable If Bernanke is right, everyone is going to get a rude awakening in the coming weeks and months and if he is wrong the US is going to quickly run into an inflation crisis, of the Fed's making. I personally think the Fed has made a monumental mistake and has effectively caved in under immense market and political pressure. Bernanke has shown himself to be weak in the face of his first major test.

The falls have been substantial over the past few weeks, as currency markets were pricing in between 0.75% and 1.0% in rate cuts. If rates were cut by only 0.25% yesterday, then the dollar would probably have appreciated, given the level of easing already priced into the market. The dollar has fallen significantly against the high yielding currencies like the Aussie and Kiwi dollars since the announcement. There are 2 pivotal price barriers to be overcome before the next leg down in the dollar can be confirmed and we see further depreciation, i.e. 1.40 Vs euro and parity with the Canadian Dollar. Both barriers are massively significant in the context of where the dollar goes to the end of the year.

a 0.5% cut in the discount rate may be as far as they go on that, I would think. Looking at oil and other commodity prices, inflation looks a bigger threat right now than it has done all year, so Fed can't ignore that. This may well make them non-commital on future rate hikes.

EUR/USD and USD/CAD are market positioned to hit key levels this week (1.40 for Euro and possibly parity for CAD), as neither is being sold off and the Canadian dollar has gained against every world currency in the past week. The CAD should in reality be weakening given that over 30% of Canada's entire economy is made up of exports to the US, so a slowdown in the US is hardly good news for the Canadian economy. There is currently a massive speculative bubble forming between oil, gold and the Canadian dollar which seems to be suggesting major inflation headaches ahead for the US, but will it burst before the Canadian dollar gets to hit parity against its US counterpart?

They could potentially cut 0.5% and indicate that it is a once-off, so no more cuts are in the pipeline. But they can hardly do that given the truth is the Fed do not know the real extent of the subprime problem and how it might play out in the wider economy in the months ahead. What we do know is that the credit issue is no longer an American problem and that contagion to the wider economy is not restricted to the US. It is conceiveable that the Fed move could prove to be a positive for the dollar in the months ahead as the Fed become the first Central Bank to step in and support the domestic economy. Most other Central Bankers have been blinkered throughout this whole issue with the Bank of england in particular living in a fool's paradise. Speculative positioning and risk taking is still driving currency markets despite all the problems we have seen of late and many currencies are currently grossly over-valued against the greenback.

This is a piece I wrote on the subject and which I decided to share with your good selves. Have been busy of late. The Fed’s Options: September 18 FOMC The US Federal Open Market Committee meet next Tuesday on what is probably the most important meeting for the Committee in 4 years. Recent financial market turmoil coupled with a slowing US economy has put the focus firmly on the Fed, with markets demanding an immediate easing in US interest rates and a shift in the Committee’s monetary policy stance. The Fed effectively moved from a tightening bias to a neutral stance in August, when it lowered its lending discount rate and issued a statement stating financial markets stresses now posed a downside risk to the growth prospects of the US economy. Last week’s payroll report which revealed a contraction in employment for the first time in 4 years, has, in most analysts minds, sealed a rate cut for the September 18th meeting, with futures markets pricing in a near 50% chance of a 0.5% rate reduction. While a rate cut seems probable, the Fed finds itself in an incredibly difficult position because recent surges in energy costs on the back of a weaker dollar pose a major inflation threat to the US economy going forward. The Fed must weigh up the risks and deliver a decision that will best serve the sustainability of US economic growth. The Fed has a number of options available to it, which I explore below: 1) What I consider the most likely outcome is that the Fed will reduce the funds rate by 0.25%, while maintaining its inflation bias. The Fed will probably modify the statement with a sentence along the lines of ‘The Fed assess there are increased downside risks to the US economy in the coming quarters and the Committee will act in a timely fashion, when needed, to support US economic growth.’ This in essence will move the Fed into a neutral position and enable it to hike or cut, depending on how the economy plays out in the months ahead. 2) The Fed reduces the fed funds rate by 0.5% and shifts to an easing bias. This is what many market analysts have been calling for and was the most likely outcome as early as last week, according to futures markets. While this would certainly answer critics who accuse the Fed of not being proactive enough, it might translate into the Fed pressing the panic button and have them stand accused of merely being seen to bail out the financial markets. Outside of last week’s employment report, most other recent data does not imply a requirement for such a drastic move and in any event it seems highly unlikely that there could be consensus amongst all voting officials to cut the rate by 50 basis points. 3) The Fed cuts by 0.25% and shifts to an easing bias. This is a possibility but not a probability in my view. To shift to an easing bias the Fed would have to soften its concerns on inflation, signalling downside risks to economic growth now outweigh current inflation concerns. This will be interpreted by many as a confirmation that the US is headed for a serious slowdown/recession and that the market should expect a cycle of rate cuts in the months ahead. This would be damning for the dollar, should it happen. However, there is insufficient wider economic data to support such a negative view at this time and such a policy decision could in itself precipitate a major slowdown/recession. 4) No change in the Fed funds rate, but a modification in the statement to stress that the Fed are monitoring the situation closely and will act when needed. The Fed could throw in a 0.50% reduction in the discount rate to offset against the resultant disappointment in financial markets. This particular option is probably the wisest one in terms of acting in the the long-term interests of the US economy, but it will require incredible bravery on the part of the Fed. It is also likely this is the preferred option of a number of Fed officials, including Bernanke himself and if the Fed Chairman manages to deliver such a result he will cement his place in history as a Central Banker that stood tall against all the pressure, influence and power financial markets could garner to unsettle him. If we did not have the recent credit market crisis, there is no question but that the Fed would not be even considering a reduction in the fed funds rate next week. Given that the crisis was created by the financial markets themselves and the fact that no interest rate reduction is going to recover bad debts, the Fed should leave the fed funds rates unchanged next week. Other Central Bankers have shown little empathy for financial markets in response to this mess, so why should the Fed be any different? What about the dollar? The dollar has been sold off at a rapid rate in the past 2 weeks, to the point that the US dollar index has firmly broken below 80 and sits at its lowest level in 15 years. The market has priced in rate cuts of between 0.75% and 1% between now and the end of the year. Although it is clear the dollar sell-off is overdone, the dollar simply cannot attract any sustainable buying support right now because of the extent of negative sentiment that surrounds it. We are unlikely to know the true fate of the dollar until after next Wednesday, once the true implications of Tuesday’s Fed statement has sunk in. We could easily see EUR/USD break above 1.40 or 1.41 in the immediate aftermath of Tuesday’s meeting, if the Fed shift to an easing policy, as the market is exclusively dollar bearish right now. But we could see a knee-jerk reaction on either side, come Tuesday, which may prove to be premature and it is a dangerous time to be entering the currency market.

It is very interesting to watch commodity prices also. Despite rising stocks in base metals, prices are increasing in sympathy with rising stock prices, because prices are being driven by speculative trading rather than demand. Copper is the best example. In the current bull market, traders will grasp at anything to push prices higher - whether it is George Bush hogwash about paying people's mortgages, Bernanke using a word that holds out hope of a US rate cut (rate cuts happen when things are going badly), 2 hours without a mention of the word subprime and a slowdown in spending and deflation in Japan. Long may it not continue!

Quote from same letter: 'Also, the Federal Open Market Committee has stated that it is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.' Markets read this as meaning Bernanke was intimating rates cuts and was said to have sparked the major rally seen on the Dow Wednesday. He speaks tomorrow in Wyoming but it would be a major surprise were he to show his hand outside of an official FOMC meeting. It would be a huge mistake for him to give anything away. US Stock markets are hung up on idea that the Fed carry a magic wand. It is definitely becoming a Wall Street Vs the Fed battle of rates, with Main Street being left to look from around the block.

I'd be very surprised, but we will learn much in the next week with the Bank of Canada, ECB and Bank of England all coming up on the calendar. The Bank of Canada will be the litmus test on Tuesday, because they were originally expected to hike. Given Canada's dependence on the US economy for their exports, if the Bank of Canada don't flinch in the current environment, then it is unlikely the European Central Banks will. Markets do not expect the Bank of Canada to hike now but with futures markets actually pricing in a rate cut in Canada before the year end, next week's Bank of Canada statement is one of the most eagerly awaited in years. It is also worth noting that the Canadian dollar is the strongest currency in the world this year and its strength has been hampering the profits of Canadian corporations (over half of Canada's exports are US dollar denominated commodities). If the US is entering a marked slowdown, a strong Canadian dollar is hardly in the interests of the Canadian economy. The Bank of Canada will never have a better opportunity to try to correct this threat than they will next week, because recent Canadian inflation data has been rather benign and gives them latitude.

Well, yes a prolonged credit tightening phase would lead to deflationary pressure. That I subscribe to. But two weeks of market volatility, one of it owing to credit tightening between lenders, hardly means the world is now entering a prolonged deflationary period. If I see markets entering a genuine bearish phase and hawkish Central Bankers have nothing to say, then I might agree with you. night to u 2

1) Agreed 2) No. Depends on how you define rampant and where you are talking about. 3) No. We are still in a bull market and bulls will jump in for the foreseeable future and continue to inflate energy and commodity prices, i.e. push up prices for us all. 4) The US is near the bottom of its housing downturn, but the staggered nature of the downturn hasn't translated into a calamity that is going to crash the wider economy. The UK economy is far more dependent on housing and a housing crash there could bring about a hard landing for the whole economy. UK banks appear to be lending more than consumers should be able to afford, so we are possibly on the edge of a major turnaround, given banks are going to be forced to tighten their lending belts. A marked slowdown henceforth could avert a fullblown crash, but if demand evaporates because lenders will no longer finance the loans, then a crash could be imminent.

The services sector covers a wide spectrum of industries, from transport to communications, from software to consulting, from education to healthcare onto government and entertainment. We spend most of our money on services, so that's why they are there. If there is no demand for them they will disappear. I never said debt creation came from housing. Falling house prices do not create debt. Too much liquidity, careless lending and over-zealous spending cause debt. German house prices didn't go up for years and yet the German economy currently leads the way in the euro area.

I don't know what you mean. Services is the backbone of most Western economies since manufacturing was sent to the East. Without services, the US and the UK don't have an economy.

It could be part of a diversification policy. Switzerland does not have a deficit, so it can't be to balance the books. Does this mean when we grow rich and famous we will be able to see our weight in gold?

They make the US economy. Over 40% of US GDP comes from domestic consumption of its services.

Well I don't see why the SNB would sell gold to achieve a lower price. How is that in their interests unless they intend buying back more immediately after? To traders and funds, the physicality of gold is irrelevant. It is bought purely as an investment or a hedge. It is a good point about banks managing the paper markets, although to be fair the CBs themselves cannot be blamed for institutions that decided to buy risky or worthless pieces of paper. Some of those institutions should suffer the pain and the extinction long before the CBs are helicoptered in with the oxygen masks.

I am only looking at the hard facts. It doesn't matter to me one way or the other if gold appreciates or not. I have only ever traded gold once and made a small profit but have never been an active trader of the metal. Speculators have a huge say in driving up the value of any commodity and gold has taken a back seat to metals like copper, zinc and nickel where demand is more closely related to economic growth because they are material metals and are attracting more and more speculative trading activity.

I'm not sure what they do with the gold. I guess it all depends on who is buying it. It could be the case that funds bought into the gold, but the holding remains with the Bank - in trust. I don't know how that arrangement works. You are correct in saying that a credit crunch is deflationary in nature. But one would expect funds to shift from risky assets such as carry currencies, commodities and equities into gold and not vice versa. Bonds have done very well but gold has been a spectator. It seems extraordinary to me that gold failed to appreciate during this episode. The crisis possibly has not gone on for long enough and most fund managers possibly think this is merely a temporary hiccup. Looking at how quickly commodities and carry currencies have been able to bounce back (prematurely) suggests that risk appetite is as mad as ever.