The dollar's drop this week was widely attributed to grim U.S. economic data and Federal Reserve Chairman Ben Bernanke's remarks suggesting more interest-rate cuts are coming.
Those factors, however, tell only part of the story.
Momentum trading, the break of key options barriers and technical levels, and crosscurrents with oil and other commodities all played a role in beating down the buck.
Take, for example, momentum trades, which are market bets made simply on direction rather than fundamentals or intrinsic values. Analysts say the dollar's rapid rise against the euro this week was due in part to this strategy.
"When prices roll higher -- or lower -- and momentum kicks in, the trend attracts fresh interest from momentum traders and models," said Andrew Wilkinson, senior market analyst at Interactive Brokers.
"If you use something like a longer term chart -- weekly -- and use a particular technical indicator, they often create strong cross-overs on a weekly basis, which tend to kick momentum models up and running," Wilkinson said.
Momentum strategies replacing carry tradeMomentum trading played a part in the dollar's drop against the yen Friday to a three-year low of 103.66 yen.
See Currencies.Last year, the dominant theme affecting dollar/yen trading was the carry trade, in which traders borrow lower-yielding currencies (such as the yen) and invest them in assets denominated in higher-yielding currencies (such as dollars). Such positions pressured the yen, because at 0.5%, Japan's benchmark interest rate is the lowest in the developed world.
Such trades usually lose their popularity as risk aversion rises, and traders, fearing losses, liquidate their positions. The unwinding of the yen-carry trade has helped strengthen the yen despite Japan's still-rock-bottom interest rates.
"For the most part, it seems as if the recent price action in the currency market can be better explained by the momentum strategies than carry trades," Marc Chandler, head of currency strategy at Brown Brothers Harriman, wrote in a report.
Momentum trading strategies also help explain the euro's rise to $1.5239 earlier Friday, its loftiest level against the dollar since the European unit began trading in January 1999.
The euro pushed above the $1.4900 three times in the past. But this time, Chandler said, speculators appeared to have less exposure to the European currency and were therefore forced to buy euros to cover their positions after the euro finally broke $1.50 in early Asian trade Wednesday.
"Many, like ourselves, were perhaps lulled into a bit of complacency by the clearly identifiable trading range which had confined the euro for the better part of four months. Until it didn't, and then various types of participants, acting like momentum traders, had to scramble and chase the euro higher," Chandler said.
Options, oil and goldThe $1.50 level was key for the euro because of the currency option positions that were said to be clustered there. Such options are traded in the interbank market, so there was no way to determine the exact size of the positions, but analysts said they were considerable.
Because such options lose their value if a currency touches the strike price, traders holding them buy or sell currencies to defend their positions. When the barrier options -- bets on a specific price -- give way, they create a spike above the knock-out price.
"Options are usually a key factor in determining the intensity by which currencies break full figures, and the break of $1.50 was definitely a case in point," said Ashraf Laidi, chief foreign exchange strategist at CMC Markets US.
"Once the dollar-selling intensified, those traders whose interest lied in protecting the $1.50 level to maintain the validity of those options failed to do so, hence accelerating the euro jump," he said.
"However, we should not ignore the effect of record highs in gold and oil as essential drivers of the dollar decline," Laidi said.
Crude oil and gold are both traded in dollars, so as the dollar declines in value, so does the price of these commodities in non-dollar terms, making them more appealing to speculators. Therefore, commodities prices rise in dollar terms as the dollar falls in value against other currencies.
Crude-oil futures closed modestly lower Friday, after hitting a record high of $103 a barrel overnight and marking new intraday highs for four consecutive sessions.
See Futures Movers.Gold futures finished with gains Friday, after hitting a record high of $978.50 an ounce overnight.
See Futures Movers.If the dollar continues to weaken and U.S. inflation rises, some analysts believe gold could surpass the psychologically key $1,000 level before the end of March.
Read more about gold.Rates still matterTo be sure, economic fundamentals remain as important as ever.
Some economists believe a U.S. recession has now begun, based on data showing declining employment, weak incomes and slumping industrial production. For the current quarter, economists are predicting no growth.
Now that Bernanke has signaled more rate cuts on the horizon, some central-bank watchers predict the federal funds rate will drop to 2% from the current 3%, most likely by the summer.
See Capitol Report.Lower interest rates erode the returns on dollar-denominated assets and can weigh on a currency, as can slower economic growth.
"Mounting recession fears on dour U.S. data and Bernanke's testimony have sent the dollar lower against most major currencies," John Rivera, currency analyst at Forex Capital Markets, told clients in a note Friday.
And the bottom line is that most traders base their actions largely on what they think other traders are doing.
"One of the most powerful market forces and the one we pay close attention to is traders' perception," said Adam Hewison, president of INO.com, a technical analysis site. "Traders' perception right now is to be long commodities, short the dollar, and short the equity markets. That's the way we think the markets are going right now."
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Labels: dollar value, foreign exchange, forex, FX, interest rates, USD
Hedge fund issues could cause economy to slow
Hedge fund issues could cause economy to slowWhile hedge fund failures are typically seen as a Wall Street problem, economists are forecasting that recent hedge fund meltdowns could impact Main Street and may even slow the U.S. economy. Turmoil in credit markets could push up borrowing costs for businesses and consumers and cause a ripple effect.
Hedge fund woes could hit Main StreetUpheaval in credit markets could hit consumer, business borrowing - and slow the economy; risk premiums already rising.
By Chris Isidore, CNNMoney.com senior writer
June 21 2007: 3:21 PM EDT
NEW YORK (CNNMoney.com) --
When Bear Stearns's hedge funds melted down this week because of too big a bet on subprime mortgages, it may have seemed like a Wall Street problem.
But numerous economists said the latest turmoil in the nation's credit markets could spill over to Main Street as well, raising borrowing costs for consumers and businesses alike - and possibly putting the brakes on the surprisingly resilient U.S. economy.
Subprime mortgages, made to home buyers with less than top credit ratings, have been skidding since early this year as delinquencies and foreclosure rates soared. Now problems with those mortgage loans have sparked a big headache for Bear Stearns (Charts, Fortune 500) and the Wall Street firms that lent it money to invest in subprime mortgages, such as Merrill Lynch (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).
But the problems threatening the credit markets could mean far more than just billions in possible losses for those firms. It could push rates higher for corporate debt, which has been relatively cheap even for companies with poor credit ratings.
Even if those companies don't fall behind in their debt payments the way many subprime borrowers have on their mortgages, the investors making money available for those riskier loans are now demanding a much higher premium than they had until just recently.
Deadly ripples threaten subprime funds That could choke off the supply of relatively cheap money that has kept the U.S. economy humming in recent years, putting a dent in everything from business investment to consumer spending.
"That's clearly high on my list of things to worry about," said David Wyss, chief economist at credit-rating agency Standard & Poor's. "I think it's healthy that pricing for risk changes. I think it's too loose now. But the transition could be painful. It depends on how fast it happens."
Wyss doesn't believe that the rise in borrowing costs for most companies will plunge the U.S. economy into recession - and many economists agree with him. They said there's enough underlying strength in the economy to keep it growing. But it will mean slow growth in the second half of this year rather than more normal "trend" growth of 3 percent a year or greater, said John Silvia, chief economist at Wachovia.
"I would think that that as you reprice risk, it will have a negative impact on economic growth going forward," said Silvia. "It will extend the workout in the housing market. And at the margin, they [higher rates] will crimp consumers and their spending."
Others see an even more drastic correction. Peter Schiff, president of Euro Pacific Capital, a brokerage firm specializing in overseas investments, said he had already been expecting a recession in late 2007. Now he believes the recession will come sooner, and hit harder, because of the problems with the Bear Stearns hedge funds.
"This is just another graveyard they can whistle by," he said, referring to Wall Street firms. "Eventually they're going to be overwhelmed. Interest rates are going to rise across the spectrum, and spreads are going to widen considerably."
That widening of the spreads - the difference between what it costs top borrowers and those deemed more risky - has already started. The spread between corporate debt that is not investment grade, popularly known as junk bonds, and a basket of U.S. government bonds was 2.89 percentage points on Thursday, according to Wyss, up from a record low of 2.65 percentage points on May 25.
Wyss said the spread had gotten too narrow and that a correction was likely even without the Bear Stearns problems. A more typical spread is close to four percentage points, and it was as high as 3.85 percentage points as recently as last September.
But he said an event in the credit market such as this week's meltdown typically sends spreads soaring. He noted the rise of roughly one percentage point in just two months in 2005 from a then record low in March following General Motors (Charts, Fortune 500) and Ford Motor (Charts, Fortune 500) debt being cut to junk bond status for the first time.
Full articlehedge funds, economics, capital markets, interest rates, bond yields, valuations, CDO, credit derivatives, derivatives, pooled securitiesLabels: bond yields, capital markets, CDO, credit derivatives, derivatives, economics, hedge funds, interest rates, pooled securities, valuations
Fed pressured to raise rates
Fed pressured to raise ratesEven with inflation at the top of the Federal Reserve's comfort zone, options on Federal Fund futures at the Chicago Board of Trade show a 41% chance the Fed will lift its target rate for overnight loans between banks from the current 5.25% to 5.5%. Options data compiled by Bloomberg show that the chance of a rate cut has fallen from 83% to 29% since the start of May.
Fed Faces Pressure to Raise Rates, Options Show (Update1)
By Daniel Kruger
June 4 (Bloomberg) -- In the options market where the savviest investors take apart conventional wisdom, the Federal Reserve is facing growing pressure to consider raising interest rates as soon as December.
Options on Federal Fund futures at the Chicago Board of Trade indicate a 41 percent chance the central bank will lift its target rate for overnight loans between banks to 5.5 percent from the current 5.25 percent, according to data compiled by Bloomberg. A month ago, they showed no expectations for an increase.
While the economy expanded at the slowest pace in more than four years in the first quarter, inflation remains at the top of the Fed's comfort zone, business activity has rebounded, the jobless rate is near the lowest in six years and stock indexes are setting record highs. Just three months ago, options traders speculated the weakest housing market in 16 years would force the central bank to cut interest rates to 4.5 percent by January.
``The economy is in better shape than people give it credit for,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments in Minneapolis, which manages $100 billion of bonds. ``People exaggerated the pass-through effects of the housing weakness. If the Fed were to do something by year- end it would be a tightening.''
The chance of at least one cut in the overnight lending rate between banks has fallen to 29 percent from 83 percent since the start of May, options prices show.
`Not Satisfied'
Federal Reserve policy makers ``have started to tell us in pretty consistent language they're not satisfied at being at the upper band'' of their inflation target, said Stan Jonas, who trades interest-rate options in New York at Axiom Management Partners LLC. ``One-third of the people think the next move is going to be a tightening.''
Options more accurately reflect changes in monetary policy than futures contracts, the most widely used barometer, because they include the widest array of wagers, according studies by the Federal Reserve Bank of Cleveland in 2005 and the Federal Reserve Bank of St. Louis in 2006.
The Cleveland Fed paper has influenced the study of monetary policy expectations and follows a ``perfectly sound procedure,'' said James Hamilton, an economics professor at the University of California, San Diego.
The CBOT first listed the options in 2003 and began offering contracts in July that allow bets on the Fed's target rate. The so-called binary options pay $1,000 if an investor bets correctly on the Fed's interest-rate decision at regularly scheduled meetings. Investors get nothing if they bet wrong.
Preferred MeasureTreasury yields climbed last week to the highest since August. The yield on the benchmark Treasury note due in May 2017 rose 9 basis points, or 0.09 percentage point, to 4.95 percent. The yield fell 1 basis point today to 4.94 percent.
Treasuries returned 1.1 percent so far this year, compared with a 1.5 percent loss last year, according to indexes compiled by Merrill Lynch & Co.
Personal spending on items excluding food and energy, the Fed's preferred inflation measure, rose 2 percent in April, at the top of the central bank's preferred 1 percent to 2 percent range. It had been above 2 percent the previous 12 months.
Central bankers reiterated their forecast for faster growth and said ``downside risks'' to the economy have ``diminished slightly,'' according to minutes of the May 9 Federal Open Market Committee meeting released last week.
``Economic growth will pick up as we move through the year,'' Federal Reserve Governor Randall Kroszner said at a June 1 conference in Athens. ``The risks to the inflation outlook are primarily to the upside.''
Merrill, Goldman, UBS
UBS AG, among the biggest bond bulls this year, changed its forecast on June 1 for the Fed to begin cutting rates in October from August. UBS, along with Merrill Lynch & Co., Goldman Sachs Group Inc., had been predicting a housing-led recession would result in at least three rate cuts this year. Merrill and Goldman are based in New York and UBS is in Zurich.
New home sales rose 16 percent in April to an annualized rate of 981,000, according a Commerce Department report released May 24. Analysts attributed the increase to developers reducing prices of unsold houses. The average selling price dropped 10 percent, the report said.
Gains in stocks that pushed the Standard & Poor's 500 index to a record 1535.56 on May 30 discouraged the Fed from cutting rates, said David Rosenberg, chief economist for Merrill in New York. Rosenberg predicted at the beginning of January that rates would fall to 4.25 percent this year. He declined to specify when the Fed will cut rates in an interview May 30.
`Bat an Eyelash'
``We came off of virtual stagnation in the first quarter and the Fed didn't bat an eyelash,'' Rosenberg said.
Economists at Barclays Capital Inc., JPMorgan Chase Inc. and Bear Stearns Cos. have been predicting higher rates since the Fed left its target unchanged last August. They forecast at least one increase this year and another by the first quarter of 2008. Barclays is based in London, while JPMorgan and Bear Stearns are in New York.
``We'll see a pick-up in the growth rate of the economy that will make the Fed a little less confident with the rate of inflation,'' said Conrad DeQuadros, an economist at Bear Stearns.
The U.S. economy grew at a 0.6 percent annual rate last quarter, the Commerce Department said May 31. The pace will increase to 2.2 percent this quarter, according to the mean forecast of 65 analysts surveyed May 9 by Bloomberg News. ``If housing can just behave itself and get back some stability there is a risk they could go to 5.5 percent,'' said George Fischer, who manages $17 billion in fixed-income assets at Boston-based Fidelity Investments, the world's largest mutual fund company.
Building the CaseThe economy added 157,000 jobs in May, while the unemployment rate remained at 4.5 percent, the Labor Department reported on June 1. The jobless rate dropped to 4.4 percent in March, the lowest since October and matching a five-year low.
Business activity rose last month, according to the National Association of Purchasing Management-Chicago's business barometer. The measure increased to 61.7 in May, higher than economists forecast, from 52.9 the prior month. Readings greater than 50 signal expansion.
``The case is building more and more'' for Fed rate increases, said Richard Schlanger, who manages $4 billion in fixed income at Pioneer Asset Management in Boston. ``We are definitely seeing more and more people moving away from the Goldman and Merrill argument that the Fed is going to cut multiple times.''
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Full articleFED, US Federal Reserve, interest rates, inflation, economy, economic growth
Labels: economic growth, economy, FED, inflation, interest rates, US Federal Reserve
