Forex Trader Top 3: U.S. Inflation, Bernanke’s Speech, Euro GDP Slowdown
Mark Whistler is the founder of www.WallStreetRockStar.com and is the author of multiple books on trading. Mark’s newest book, The Swing Trader’s Bible – co-authored with CNBC/Fox News regular guest Matt McCall – will be on shelves in late summer, 2008. In addition, Mark also writes regularly for TraderDaily.com and Investopedia.com.
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1. Inflation Not Embedded in U.S. Economy
The News
In April, the consumer price index came in at 0.2%, below market expectations of 0.3%. Â Â
The Breakdown
April’s better than expected measure of inflation of consumer prices indicates that the U.S. economy is in much better shape now then it was just a few months ago. On a year over year basis, consumer prices have grown 3.9%, with core CPI increasing a mere 2.3% year over year.
When looking at the past three months alone, core CPI grew a tame 1.2%.
When the CPI report was released, the U.S. Dollar immediately fell lower, as the market inferred lower consumer prices will allow the FOMC to keep interest rates low for a while. However, what traders were not considering is the simple fact that the U.S. economy is recovering and can continue to do so at a healthy clip with inflation relatively low.
What’s more, Bernanke and company have clearly stated they are not lowering rates any more, and are actually keeping an eye out for the moment when the Federal Reserve can retract liquidity. (See number #2 below for a detailed explanation as to why.)
The Bottom Line
The knee-jerk reaction in the euro this morning – upwards – just after the CPI report was based on trader’s reactions to the U.S. CPI report. However, the first move is usually the wrong move, so traders may want to look for a late day U.S. Dollar rally.
2. FOMC Sends Clear Message
The News:
On Tuesday, FOMC policymakers made clear statements that they are done cutting rates for now; however, the Federal Reserve will continue to provide liquidity, as needed.
The Breakdown:
There were six speeches in all on Tuesday; however, the most notable was Ben Bernanke’s address to the Atlanta Financial Markets Conference, Sea Island, Georgia (Via Satellite). The overall speech was quite lengthy, directly commenting on the state of U.S. banks and credit conditions within America.
Throughout the speech, Bernanke’s main theme was from Walter Bagehot’s 1873 paper, Lombard Street: A Description of the Money Market, whereby Bernanke quotes, “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times” (p. 24).
Specifically within the address, Bernanke pointed out the Federal Reserve has taken extraordinary measures over the past few months to restore trust within credit markets including:
1. “Federal Reserve used its emergency authorities to create the Primary Dealer Credit Facility (PDCF). The PDCF allows primary dealers to borrow at the same rate at which depository institutions can access the discount window, with the borrowings able to be secured by a broad range of investment-grade securities. In effect, the PDCF provides primary dealers with a liquidity backstop similar to the discount window for depository institutions in generally sound financial condition.”
2. “…narrowed the spread of the primary credit rate over the target federal funds rate from 100 basis points in August to only 25 basis points today.”
3. “In addition, to address the pressures in term funding markets, we now permit depositories to borrow for as long as 90 days, renewable at their discretion so long as they remain in sound financial condition.”
4. “Last December, the Federal Reserve introduced the Term Auction Facility, or TAF, through which predetermined amounts of discount window credit are auctioned every two weeks to eligible borrowers for terms of 28 days. In effect, TAF auctions are very similar to open market operations, but conducted with depository institutions rather than primary dealers and against a much broader range of collateral than is accepted in standard open market operations. The TAF, apparently because of its competitive auction format and the certainty that a large amount of credit would be made available, appears to have overcome the stigma problem to a significant degree. Indeed, a large number of banks – ranging from 52 to more than 90 – have participated in each of the 11 auctions held thus far.”
5. “The size of individual TAF auctions has been raised over time from $20 billion at the inception of the program to $75 billion in the auctions this month. We stand ready to increase the size of the auctions further if warranted by financial developments.”
6. “In March, to ease strains that had developed in the agency mortgage-backed securities market, the Federal Reserve initiated as part of its open-market operations a series of single-tranche repurchase transactions with terms of roughly 28 days and cumulating to up to $100 billion.”
7. “Additionally, the Federal Reserve introduced the Term Securities Lending Facility (TSLF), which allows primary dealers to exchange less-liquid securities for Treasury securities for terms of 28 days at an auction-determined fee. Recently, the Federal Reserve expanded the list of securities eligible for such transactions to include all AAA/Aaa-rated asset-backed securities.
Referring to the PDCF (#1 above), Bernanke said, “Liquidity is better in several other markets as well. For example, spreads on agency mortgage-backed securities have dropped in recent weeks after reaching very high levels in mid-March, as have spreads between conforming fixed-rate mortgage rates and Treasury rates. Spreads on jumbo mortgage loans have retraced a portion of their earlier large increases, but recent regulatory and legislative changes make it difficult to assess the impact of liquidity measures in that segment of the market. Corporate debt spreads have also declined somewhat from recent highs.”
Overall, Bernanke clearly feels the Federal Reserve has taken the appropriate steps, “acting as a good banker” to provide liquidity during a time when it was sorely needed. Interestingly, the PDCF was created subsequent to the Bear Stearns
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PowerRating) debacle. Some feel the Bear Stearns bailout was immensely unfair, as the bank was given Federal Assistance at the same time as thousands of individual homeowners have seen their property move to foreclosure – without a clear, easily accessible rescue from the Government.
Bernanke did also hit on this point, the latter part of his speech, where he addressed “moral hazard” of the banks intervention activities this year.
Addressing moral hazard directly, Bernanke’s conclusion was one of policy reform, something the FOMC is working on through recommendations from the President’s Working Group on Financial Markets. Bernanke said, “Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis.”
In his closing comments Bernanke referenced Bagehot’s statement again, “A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.”
Moreover, in his last two sentences, Bernanke said, “Of course, even the most carefully crafted regulations cannot ensure that the liquidity crises will not happen again. But, if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.”
Bernanke was sending a clear message to markets that the FOMC has acted in the best manner possible to solve the liquidity issues with the U.S. To wrap up his entire speech in one shot, what Bernanke was saying can be summarized as: Â
My Translation of the whole speech – From Bernanke’s perspective: “We’ve done everything we can to help credit markets stay afloat, now banks, lending institutions and Government policy needs to be tightened up to make sure we don’t have this problem again. Borrowers, lenders and institutions investing recklessly – caused us to dip into our pot of reserves, which we promptly did and will continue to do – However, when things get back to normal, we’re going to curtail the liquidity injection – and hopefully the policy changes addressing moral hazard will keep this from happening again.”
The Bottom Line:
Clearly, the FOMC will most likely NOT lower rates again – and if anything – will begin raising, as soon as the economy and credit markets show further signs of improvement. At the end of the day, when the price of oil finally starts to cool, the current press campaign by the Federal Reserve will translate to a U.S. dollar recovery.
Notable references from Bernanke’s speech:
Bagehot, Walter (1873). Lombard Street: A Description of the Money Market. London: King. Reprint, Gloucester, U.K.: Dodo Press, 2006.
President’s Working Group on Financial Markets (2008). “Policy Statement on Financial Market Developments (1.36 MB PDF),” March.
3. Euro Hurts Industrial Production
The News:
Industrial Production in the Euro area declined 0.2% in March over February and was up a mere 2% year over year.
The Breakdown:
Within the Euro zone industrial production report, activity in the Euro zone fell in March, posting the second consecutive month of declining capital goods output. What’s more, the BTC Research manufacturing purchasing manager index declined from 52.0 in March to 50.7 in April, which translates to more weakness on the way, at least in the near-term.
Overall, consumers are holding back on purchasing, as inflation coupled with lackluster real wage growth are both compounding the problem.
Interestingly, weakness in the U.S. dollar has actually made American products look relatively attractive in the Euro zone, especially considering the euro is still trading at the top end of the 6-year bullish trend.
The Bottom Line:
Industrial production in the Euro zone is clearly falling; indicating that GDP growth within the euro zone could be in big trouble. The ECB needs to cut rates, but with inflation still almost 1.6% above the ECB’s target rate of 2.0%, the central bank has its hands tied. If the euro were to cool, the event would definitely help cool inflation within the Euro area, something that would help 2008 GDP growth. However, Jean-Claude Trichet and other ECB policymakers continue to artificially prop up the euro though their inflation-oriented comments to the press. At this point, comments from ECB members are working against Euro area GDP growth by keeping the euro at elevated levels. Because of the ECB’s lack of care in handling the overall situation very carefully, Euro zone GDP growth could be in big trouble in 2008.