Category: News Analysis

To cut rates or not to cut, that is the question that Ben Bernanke and his fellow associates at the Federal Reserve must still be mulling over as the September 18, 2007 highly anticipated FOMC meeting looms ever closer.

There is ample evidence that a good dose of inflation, like an ill wind, is headed our way. For example take a look at this Commodity Research Bureau (CRB) Spot Index Chart that plots the index of 23 industrial commodities.

Then consider that we have wheat at record price levels. Gold is trading at over seven hundred Dollars an oz. There are record prices for crude oil at over $80 a barrel. Milk is at record levels as is the price of beef. I could go on but I’m sure that you get the inflationary picture.

If Ben Bernanke and company were to focus simply on the inflation outlook, the real inflation outlook, not the watered down official government one that excludes energy and food prices, they would not dare to cut interest rates at this time.

However, it is not as simple as that. The trouble originating out of the sub prime mortgage lending market and the resulting infection of troubles throughout the US housing market must be deeply troubling. With housing foreclosures already at record levels and with housing such an important part of the US economy some rate relief would seem to be in order.

The markets seem to have already priced in a 25 basis point reduction on the federal funds rate. Some analysts think that the discount rate will also be cut by 25 basis points. Others think a rate cut of 50 basis points is in order.

The US “Jobs Jamboree” report released by the US Department of Commerce this Friday, September 7th was a real shocker to the so called experts. While the pre-release consensus guesstimate figure was for the addition of 100,000 jobs for the month of August the actual figure was a minus 4,000. This was the first time in four years that job growth was reported as being negative.

The Dollar immediately sold off hard on the news as speculation mounted that the Fed will cut interest rates by a full 0.50 basis points at its September 18th meeting. The Federal Reserve is in a no win position at this time. A cut in the Fed funds rate may help Wall Street but it certainly won’t help the Dollar which is already under a lot of pressure. And a collapsing Dollar given the extend of carry trade financing that will come unglued as especially the Yen gains strength can not possibility be favorable for the stock market.

There is likely major trouble coming next week for the Dollar and the stock market. The Yen gained over 200 pips today against the Dollar, finishing the week out at about 113.37. This was enough of a move that will force additional carry trade liquidation.

The important thing to remember about forced liquidations is that those forced to liquidate, like hedge funds, are finding there is no real market for their portfolios of funny money marked to model derivatives of which they are holding billions. The smart guys have outsmarted themselves.

The Summer forex action break is just about over. After labor day in the US pretty much wraps Summer up even though there are a few weeks to go before the calendar officially says that Summer is over.

All of Europe is pretty much on vacation during the month of August. Senior forex traders will be returning to their desks this week, very likely eager to get back to the task of trading forex and of spinning money.

Look for a very busy and active market this Fall starting about now. The Yen carry trade debacle will soon heat up again. The unwinding of the carry trade will likely be the dominant force at work in the forex and equity markets this fall.

Look for the Yen to gain against all currencies as the trade upwinds. In equity markets the fall out from the unwinding of carry trade positions is just getting underway.

The forex market should have an exciting Fall.

The carry trade developed out of the depression and deflationary period that Japan has endured for most of the past twenty years.

The Japanese government insured that the Bank of Japan supplied copious amounts of low cost credit to the Japanese economy in an effort to fight domestic deflation. During most of this easy money time period interest rates were near zero in an effort to stimulate domestic demand.

International financial operators soon learned that they too could take advantage of the low interest rates being offered in Japan. They were soon borrowing huge sums in Yen from the Bank of Japan, converting the Yen into Dollars, British Pounds, Euros, and high yielding currencies like Kiwis and the Australian Dollar, and then investing the proceeds in high yielding financial investments.

At first the proceeds of the loans originating in Japan were used to invest in traditional financial instruments, like US Treasury bills and notes. However, as what was considered by many carry trade operators as a “free lunch” continued large amounts of funds begin to flow into all sorts of real estate investments, mortgages, and hedge funds that had great flexibility as to how they could invest the funds.

So what started as a domestic Japanese operation used to fight deflation morphed into an international financing mechanism favored by the world’s “smart money” crowd. The sums involved with carry trade investments become so large that a great many people around the world became quite rich by collecting fees and commissions from the placement of these funds.