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Déjà vu All Over Again
Banks are suddenly uneasy about lending money to each other. The words "subprime" and "credit crunch" dominate the business headlines. And the U.S. Dollar is gaining strength. If you feel as if you are in a virtual "Groundhog Day" time loop, you're not alone; we could be setting up for a rerun of August, when the greenback gained six hundred pips vs. the Euro in just a few weeks. Already, the EUR/USD currency pair has plunged over four hundred pips this month, after peaking just shy of the psychologically important level of 1.5000, the point at which one Euro would be equal to $1.50 in U.S. funds. The pullback accelerated when two separate reports last week showed that inflation in the U.S. is alive and well. However, despite all the jubilation about the strong dollar, a reality check is in order. The monthly chart indicates that the uptrend in the EUR/USD currency pair is still intact. A much deeper pullback would be required just to pull this pair back to its trendline support, in the area of 1.40 (see figure 1).
Figure 1: Monthly chart shows EUR/USD trend is still intact. Source: Saxo Bank
In addition to the inflation reports, the buck was also supported by the Fed's decision to cut the benchmark interest rate by just 25 basis points on Tuesday. On Friday, during a visit with CNN's Charles Hodson, I pointed out that traders who had been screaming for Bernanke's head just a few days earlier now believed that the Fed had been right to cut the Fed Funds rate by only 25 basis points, instead of the 50 basis point cut they had previously desired. The Fed's actions were justified by the inflation reports. My only beef with Bernanke is that he didn't reduce the discount rate by more than a quarter point, but that issue was dealt with on Wednesday with the announcement of a massive effort to provide liquidity in conjunction with a Who's Who of the world's top central banks.
Cheers!
Less bullish than the Euro is the chart action on the GBP/USD currency pair, which shows a cascading series of lower highs and lower lows. The Pound is sliding ever closer to the magic 2.0000 level, the point at which one British Pound is equal to two U.S. Dollars. This area could act as psychological support (see figure 2).
Figure 2: Series of lower highs, lower lows on GBP/USD daily chart. Source: Saxo Bank
Here in London, the sentiment has turned against the British currency, due to falling housing prices and increased signals that exposure to the subprime mess is worse than previously anticipated. Still, tourists from the U.K. are spending freely on the streets of New York this holiday season, as the weak dollar has made spending sprees in the U.S. a holiday staple for the past few years. On Sunday December 16th, the New York Times featured a story about a family visiting from the U.K. who arrived in New York armed with credit cards and six large, empty suitcases that they planned to fill with gifts. Amazed at the bargains available, one member of the party remarked, "We had trouble spending all our money." Now that's a good problem to have!
Connect The Dots
Inflation is bad news for the economy, so why did the Dollar gain when the inflation reports were released? On December 13, the Producer Price Index report, also called PPI, showed that prices paid by manufacturers are rising at a 3.2% rate. Traders were only expecting 1.6%, and the rate of inflation was the highest measured at the producer level in over 30 years. On Friday the 14th, the Consumer Price Index showed an increase of 0.8%, worse than the anticipated rate of 0.6%. The CPI report confirmed the previous day's PPI report, showing that inflation was a problem for both producers and consumers in the U.S. economy.
The reason why the buck rallied on this news is because high inflation, while bad for the economy, makes it difficult for the Federal Reserve to reduce borrowing costs. The more the Fed cuts, the worse the inflation problem becomes. Fewer rate cuts mean that U.S. interest rates will be higher, and therefore U.S. Treasuries and corporate bonds become more attractive to investors seeking a conservative investment with stable returns. Since there is so much money in the world seeking higher yield plus safety, the reasoning is that the Fed's actions might be limited, and the resultant higher rates will attract money into the U.S. That anticipated flow of capital coming in to take advantage of higher than expected yields is what causes the underlying currency to strengthen.
What's The Deal?
What sort of arrangement did Bernanke and company make last week? The Fed joined forces with the European Central Bank, the Bank of England, the Swiss National Bank, and the Bank of Canada "ease the squeeze" and grease the wheels of commerce by providing ready capital. The Federal Reserve, which led the coordinated action, will lend $40 billion this month, while the others will offer a total of $50.2 billion this month and in January. The Bank of Japan said Thursday that it was also ready to act, and Australia's central bank put its weight behind the coordinated plan. Banks in those countries have so far been largely spared from losses related to the subprime mortgage problems in the United States, United Kingdom, and Europe.
This type of joint cooperation, done on such a major scale, is rare and shines a spotlight on the severity of the credit issue. So what is the real problem? Simply put, banks don't trust one another, and are afraid to lend capital to other banks out of a fear that the borrowing banks may have difficulty repaying the loans. Nobody wants to be the guy who OK'd a loan to a bank that, like a doomed dinosaur trapped in a tar pit, is unable to extract itself from the subprime ooze. Initially, the equity markets responded well to the news of this joint agreement, but the euphoria faded when traders realized this fact; no matter how much liquidity the plan provides, nobody can force banks to lend money to each other if they don't want to do it. Even after all of these months, the banks still don't know how much of these mortgage-backed investments each other are holding, or how bad the damage will be.
Start Spreadin' The News! Pop quiz – which Online Trading Academy location was voted Franchise of the Year for 2007? Why, New York of course! John Bang, Tony Michaels, and the whole gang at Online Trading Academy New York would like to invite you to attend a free seminar and book-signing event with me on Wednesday January 9, 2008. Hey, what else would you expect from the Online Trading Academy's Franchise of the Year? Mark your calendars and don't miss this event - I can't wait to see all of my friends in the New York area!
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through