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Average Joe, the Ted Spread, and Pistachio Ice Cream
Greetings from Acapulco! The skiing in Colorado was great, but we needed a nice place to warm our toes. I'm still sifting through your backlog of questions, and I just want to say thanks to all of you for your overwhelming response. I've also noticed that the questions are becoming more diverse and sophisticated, which says a lot about you, the readers. On with your questions!
Q) Isn't the Fed showing it is really concerned with the trade balance by protecting our auto industry from foreign imports and making our massive debt not worth as much? Won't we then get more investment back to the U.S. with cheap prices? What becomes of the common man to shoulder this policy?
Ed Ponsi) Thank you for your questions. Weakening the US Dollar improves the US trade balance in several ways. First, as you pointed out, it's good news for GM and Ford, as they export more vehicles. It also makes European and Asian autos more expensive for Americans, so fewer autos will be imported. The trouble is, it doesn't stop there – the weaker USD makes everything Americans import more expensive, including oil. Despite the absolute shellacking that the Dollar has received, you may have noticed that the Trade Deficit really hasn't improved all that much. This is because any gains that were made through increased US exports are being at least partially offset due to the fact that we are paying higher prices for our imports, creating inflation (see figure 1).
Figure 1: The US Trade Deficit has improved only slightly despite the weak USD. Source: Briefing.com
While the weaker USD and ensuing cheaper export prices will lead to higher income for automakers and other exporters, this will not lead to higher investment in U.S. Dollar denominated instruments. If the USD continues to fall like a brick, overseas investors will be reluctant to invest in anything that will expose them to the weak greenback. This will mean less money invested in U.S. Treasuries, and in U.S. stocks, because investors do not want to be exposed to currency risk.
For instance, suppose you live in Germany and you decide to invest in U.S. stocks. Let's say you made a 10% profit, but when you pull that profit out and exchange it for Euros, you realize that the US Dollar has fallen by 10% against the Euro, wiping out your profit. You will likely lose interest in owning U.S. stocks. The same is true with foreign fixed income investors; many of them have been buying low-yielding Treasuries and are actually losing money on the exchange rate, despite collecting interest on the investment. These overseas investors are one of the few factors currently working in the Dollar's favor, but if we continue to alienate them with our plunging currency, their exodus from US investment markets could lead to lower prices for stocks and bonds.
The last part of your question is the toughest, but the most important – what becomes of the common man? Let's say A.J. (Average Joe) works at the auto parts store, and he just got a raise – in fact, he's making more money than ever. His raise was based on the Consumer Price Index (CPI), which is rising at an annual rate of about 4%.
Here's the problem – does anyone really believe that prices are just 4% higher than they were last year? If that were true, then on average, every item that cost $1 last year would now cost $1.04. Most analysts believe that government statistics significantly understate the true inflation rate, because many cost-of-living increases for entitlement programs are tied to the official inflation rate. Therefore, the government can save billions by reporting an artificially low inflation rate. According to John Williams, a Dartmouth-trained economist and Fortune 500 consultant, the only reason the inflation rate is so low is because the Reagan and Clinton administrations rewrote the way the CPI is calculated. By Williams' calculations, inflation is actually running at an annual rate of just under 10%.
Let's assume for the moment that Williams is correct. So while A.J. now earns 4% more dollars than last year, each one of those dollars is worth 10% less than a year ago. A.J. has more money, and yet he is poorer than he was before. If this keeps up, A.J. won't belong to the middle class for much longer. He'll be working harder, he'll be making more money than ever before, and he'll be poor. That is the real evil of inflation and of the weak dollar, and that is why we have to stop ignoring it and do something about it, before the middle class – the backbone of the nation - is sacrificed.
Q) This morning the TED Spread hit 221 basis points. It doesn't seem that Uncle Ben's efforts are making any difference in this credit crisis. Last summer the TED Spread hit the 200 basis points area, was it the beginning of the drop or at the end?
Ed Ponsi) Thank you for your email. First I'd like to get everyone caught up on the concept of the TED Spread. We start with the idea that an investment that contains risk should yield more than an investment that doesn't. For example, if a person invests in a 3-month Treasury bill, which is backed by the full faith and credit of the United States, it could be said that a person who holds that investment until maturity is certain to get his or her money back, plus interest. On the other hand, if this same person were to invest in a 3-month instrument that is not guaranteed, he or she should receive a higher return because the investment contains risk. The higher the perceived risk, the more the investor should get in return. This is known as "risk premium".
Now think of that guaranteed 3-month investment (T for Treasury) alongside the non-guaranteed 3-month investment, represented here by the 3-month LIBOR (ED for Eurodollar). T+ED = TED, and the TED Spread is the difference in yield between the two. The riskier the market environment becomes, the more likely traders are to put money in Treasuries, which drives up the price and lowers the yield. LIBOR is the London Interbank Offered Rate, and it rises as banks become reluctant to lend money to one another. So we have the yield on the safe investment falling, because everyone is piling into it, while the 3-month LIBOR is rising, because nobody wants to be the person who lends money to the next bank or hedge fund that needs to be bailed out. Because of this, the TED Spread has been wider than normal recently. It is considered a gauge of overall market fear.
In a normal market environment, the TED Spread is small, usually between about 10 and 50 basis points. For example, if the 3-month Treasury has a yield of 2.00%, and the 3-month LIBOR were currently 2.25%, the TED Spread would be 25 basis points, and that would be considered normal. The recent heightened state of anxiety has the current TED Spread around 140 basis points. Last summer, the TED spread began to rise as the words "credit crunch" worked their way into our collective consciousness. The spread deflated when Bernanke cut the discount rate in August, but as we know now, that was not the end of the story, it was just the beginning. A high TED Spread is not always indicative of an impending stock market crash, although the spread was quite high just prior to the crash of 1987. It simply indicates that the level of fear in the marketplace is elevated right now, as everyone wonders if there is another Bear Stearns-style fiasco lurking out there.
Q) Hi Ed, I'm new to this trading world, still a student. I want to better understand how it works. Can you please help me to understand the basic factors that affect all these transactions? Thank you.
Ed Ponsi) Thank you for your email; that's a pretty broad question, but I'll give it a shot. There are a lot of different factors that affect currency rates, but the supply/demand equation is at the heart of it. For example, when the Fed prints U.S. Dollars, they are adding to the supply of money. What happens when you add too much to the supply of anything? The value of the item is reduced.
For instance, imagine that you've just won a month's supply of pistachio ice cream. You hate pistachio ice cream, so you decide to sell it to your neighbor – only now you've learned that he's won a month's supply of the stuff too. In fact everybody in your entire city has won a free month's supply of pistachio ice cream. You can't even give it away! This is a case of too much supply, and too little demand. Your prize is essentially worthless on the open market because everybody else already has it; there is no demand for the product. The same is true of a currency, or a commodity such as oil, or really anything that is bought and sold on the open market – too much supply drives the value down, while increased demand (think gold or oil) drives the price higher. That equation is at the heart of every trading market.
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