Thursday, October 14, 2010

Lost in Transition

As the memories of summer dawn upon us and autumn's head-winds transition us into colder months, we remain stuck in a period of cryptic transition.  The green leaves are slow to transform into  red, yellow, and orange decay.  Throughout September and early October, temperatures here on the Eastern United States remain elevated with splashes of summer, spring, and autumn surprising us on a daily basis.  I seek clarity in these matters.   Moreover, when will a new forceful trend form and carry us into colder, cooler, and darker days?

This same phenomena can be easily applied to current market conditions.  We are at a a cliff looking over the edge and waiting to be pushed by "someone or something."  For the past month of trading the impetus for asset price appreciation came at the behest of the U.S. Federal Reserve.  Mr. Bernanke made it clear at the Fed's anual Jackson Hole Summit:

Notably, since December 2008, the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points. Moreover, since March 2009, the Committee has consistently stated its expectation that economic conditions are likely to warrant exceptionally low policy rates for an extended period. Partially in response to FOMC communications, futures markets quotes suggest that investors are not anticipating significant policy tightening by the Federal Reserve for quite some time. Market expectations for continued accommodative policy have in turn helped reduce interest rates on a range of short- and medium-term financial instruments to quite low levels, indeed not far above the zero lower bound on nominal interest rates in many cases....

In support of the stock view, the cessation of the Federal Reserve's purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads. 

Many Market participants took statements like these as indicative of greater 'Quantitative Easing' measures in the near-term with an emphasis placed on purchases of longer-term maturing Debt instruments.  Thus, the cruise ship 'QE2' set sail and every trader, analyst, investment banker, and speculator jumped aboard.  The rumors of 'QE2' allowed an appreciation  of equity prices, commodity prices, and a continued rally in the bond market.  However, many market participants fight a potentially painful hangover as they wait for another round of cocktails to tide them over.  Until 'QE2' becomes a reality, the current run-up in asset prices will continue to be predicated on rumors supported by ubiquitous supply & demand, fundamental, and sentimental data.

Consequently, The USD has taken the brunt of the pain over the past month of trading.  The US Dollar Index is down 6.8% in the period from September 1st -October 11.  Even though this downward trend has been in place since early June, the recent rumor mongering has certainly contributed to the Greenback's precipitous plunge in value.

EUR/USD has appreciated by 9% since September 1st.

OK so what, why does a weak dollar matter? As the emerging markets transition into developed economies won't the USD need to allow the wealth to spread to other currencies, 'new reserve currencies'?  In the future, the USD may no longer be the benchmark for which emerging market rates are pegged or for which all central bank reserves pile into.  However, these structural changes will not placate current financial psychology for some years time.  Hence, we must look at the short-term trends to discern directionality.  Disregard, financial profits, journalists, and fund managers who say otherwise.  Trade the trends.  Block out the noise.

-Patrick M. Ambrus


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