Afternoon Run … April 26, 2011

Key News

* Greece’s Budget Deficit Wider Than Expected (WSJ)

* ADB: Food, Oil Could Hurt Asia Growth (WSJ)

* Geithner Says U.S. Won’t Pursue Strategy to Weaken Dollar (Bloomberg)

* PBOC Plans Forex-Reserve Investment Funds (WSJ)

The Event Agenda


Afternoon Run-Down

The dollar is sitting on lows going into one of the most anticipated Fed meetings in history. Tomorrow we’ll get a statement from the Fed at 12:30 (according to Market News International) and then, for the first time, Bernanke will sit for a 45 minute Q&A with the press at 2:15.

Last month the Fed recognized that commodity prices had climbed “significantly” and were “putting upward pressure on inflation” but they considered the effects to be “transitory.”

With the ECB already in tightening mode, asset prices continuing a parabolic trajectory and headline inflation in the U.S. moving consistently away from the 2% area, there has been growing division among Fed members on the appropriate monetary policy. So, given that markets are pricing in no change in policy, there’s significant risk to the “asset reflation, weak dollar” trade if there is any hawkish leaning out of the Fed.

If their “transitory” view still holds, look for the Fed to acknowledge that the $600 billion asset purchase program will expire in June as planned. Any changes to that view may prompt the Fed to stop reinvesting principal payments from its current securities holdings and (in a more hawkish response) they may pull the plug on the remainder of their planned asset purchases due to expire in June.

In Europe, the news continues to worsen, yet the euro continues to print higher highs on this 2011 rally. An ECB board member said today "any debt restructuring would imply the breach of legal obligations, which most likely would have a more negative systemic effect than the Lehman [Brothers] catastrophe." The Greek government 2-year yields are now trading at a euro-era record high of 22.48%. And after bailouts and austerity, a Eurostat statement today showed budget deficit numbers in Europe for 2010 remain disappointing — Ireland at 32.4%, Greece at 10.5%, Spain at 9.2% and the UK at 10.4%.

Meanwhile, Geithner made an unusually specific statement on the dollar today saying that “our policy has been and will always be, as long as at least I’m in this job, that a strong dollar is in our interest as a country.”

With the day’s news clearly negative for the euro, it fittingly sits on the highs — maintaining its recent negative correlation with the deteriorating sovereign debt problems (and arguably common sense).

Here’s a look at the charts …

Key Charts

The Fed watch

Going into the Fed tomorrow, these charts from Bloomberg make the case for a tightening campaign to commence.


The Fed has maintained its target for fed funds at near zero as long as there is slack in the economy and inflation expectations are stable. The above chart shows to trending rise in capacity utilization (a closing of the output gap) which has historically led to a rising fed funds rate. Its last hiking cycle began right around this area on the capacity utilization reading.

Fed’s Dual Mandate …

Sticking to the Fed’s dual mandate of price stability and full employment … historically the Fed responds with interest rate hikes when the non farm payroll (the gray line) number begins trending positive (from negative).


Global FX Reserves

Last week China reported its FX reserves had grown to $3 trillion. Now Chinese officials are admitting that their currency reserve accumulation (thanks to their currency manipulation) is driving dangerous inflation. They say $3 trillion is enough. The below charts show the sharp rise in global FX reserves to $9 trillion (a third of which China owns).


In the next chart you can see the gradual decline in the dollar’s composition (from 70% to the low 60s) and the gradual increase in the euro’s composition of global FX reserves.


And because of this consistent build in China’s FX reserves in the past decade, and the gradual diversification into euros, the next chart shows its significant impact on the eur/usd exchange rate …


Fed’s last two statements – Side by Side …


Leave a Reply

Your email address will not be published. Required fields are marked *

Comments 1

Mike April 27, 2011

My two questions: if the Fed stops buying bonds, who steps in to fill the gap? And how does the Fed allow an increase in interest rates when interest on the debt already consumes 24% of the budget at these ridiculously low rates?