FXIB Fourth Quarter and Yearly Review With 2011 Outlook

Foreign Exchange Market

Fourth Quarter Review
In our fourth quarter outlook we predicted that the market had overpriced in the US Federal Reserve Quantitative Easing program and that the US economic recovery would strengthen. The US economy did produce stronger growth this quarter and the US dollar did initially rally once the market knew what the Quantitative Easing program would consist of. Some important economic events we witnessed this quarter includes Ireland being bailed out by the EU, China hiking interest rates and reserve requirements, and commodities continuing to rally.

Yearly Review
The US dollar finished the year stronger against the Euro, at the start of 2010 the exchange rate traded around 1.43, and finishes the year at 1.3365. The primary driver for the US Dollar gaining against the Euro is the European Debt crisis making Euro denominated assets less appealing to investors.  The Yen also made significant gains against the US dollar  in which at the start of 2010 the exchange rate was at 92.50 and finishes the year at 81.00. This year saw the Yen at record levels against the major currency crosses. The  US dollar finished slightly stronger against the British Pound, in which the exchange rate started at 1.61 and finishes the year at 1.55. The following should come no surprise, but the Australian Dollar made significant gains against the US dollar, rallying from .90 to 1.0200. The Australian economy has been  strongly supported by this year’s rally in commodities and Chinese growth. The Swiss Franc finished stronger against the US Dollar due to its “safe haven” status amidst the European Debt crisis. The Swiss Franc started the year at 1.0300 and finishes at .9300. The US Dollar also finished weaker against the New Zealand Dollar, as the New Zealand Dollar rallied from .7250 to .7800.  Last but not least, the US Dollar fell against the Canadian Dollar as the exchange rate went from 1.0550 to finish the year at .9900. The reason for the US Dollar decline this year can be largely attributed to a slow recovery and the US Federal Reserves Quantitative Easing  program in which the market severely overpriced.

The 2010 Commodity Bubble
Commodities posted a record gain as adverse weather slashed global crops, debt woes in Europe boosted demand for precious metals as investment havens and China consumed more of everything from cotton to copper. The Thomson Reuters/Jefferies CRB Index of 19 raw materials jumped 29 percent in the last six months of 2010, the most since the gauge debuted in late 1956. Last month the gauge reached 333.67, the highest since Oct. 1, 2008. Cotton extended a rally to an all-time high, silver rose to a 30-year peak and coffee jumped to the highest since 1997. In 2010, commodity prices beat gains in stocks, bonds and the dollar as China led the recovery from the first global recession since World War II. Crops were ruined by Russia’s worst drought in at least a half century, flooding in Canada and parched fields in Kazakhstan, Europe and South America. Corn and soybeans recorded the biggest second-half increases in five decades. We at FXIB believe commodities are in a bubble and have been in a bubble since the third quarter of 2010. Recent economic reports from China are indicating that the Chinese economy is starting to slow down and this should start to take the steam out of commodities. We at FXIB are expecting the commodity bubble to deflate in the first half of 2011 as market prices become more aligned with fundamentals. The US economy has not recovered to pre-2008 levels but yet commodity prices set new record highs that exceeded 2008 levels.

Looking Ahead at the First Quarter and  2011

We have identified 11 potential risks for 2011 that we will be keeping an eye on:

Potential US Dollar pluses:

1. European sovereign debt crisis intensifies, driving European yields higher.
   
2. European Central Bank drops vow to remove stimulus; adds liquidity instead.
3. UK adds to Quantitative Easing to offset economic drag of fiscal austerity.
4. Chinese property bubble bursts.
5. US yields rise as US economic recovery gains strength.
6. US adopts comprehensive long-term fiscal program modeled after Simpson-Bowles Commission recommendations
7. USD retains and builds on reserve currency status as central banks shun euro and reduce existing holdings.
8. Geopolitical uncertainty in Iran, Korean Peninsula revive USD safe-haven status.
9. Bank of Japan, Bank of England, and European Central Bank embark on expansive new monetary easing, including Quantitative Easing.
   
10. Bank of Japan joins Asian neighbors in actively managing the JPY FX rate
11. Commodities bubble bursts as fear of dollar collapse abates.

Potential US Dollar Minuses

1. US and Japan join global sovereign debt crisis; gold and other metals benefit
2. US yields fall as US economic recovery flags; deflation fears revive
3. UK economy rebounds despite austerity; Bank of England raises rates to contain inflation
4. US yields soar as government fails to get a handle on fiscal policy and market loses confidence
5. Risk appetites rise, fueled by a rush of global central bank liquidity sending metals, agricultural products and energy sharply higher
6. Emerging markets continue to grow steadily, drawing capital from developed markets
7. JPY resumes climb versus USD and Asian currencies as Japan keep money at home rather than seek higher returns abroad
8. European sovereign debt crisis abates; banks replenish capital
9. China engineers a soft landing, restraining inflation without damaging asset markets
10. India overtakes China, becomes the market focus in emerging markets
11. Euro regains market confidence, dollar’s share of reserves declines

Is USD/CHF the Canary in the Coal Mine?

10/26/10 - Click to Enlarge

For the past few weeks we have been expecting the dollar to rally and today we finally got another confirmation that the US dollar could finally be turning the corner.  USD/CHF  closed above the bearish trend line that has been in place since early June and consequently we think that the dollar could extend gains against the major currencies.  For the dollar to extend its gains, we would like to see Gold go below $1,300 an oz. Gold is currently trading at $1,335 well off its all time record high at $1,387. We have been keeping an eye on Federal Reserve statements and at this time we believe that at least 3 of the 5 voting members for next month FMOC meeting are hesitant about more QE. We are expecting QE around $500 billion,  the market has priced in a QE program of around $1 trillion so anything that is less then $1 trillion in QE should support the US dollar.  And of course, if the Fed doesn’t do any QE next week then the US dollar will rally.  At FXIB we believe that more QE is pointless and will have minimal impact on the recovery due to bond yields being near record lows. More QE will only create higher inflation as the economy recovers.  In regards to US bonds, bond yields have finally broken out of their bearish trend line. The  stronger yields have been supportive of the US dollar today, and is another confirmation that the US dollar could extend recent gains.

For the rest of this week we are looking for the dollar to continuing rallying against the Swiss Franc, Euro and commodity currencies.

FXIBonline Third Quarter Report 2010

Foreign Exchange Market
In the third quarter we saw the dollar sell off across the board, due to the Federal Reserve board being  bearish on the US economy and considering more Quantitative Easing towards the end of the year if need be. We do not foresee the Fed needing to institute more QE because we believe this summer was a soft patch in the economic recovery and will strengthen going into the fourth quarter. The US dollar has recently declined to a six month low against the Euro, the stronger Euro is already negatively impacting smaller European counties such as Greece and Ireland that actually need the Euro to depreciate to remain competitive and finance their debt.  It is also interesting to note that US dollar shorts have hit a high not seen since mid-2008. In mid-2008, the EUR/USD was trading at 1.60 and eventually sold off to 1.23 as traders and asset managers reduced their dollar short positions.  A benefit of the weaker dollar  is it will help our exports creating a positive impact on our economic recovery. The weaker dollar will act as a mini “stimulus” and should help the manufacturing sector which has been leading the recovery. A recent report by Bloomberg utilizing a purchasing power basis estimated that the Australian dollar was overvalued by as much as 67%. Not only does a strong Australian Dollar have a negative impact on the Australian economy, but it means that at some point Australia will need to take steps to curb the strength of their currency to prevent deflation.

Commodities
This past quarter we saw commodities prices at record highs.  Wheat hit 815.50 a bushel and currently is trading around 700, up almost 67 percent from its low in early June of 474.  Corn hit a high of 536 from its yearly low of around 356 also established  in June. This price action was prevalent throughout the commodity sector during the third quarter, including gold and silver which are enjoying all time highs.  What is causing this?  Russia was an unfortunate recipient of poor weather this year resulting in damaged crops with the consequence being a cap on their commodities exports. Australia has also struggled with production given their weather patterns however, the U.S. has managed to remain fairly consistent because of our technological advances such as irrigation and types of seed. One exception to this quarter’s commodity rally is oil. Oil has not enjoyed this surge in pricing primarily due to the underlying economic factors surround global expansion. Not even the massive oil leak in the Gulf of Mexico was able to  push prices significantly higher.  These kind of price increases remain unsustainable in the short term given that the US still has a 9.5% unemployment rate.  Many market participants including us at FXIB compare this current situation to that of oil in the summer of 2007.  When prices of commodities rise this high this fast the shock to the global system hits in waves, these waves cause mini bubbles in prices not only for food producers and consumers but in how banks structure loans and lines of credit based on overcapitalized hard assets.   As a result of these bubbles when markets do re-align themselves, (and they will as we saw with oil) you are left with over priced bonds, loans and market valuations that will not be able to be sustained at these historical price levels.  What does this mean for the average investor?  Be careful buying commodities or commodity tied investments at these prices. Based on our research, gold is not an effective hedge against inflation, but is  rather more effective as a  hedge against the debasing of the US dollar. If the US Federal Reserve does start more Quantitative Easing, commodities could rally further however, we do not believe the Fed will need to do another round of Quantitative Easing.

Fourth Quarter Outlook
Given this backdrop, we expect commodities and commodity related investments to sell off in the fourth quarter and possibly into the first quarter of next year. We expect the US dollar to recovery some if not all of its recent losses and will keep a close eye on the US Federal Reserve statements as to any clues or direction they may take in regards to Quantitative Easing. We are also keeping an eye on the Chinese Currency Bill that just recently passed the US House of Representatives. The bill labels China as a currency manipulator and gives US companies the ability to levy charges on Chinese imports. If this bill is signed into law, we should see AUD/USD sell off as a proxy for the USD/CNY exchange rate. This bill is the toughest response by the US in regards to China’s polices.  A currency war is already raging behind the scenes in which each country is trying to devalue their currency to stimulate economic growth. (what we call a race to the bottom).  We do expect volatility to remain about the same, and we will continue to keep on eye on the leading economic indicators for the US economy.

US Dollar Index Update

09/30/10 - Click to Enlarge

On September 14th I wrote about the Dollar Index short set-up that we anticipated hitting the market.  Since then the follow through on the trade has worked out perfectly and appears to be looking for a bottom and indicating a possible future dollar rally.  Several things happened this morning that I believe will help fuel the turnaround in the coming days:

1. Initial jobless claims came in at 453,000 better than the expected 457,000
2. GDP (QoQ) came in at 1.70% against a 1.60% forecast
3. Chicago PMI shattered expectations coming in at 60.40 against the forecasted 56

These good numbers will help to alleviate the market fears of quantitative easing from the fed that has the market shorting the dollar on lower interest rates.  Paired with the dollar turnaround, commodity currencies and the euro have enjoyed nice rallies through September and have the market a little overextended on the long side.  Europe’s debt crisis is far from over and the higher valuation of the commodity currencies is hurting their local economies.
So what to watch for:

• Consolidation around the 79-80 level
• A move above the previous point of resistance that comes in around 80.15
• Longer-term bulls look for a move above bearish trend line resistance and overcoming the 200 day moving average, currently at 82.126
• Open interest continues to increase with price stability which is generally an indication of bullish momentum.