Trading Tip - As we have said over the past few days, current market conditions are not at all favorable for range trading. Volatility has surged market wide producing a number of breakouts, the winds of risk trends have kicked up, and the global calendar has filled out with a number of key rate decisions. With so much going on, few charts are carving reliable ranges. AUDCAD happens to be on of the few pairs that has an appealing range. And, what’s more, though there is considerable event risk from both the Australian and Canadian economies, our long position would be aligned with both the dominate technical trend and the underlying interest rate outlook. Forecasts suggest the RBA will hike a quarter point to 7.25 early Tuesday while the BoC lowers its benchmark a quarter to 3.75 later the same day. However, despite our promising positioning, there is still considerable risk in taking a trade with so much market moving data. Cautious traders should avoid range trades all together. To reduce risk on this trade, we will only take half our usual position to lower our wide risk. Also, we will cancel any open orders by Thursday or should spot hit 0.9225 before we are entered on our long trade.

Event Risk Australia and Canada

Australia - Australian economic event risk will pick up in the days ahead, but we hope that bullish Aussie data will be enough to lift the currency against its lower-yielding Canadian namesake. Indeed, markets broadly expect that the highly-anticipated Reserve Bank of Australia rate decision on March 3 will bring a further 25 basis points in yield to the Aussie. At the same time, the Bank of Canada is forecast to cut its interest rates by the same amount on March 4. Given such divergent monetary policy regimes, we feel that medium term risks remain to the topside for the AUDCAD. Yet range traders should watch out for key surprises out of Retail Sales and the RBA Decision on the 3rd, with the subsequent days’ GDP and Trade Balance numbers likewise to cause intraday volatility on the AUDCAD.

Canada - Canadian economic event risk is similarly elevated in the days ahead, but we hope that bearish results out of Canada will be enough to send the AUDCAD higher in the days ahead. Range traders should nonetheless be mindful of the fact that any particularly sharp surprises out of GDP, the Bank of Canada Rate Decision, or Net Change in Employment reports could easily derail our proposed range trade. As such, we urge a modicum of caution in setting position size and monitoring the position.

DailyFX

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The three rules of monetary policy- goes the old adage- are inflation, inflation, inflation.  Well, maybe not.  But that is certainly the story in the Middle East; Saudi Arabia’s official inflation rate is the highest in 12 years, and Qatar and the UAE have witnessed double-digit percentage increases, in annualized terms. Since their currencies are pegged to the USD, however, their Central Banks are unable to raise rates accordingly, leaving them with a tough decision: allow the currency to appreciate or watch prices spiral out of control.  It is the same story being told in every developing country that pegs their currency to the Dollar, and the members of the Gulf Cooperation Council (GCC) are certainly not exempt. As the ranking member, Saudi Arabia will all but determine if and how the official forex policy changes.  An announcement could come any day. The Gulf Times reports:

Mohammed al-Jasser, Saudi Arabia’s deputy central bank governor, had said last month that the Gulf Arab states should maintain their currency pegs to the US dollar regardless of rampant inflation in the region or the impact of US rate cuts.

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This week’s highlights

No, we do not believe that he will do that at the monetary-policy meeting next week. But he is carefully considering whether he needs to pull out the drawer with the cartridge or the interestrate weapon. The growth scenario in Europe has become more uncertain and the risk that American growth caves in - with a spill-over effect on the European economy - has increased over the past month after a string of very weak economic indicators.

We therefore expect the ECB to change its estimates when it presents new growth and inflation projections. With respect to growth, this means that the picture has become more negative and we therefore expect the ECB to cut 0.2-0.4 percentage point off its current growth estimate for 2008 which is 2.0%, i.e. growth will fall below the potential growth rate.

This is a growth scenario which matches our own growth estimate at the moment, but also a growth estimate which is currently under pressure by the weak American indicators. We still expect growth around 1.75% this year when growth will be weakest in the first six months but rise slowly in the last six months given that inflation falls and thus contributes to lifting the purchasing power of consumers, which will boost consumer spending a little.

With respect to inflation, the ECB is likely to revise up its inflation estimate from the current 2.5% to about 2.7%. This is a growing concern at the ECB. A current rate of inflation at 3.2% is much too high to the liking of the ECB. And it is the highest rise in the history of the ECB’s monetary-policy.

Although the ECB may see and also say that a very large part of the high rate of inflation can be ascribed to temporary factors - high energy and food prices - the bank’s concern is not removed with a stroke of the pen. The reason is that it fears that the high rate of inflation will lead to second-round effects, including that the current inflation rate will give the German unions another alibi in the on-going collective bargaining - in addition to sharply falling unemployment - to demand high wage increases.

This fear means that the ECB will be somewhat hesitant to cut interest rates although we assess that the high rate of inflation in the first six months of 2008 will fall towards 2% at the end of the year. However, a somewhat weaker growth picture than the current may prompt the ECB to react - also because slower growth puts a damper on the inflationary pressure - although the market forces are not always known to dampen prices and wages in all European countries due to rigid structures in the labour market. This means that if the growth scenario deteriorates and thus also the ECB’s assessment of the growth scenario, the first interest-rate cuts may come already in the last six months. We still expect unchanged ECB rates for the rest of the year.

This week’s other highlights

• The US: employment report and ISM for both the manufacturing industry and the service sector
• Japan: monetary-policy meeting at the Bank of Japan
• The UK: monetary-policy meeting at the Bank of England and PMIs

Monday

The US: ISM Manufacturing - February

ISM is the nationwide sentiment indicator for the manufacturing industry and gives a good indication of the development in industrial production and GDP. ISM may also signal whether the manufacturing industry has been hit by the financial crisis and the slowdown in the housing market. Moreover, it indicates how close the US is to a recession. Usually, ISM must fall to around 42 before the US is in recession.

The regional indices announced over the past few weeks - NY Empire State and Philly Fed - are both pointing towards a weak ISM number for February. Moreover, the leading indicators of the ISM Index: order intake, order books and stocks also point towards a weaker ISM overall.

Since the last announcement, the negative view has been strengthened by weak data about consumer confidence, the struggling housing market and a weak development in employment. We therefore expect ISM to fall after its rise in January, when it rose from 48.4 to 50.7.

In addition to the index, focus will be on new orders, production, employment and the price index.

The UK: PMI manufacturing - February

For the past couple of months, PMI Manufacturing has been falling, and in January it was 50.6 against 53.9 in November 2007. This means that the index is now at its lowest level since August 2005.. The order index pulled down overall PMI, falling in January to 49.7 which (since it is below 50), indicates a fall in new orders. It has not happened since 2005. This is partly due to export orders - the index of export orders fell to 47.6 from 55.3 in November 2007. Expecting slower growth in the UK as well as the important business partners the US and the euro zone - particularly during the first six months of the year - we find it likely that PMI will remain low or fall further in February.

Wednesday

The US: ISM Service - February

Moreover, the sentiment indicator ISM for the service sector, is important since it accounts for about 80% of the economy. The financial sector is part of the service sector. This is thus one of the indices where any consequences of the financial crisis are reflected. ISM for the service sector has so far been represented in the form of a production index, but as from January the ISM was calculated as a weighted index as is the case for the manufacturing industry. This will undoubtedly increase the interest in the ISM for the service sector, since it is expected to make the index more representative and less volatile.

The service sector index plunged in January to 44.6 from 53.2 (our calculation based on the indices included in the aggregate index). Although the growth situation has deteriorated in recent months and there was a certain degree of unrest in the financial markets in January, it is hard to see that the situation should have deteriorated this much in such a short time. We therefore expect ISM Service to stage a small come-back in February, albeit remaining at a low level. For instance, the order index fell sharply, and the order book thinned slightly in January. Overall, it does not point towards great activity in February.

The US: ADP employment - February

The ADP employment report gives an indication of the rise in employment in February (job report to be released on Friday). The survey covers only the private sector and is based on reports from the agency which manages wage payments to about 24 million employees (ADP). It corresponds to a little more than 20% of the overall staff in the US private sector. As it refers only to the private sector, the trend growth in public-sector employment of just over 21,000 a month should be added to the aggregate number of employees.

However, ADP is not always the best indicator of employment growth. For instance, ADP greatly overestimated growth in January when ADP reported a rise of 130,000 persons, whereas the overall employment fell by 17,000, and employment in the private sector rose by a mere 1,000 persons. This means that ADP’s estimate is likely to be regarded with scepticism.

The UK: PMI service - February

PMI service rose marginally in the past two months after a sharp fall during the period September-November. The index is now at 52.5 against 51.9 in November 2007 - the lowest level since May 2003. In August 2007 PMI service was 57.6. We expect that PMI service will fall slightly again as a result of slower-thanexpected growth - not least in consumer spending - a slowdown in the housing market and continued financial turbulence.

Thursday

The US: pending home sales - January

The number of pending home sales is a relatively good leading indicator of home sales. Pending home sales cover only about 20% of all home sales but are nevertheless a good indication of home sales in the following two months.

After two months of increases in pending home sales, we saw a fall in the past two months and they have therefore stabilised in the past four months just below index 90 (85.9 in December). However, home sales are still falling, though at a more measured pace than in Q3 2007.

Interest rates and house prices have fallen, and consumers’ disposable income for home purchases has risen by more than 17% since July 2007, pointing to an improvement in the housing market. On the other hand, the number of mortgage loan applications indicates falling home sales, and the combination of a large volume of homes for sales and falling house prices makes it less attractive for the speculative buyer to enter the market.

We expect the number of pending home sales to remain at the low level below 90 in January. This is an indication that we do not expect any decisive turn in home sales in coming months.

The UK: monetary-policy meeting at the BoE

We expect the Bank of England to leave interest rates unchanged at 5.25% following a quarterpoint cut at the meeting in February. Since the last meeting, the inflation report with updated inflation and growth forecasts from the BoE has been announced. The report indicated that the BoE will not lower interest rates so much as market participants had expected at some time, but the report still emphasised that lower interest rates are necessary. The monetarypolicy committee (MPC) is currently faced with an expected sharp slowdown in growth combined with rising inflation in the short term.

Inflation was above the BoE’s target of 2% y/y in January, and several indicators signal that it will rise further in coming months. The majority of the large gas and electricity suppliers have announced that they will increase prices in January and February, and a new calculation method for the consumer price index as of February will mean that these increases will affect inflation immediately (previously it took four months before such price changes were reflected in the inflation rates).

With respect to growth, retail sales delivered a surprise with a significant increase in January, but there are many indications that they were driven by an unusual level of sales in January, and the CBI survey of retail sales in fact indicated that retail sales will decline again in February. Furthermore, figures from the housing market still indicate signs of weakness, which will also contribute to slower growth in future.

Hence, nothing much has changed compared to the picture given by the BoE in the inflation report from the last monetary-policy meeting. The MPC is still facing an important decision since it has to weigh the risk that a significant decline in growth will pull inflation down below the target against the risk that rising inflation and high inflation expectations will result in a more lasting high inflation rate above the target in the longer term. We therefore expect interest-rate cuts from the BoE will take place gradually, i.e. we expect interest rates to remain unchanged over the next two months and then we expect an additional quarter-point cut to 5% in May.

Japan: monetary-policy meeting at the BoJ

The Bank of Japan has left interest rates unchanged at 0.5% since February last year, and we do not expect changes within the near future. According to the monthly report from February, the BoJ still expects moderate economic progress although growth seems to be slowing down. The BoJ also expects headline inflation to rise due to rising energy and food prices for the short term and higher growth for the long term. Core inflation (exclusive of food and energy) was still below zero in December.

Few economic indicators have been released since the latest meeting at the BoJ on 14 February. Figures for the industrial production in January have been released. The industrial production has fluctuated quite a lot since mid- 2007 and declined in January by 2% m/m, the largest fall since the same month the year before. However, in y/y terms, it is still at a fair level around 2½%. The manufacturers also expect the production to fall by an additional 2.9% in February followed by a rise of 2.8% in March. This means that the production will fall by 2½% in Q1, which will then be the largest fall since Q4 2001.

Given the prospects of slower growth in Japan and in the global markets, we do not expect the BoJ to raise interest rates again within the next months. A hike will not be mentioned again until core inflation (exclusive of food and energy) will start to show a convincing positive trend. Uncertainty about the development in the global economy increases the probability of slower-than-expected growth in Japan, which will keep the BoJ from raising interest rates in the short term. Therefore, we do not expect interest rates to be raised until late 2008.

Germany: industrial orders - January

New orders have been solid, and they are an important indicator since they indicate the future development of the industrial production. On the basis of the development in PMI new orders for Germany - this index has been below the long-term average in the past four months - we assess that new orders will now also be affected. We therefore expect a weak order intake in January.

Friday

The US: job report - February

As usual the job report is a very important economic indicator from the US. And focus on the job report has only grown after the surprising data in January when employment declined by 17,000 - the first fall in employment since August 2003. The employment indices for manufacturing and service for January indicate that a significant upward revision of the employment data in January should not be expected. Thus employment as indicated by ISM service declined from 51.8 to 43.9 (the lowest level since February 2002), and employment as indicated by ISM manufacturing declined from 48.7 to 47.1 (the lowest level since September 2003). After a sharp increase in unemployment in December to 5% from 4.7% unemployment declined slightly in January to 4.9%.

More important employment indicators for February will be announced next week - e.g. the ISM employment index and ADP. However, other economic indicators have been released which indicate that the labour market continues to weaken:

The number of jobless claims has been quite high in recent weeks. The four-week moving average was 360,500 in week 7, which is the highest level for the average since 2005. In February Conference Board Consumer Confidence stated that it has become increasingly difficult to get a new job (the jobshard- to-get index rose) and furthermore, there are not so many vacant jobs any longer (the jobs plentiful index declined).

With respect to the regional business indicators, the index of the Empire State dipped below zero for the first time since 2003, while the corresponding Philly Fed index increased in February.

Focus will also be on the wage development in the job report. Following significant wage growth in December of 0.4% m/m, average wages rose at a more moderate pace in January by 0.2% m/m. The annual rate of increase in wages has declined slightly in recent months to 3.7% y/y in January from. 4.1% in September. We also expect moderate wage growth in February.

Germany: industrial production - January

For December, the industrial production increased by 0.8%. This happened after two months of small declines in the industrial production, and with an average monthly increase of 0.4% over the past six months, the industrial production has shown quite a solid development and perhaps a better development than that of PMI manufacturing. The increase in orders in recent months - in spite of the fall in December - points to an increase in January. For the period ahead, a fall in the number of new orders is expected, which is also expected to spill over into the industrial production.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt

The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice. The analysis is for personal use of Jyske Bank’s customers and may not be copied.

Highlights

• EUR-USD hits new all-time high of 1.5240, USD-JPY approaches 104
• Fed representatives indicate further monetary policy easing
• Diminishing growth momentum in EMU makes interest rate cuts likely

Divergent Monetary Policies Lift Euro Over 1.50

It took the euro three months to break its previous record of 1.4968. Many people had no longer believed that this could happen. But this week, EUR-USD sailed past the 1.50 mark for the first time ever. The European single currency is currently quoted at 1.52, and the new all-time high is now 1.5240. The yen was also boosted by the dollar’s weakness. Supported by favourable Japanese economic data, USD-JPY is close to 104 at the end of the week. This is the strongest the yen has been since the end of 2004/beginning of 2005.

The move above 1.50 was triggered by a slight improvement in the ifo business climate index, and a steep drop in US consumer confidence. But the real reason is more deeply rooted: it lies in market participants’ impression that the European and US economies, and their monetary policies, are drifting apart.

That diverging monetary policies in two regions trigger exchange rate adjustments is nothing new. By January at the latest, the Fed had abandoned its reservations concerning inflation risks and has been pursuing a clearly expansionary policy since then. Various Fed members, including Ben Bernanke, have explained that particularly aggressive monetary policy action is advisable to guard against “financial accelerator” effects. At the same time, the latest economic indicators confirm that the slowdown in the US is now well underway:

• In the fourth quarter, GDP growth in the US slowed to an annualised 0.6% qoq, and there was actually a drop in domestic demand.
• Existing and new home sales, and declining prices, show that the housing market contraction is still ongoing.
• The January labour market report and the indicators available for February, particularly initial jobless claims, prove that the downswing has started to affect the labour market.
• Consumer confidence has now slumped to levels usually associated with the onset of a recession, and retail sales and personal spending are, at best, stagnating, if the price effects are excluded.
• Rising prices, especially for energy and food, are curbing purchasing power.
• For the last few months, industrial production has been more or less stagnant, in fact it is actually trending down: the February surveys for the manufacturing sector have deteriorated markedly.

The ECB, on the other hand, seems to be showing little inclination to follow the Fed’s example. Although it is expecting growth to weaken, it is hoping that private consumption and foreign demand, especially from buoyant emerging markets, will keep the economy going. In this growth scenario, and in view of higher cost pressure due to increased commodity prices and wage agreements, the ECB is still emphasizing the inflation risks. Indeed, Bundesbank president Axel Weber has remarked on more than one occasion, that the markets’ rate cut expectations are not in line with a stability-oriented monetary policy.

Diverging monetary policy expectations and the (expected) widening of the interest rate gap as a result, have been largely responsible for EURUSD breaching the 1.50 mark. However, with regard to the impending ECB governing council meeting, there is a risk of a market correction. At the beginning of February, the ECB refrained from propagating a growth rate close to potential, and deliberately so, in our opinion. Instead, it is now only talking of “ongoing growth”. At the same time, the ECB underlined the particular macroeconomic uncertainty in connection with the credit crisis.

At the meeting next Thursday, the ECB will introduce its latest staff projections. We are expecting the inflation forecast to be raised both for this year (middle of the range 2.6-2.7%) and for 2009 (to about 2.0%). However, we are also expecting the growth projections to be cut to around 1.6% for this year and 1.9-2.0% for 2009. The uncertainty of the forecast is likely to be indicated by a spread that is wider than the ± 0.4 percentage points usually projected in March. We could envisage a range of 1.0 to 2.2% for 2008.

We regard the lower half of the range as realistic; the growth risks in the euro area have increased rather than decreased over the last few weeks: firstly, higher energy and commodity costs are squeezing companies’ margins and households’ purchasing power. Secondly, the appreciation of the euro is hurting companies’ price competitiveness. Exports from the eurozone have already been losing momentum significantly over the past few months. Moreover, exchange rate developments seem to be increasingly affecting location and thus investment decisions. Thirdly, higher credit costs, tighter lending conditions and economic uncertainty will probably dampen investment activities. This will be particularly noticeable in residential construction, but is also likely to have an impact on investment in machinery and equipment.

Economic sentiment is constantly declining in the euro area, and the ECB Council will have to take this into account. We forecast that in the next few weeks, its monetary policy stance will shift further towards interest rate cuts. This will cap the euro’s rally.

BHF-BANK
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European Mid Morning Update

Releases from Europe

German retails sales marked a strong recovery in January bringing the annual pace back into the black. Note that the annual pace recovered strongly due to the large dip last year following the sales tax hike.

Still, overall it does show that the German consumer is still hanging in there and this will help cushion the softness generated in other areas.

U.K. house prices continue to decline with the annual pace dipping to the lowest level in over 2 years at +2.7%. However, the building society pointed out that this had more to do with the dropping out of large rises a year ago.

Indeed they feel the decline is slowing and probably close to a base for the time being at least. They neither see a return to strong price gains for ’some time to come.’

The following economic releases are due today:

December

Italian 2007 GDP +1.7%

January

U.K. M4 Money Supply (F) (MoM) +1.3%
U.K. M4 Money Supply (F) (YoY) 12.9%
U.K. M4 Sterling Lending GBP 21.6bn
Euro-zone CPI (MoM) - 0.4%
Euro-zone CPI (YoY) +3.2%
Euro-zone CPI Core (YoY) +2.0%
Euro-zone Unemployment Rate 7.2%
U.S. Personal Income (MoM) +0.2%
U.S. Personal Spending (MoM) +0.2%

February

Italian CPI (MoM) +0.2%
Italian CPI (YoY) +2.9%
Euro-zone Business Climate Indicator 0.75
Euro-zone Consumer Confidence -12.0
Euro-zone Economic Confidence 101.2
Euro-zone Industrial Confidence 1.0
Euro-zone Services Confidence 11.0
GfK Consumer Confidence Survey -15.0
Swiss KOF Consumer Confidence 1.6
U.S. Chicago PMI 49.7
U.S. University of Michigan Confidence 70.0

It’s month end and the end of a week which has seen the Dollar sink lower on the back of poor data and increased prospects of a recession in the world’s largest economy. How things can change so dramatically in the space of 12 months.

One year ago the market was still sunning itself in the comfort of the globalization boom only to be hit by an earthquake that has been felt around the globe. Can the same crisis occur in Europe?

No say the Europeans. But had you asked Fed officials a year ago they would have provided exactly the same response.

Only now that the financial markets have been weakened the vulnerability to further shocks potentially brings the risk much closer…

Never-the-less there is no additional crisis until it occurs and until then the States and the Dollar will remain in the firing line. The fiscal stimulation package actually looks as if it may be too late having seen the rise in jobless claims which will see consumer confidence sinking further deeper.

The release calendar is full but so full the market generally sits back and refuses to react with just too much to absorb.

On top of that most of the data is from Europe and thus will have limited impact. We have CPI numbers and European confidence numbers. Yesterday’s PMI numbers were good but a prominent feature of recent surveys has been the deterioration in consumer confidence and this could well be a problem for industry.

Thus for the while the Dollar will remain under pressure though the near term looks as if a small pause is possible. Not that the market will buy Dollars with enthusiasm but in these days of uncertainty profits pocketed provides a comforting feeling.

Note important support and resistance areas:

Ian Copsey
Global Forex Trading
http://www.gftforex.com

DISCLAIMER: This forum and the information provided here should not be relied on as a substitute for extensive independent research before making your investment decisions. Global Forex Trading is merely providing this column for your general information. The views of the author are not necessarily those of Global Forex Trading, its owners, officers, agents or employees. In addition, any projections or views of the market provided by the author may not prove to be accurate. Global Forex Trading and Cornelius Luca will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained in this column. Global Forex Trading and Cornelius Luca do not render investment, legal, accounting, tax, or other professional advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be sought.

The USD continued to rebound yesterday after a surprising gain in January Retail Sales suggested consumer spending was holding up….

… Retail Sales increased 0.3% last month, following a 0.4% drop in the prior month.

Government data showing higher Retail Sales in the month of January - diminished
economists’ expectations for a decline in the greenback. The report was also a
surprise for investors because it followed a weak January jobs report and shrinking
service sector numbers, which normally acts as an early indicator to sub par Retail
figures .

Yesterday’s data pushed the greenback primarily against the JPY, while against the
rest of the major currencies such as the EUR and GBP, the USD remained relatively
unchanged. Traders continue to scale back positions ahead of today’s’ testimony by
Fed Chairman Ben Bernanke. The Federal Reserve Chairman may signal more rate cuts in
the near future, as the last few days of bullish dollar behavior may only be a
glitch in the bearish dollar trend that has existed for most of 2007 and 2008. Based
on Interest Rate Futures, markets are expecting the Fed to reduce its benchmark
interest rate to as low as 2% this year, although expectations for another 50bp rate
cut have decreased. The market is now pricing in a 68% chance for 50bp cut, down
from yesterday’s 80%.

Today, the greenback’s momentum may continue as all attention will be focused on the
U.S. Trade Balance, Unemployment Claims data and Fed Chairman Bernanke’s speech. We
may see the greenback extend its gains across the board if the U.S. news surprises
on the upside but it may also retreat slightly as the current market sentiment seems
to be that the recent USD rally is running out of steam.

* EUR
After developing a small rally for 3 days running, the EUR lost ground against the
USD on the back of weaker Euro zone Industrial Production and stronger U.S. Retail
Sales numbers yesterday. The EUR was down 0.1% at $1.4569 after hitting a session
low at $1.4534.

The unexpected increase in Retail Sales, helped ease fears of an economic slowdown
in the U.S., placing some additional pressure on the 15 nation currency. The
European market was looking for Industrial Production to accelerate in the month of
January, but instead the indicator printed at -0.2%, far below the forecasted 0.5%.

Today, we await the release of the GDP data from Germany and France. Both of the
figures are expected to drop, further dragging the EUR down. Today’s price action
could be critical in determining whether the retreat this week is a correction or a
larger rebound in the greenback.

Also the ECB President Trichet is expected to deliver a speech later today in Spain.
The speech will be closely followed by investors for hints on future ECB monetary
policy. Today, we may see the EUR extending its losses against the USD if the U.S.
news will indeed surprise on the upside.

* JPY
Yesterday, the JPY dropped to a one-month low against the USD after U.S. government
data showed an unexpected rise in Retail Sales last month, easing concern that the
biggest economy will slide into a recession. On its way down, the JPY reached a low
of 108.37 before easing to 108.10 by the end of Tokyo session yesterday.

Carry trades unwind resumed yesterday as the Japanese GDP figure rose to 0.9%, after
growing only 0.3% through the previous quarter. On the other hand, The GDP deflator,
a broad measure of prices used to derive real growth from nominal, fell 1.3% from a
year earlier, the biggest drop since 2006.

Today the Japanese economic calendar is barren of any scheduled events. Forex
traders should keep an eye on the economic events around the world, as today could
prove to be very volatile.

Technical News
* EUR/USD
The pair is consolidating around 1.4570 with a moderate bullish momentum. The 4 hour
chart is still bullish and the daily chart indicates that there is still room to
run. 1.4590 is a key Fibonacci level which if breached will validate the next move
up with a target of 1.4650.

* GBP/USD
The 4 hour chart is showing a very strong uptrend with increasing momentum. The
1.9650 level was fully breached indicating that the bullish momentum will continue
to grow locally. The daily RSI is floating around 50 which indicate that on the
longer run we might see the trend reach 1.9850 as a valid target price.

* USD/JPY
The much anticipated breach through the 108.00 has occurred, as the pair now heads
up north. The positive slope on the daily slow stochastic strengthen the notion that
the bullish momentum is about to grow. Being on the buy side appears to be the right
choice today.

* USD/CHF
The pair maintains the bullish move with a diminishing momentum. The daily chart is
indicating an upcoming bearish with a potential to bring a bearish correction move.
The 4 hour chart is still bullish which make the selling on high strategy quite
feasible today.

The Wild Card
* Gold
The massive uptrend continues with full momentum as Gold is now regaining energy for
the next move on the daily channel. All oscillators support the bullish notion and
this could be a great opportunity for
forex traders to enter a very intensive uptrend with no intentions to stop.

www.forexyard.com

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It…

… is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started.

But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

That is the reason the Fed had thrown all caution to the wind - after a year in which it was behind the curve and underplaying the economic and financial risks - and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.

To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario - however extreme - has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume - as likely - that this recession - that already started in December 2007 - will be worse than the mild ones - that lasted 8 months - that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households - whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages - already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing - rather than reducing systemic risk - and making the credit crunch global.

Third, the recession will lead - as it is already doing - to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package - short of an unlikely public bailout - is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses - and potential runs - on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead - with a short lag - to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide - an institution that was more likely insolvent than illiquid - has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans - a good chunk of which were issued to finance very risky and reckless LBOs - is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone - not avoid - such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD - or recovery given default - rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen.

While on average the US and European corporations are in better shape - in terms of profitability and debt burden - than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection - possibly large institutions such as monolines, some hedge funds or a large broker dealer - may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that - like banks - borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system - stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession - rather than a mild recession - and a sharp global economic slowdown. The fall in stock markets - after the late January 2008 rally fizzles out - will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates - TED spreads, BOR-OIS spreads, BOT - Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion - will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds - about $80 billion so far - will be unable to stop this credit disintermediation - (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties - driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities - will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.

Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question - to be detailed in a follow-up article - is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response - monetary, fiscal, regulatory, financial and otherwise - is coherent, timely and credible. I will argue - in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.

Conclusion

Your working too early in Phoenix analyst,

John F. Mauldin
johnmauldin@investorsinsight.com
investorsinsight.com

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