How Will The Markets React?

How Will The Markets React?

Inflation pressures in New Zealand are expected to have held strong during the third quarter, as tight labor markets drive up wages and encourage domestic spending. Furthermore, rocketing food and energy costs are likely to fuel inflation as well, and consumer prices are estimated to have risen 0.8 percent from the second quarter, pushing the annualized rate up to 2.1 percent. Such an increase would be in line with central bank forecasts, as Reserve Bank of New Zealand Governor Alan Bollard said last month that CPI will accelerate to the top of the 1 – 3 percent target range by the end of 2007 and remain there until mid-2009. The situation has become somewhat dire in regards to inflation, as record-high interest rates of 8.25 percent may be unable to keep price growth under control. Furthermore, Finance Minister Michael Cullen has started to mull over introducing fiscal policies including tax cuts and increased government spending, which could fan inflation even further. The question is: can the RBNZ afford to raise rates even further? Given the potential for another round of monetary policy tightening to drive up the value of the New Zealand dollar even higher, the risks to export growth would likely be too large. However, if inflation growth starts to accelerate above the central bank’s target band over the course of the next year, RBNZ Governor Bollard may have no choice but start hiking rates again. As a result, if consumer prices for the third quarter prove to be stronger than expected, forex markets will likely respond in the sharpest manner and send NZD/USD higher.
Bonds – NZ 3-Month Government Bonds

New Zealand’s government bonds have done nothing but trend lower over the past year and a half, especially those with shorter-term maturities. Price action on the daily charts show the 3-month contract getting squeezed between channel resistance and trendline support, leaving it likely to break out. Upcoming economic data is expected to show that inflation pressures in the New Zealand economy continue to mount, which could lead traders to price in additional rate increases and take 3-month government bonds to break down through support at 91.27.

FX – NZD/USD
The combination of a return to carry trade buying along with rallies in commodities has helped push NZD/USD to retrace nearly 76 percent of the decline from 0.8110 – 0.6641. The pair has recently pulled back from resistance at 0.7760, though it is clear that the uptrend remains intact. However, the release of consumer price growth in New Zealand has the potential to shake NZD/USD up quite a bit, especially if the data deviates substantially from expectations. If CPI rises more than estimates, traders may start to speculate once again that the RBNZ will consider raising rates to yet another record high of 8.50 percent and push NZD/USD to break resistance and take on the 0.8000 level. However, if consumer price growth proves to be tepid, Kiwi could plunge towards trendline support near 0.7550 as investors will judge that the RBNZ’s ultra aggressive monetary policy tightening scheme earlier in the year has put a dent in inflation, and that economic expansion as a whole could be next.

Equities – NZX 50 Index

Similar to other global equity markets, the NZX 50 Index has rallied substantially since mid-August, but the record highs looming just above 4,333 have blocked any additional gains. If commodity prices continue to mount and traders remain risk seeking, the NZX 50 will likely take on the highs once again. However, if the release of NZ consumer prices shows that inflation pressures built up more than expected during the third quarter, speculation of additional rate increases down the line by the RBNZ could push equities lower. If such negative sentiment pervades the NZ equity markets, the index could break down through trendline support towards 4,230. However, if the data actually shows easing inflation, the NZX 50 rally could go on unfettered to target new record highs

Reserve Bank of Australia vs Federal Reserve: Battle of the Central Bankers

Reserve Bank of Australia vs Federal Reserve: Battle of the Central Bankers

A by-product of Australia’s and the US’s growth forecasts, the divergence in monetary policy has become another major driver for AUDUSD strength. The Reserve Bank of Australia (RBA) last raised its overnight lending rate in August by 25 basis points to an 11 year high of 6.50 percent. RBA Governor Glenn Stevens made it abundantly clear that he sees no reason to relax monetary policy, even with the recent ripple in the global credit market. The central banker remarked last month that the economy remains “strong.” More than likely, the outlook on expansion has to perform only well enough to allow the policy group to keep its concentration on inflation. Should growth hold steady, the RBA will remain fully occupied by core inflation hovering just below the central bank’s tolerance limit since peaking in 2006. Futures tied to Australian interest rates have priced in at least one more rate hike by the first quarter of 2008.
Australian monetary policy will continued to be measured against the Federal Reserve’s bias. The Australian dollar already enjoys a considerable 175 basis point premium over the US lending rate, but the forecast for future shifts in lending rates is clearly where the AUDUSD’s potential lies. The Fed has already set a somber tone for its own policy stance going forward, not to mention for other major central banks around the globe. On September 18th the Federal Open Market Committee announced its decision to cut the nation’s primary lending rate by 50 basis points to 4.75 percent.

Despite the considerable effort to forewarn the market of this impending shift from its previous neutral stance, the impact of the cut was hardly dampened. What’s more, expectations have been officially tipped lower, with further cuts priced into the futures market. However, there may be a glimmer of hope for the greenback. The minutes to the Fed’s two-day meeting in September offered no concrete indication of future cuts in the pipeline, perhaps buying time for the credit market to stabilize and inflation to come back into focus. After the report was digested by the markets, the probability of an October rate cut derived from Federal Funds futures dropped from 48 percent to 36 percent. So far, we have not seen a reaction in the AUD/USD despite a shift in interest rate expectations. This price action is important because it illustrates the overall demand for high yielding currencies.

Conclusion

After the Canadian currency’s momentous rise to parity against the benchmark US dollar, the strength of the commodity bloc and the significant weakness of the staple greenback were brought into focus. Considering the market currents that have consistently driven the loonie to its psychological high against the Forex market’s most liquid currency, it is easy to draw comparisons between USDCAD and AUDUSD. Australia is among the largest exporters of many of the world’s key commodities, while the US is one of the largest consumers of natural resources.

What’s more, the basic divergence in growth is clearly tipping towards the momentum underlying the Aussie economy with consumer spending, business investment and export income promising strength for the economy and currency in the months to come. Finally, the ever-present interest in the carry trade certainly favors the already high overnight lending rate attached to the Australian dollar, especially with the RBA holding true to its hawkish convictions and the Fed taking a big first step in a potential new easing trend. As a result, the Australian dollar hitting parity with the US dollar is not only possible, but probable.

Reserve Bank of Australia vs Federal Reserve: Battle of the Central Bankers

Reserve Bank of Australia vs Federal Reserve: Battle of the Central Bankers

Australian Dollar: The Next to Reach Parity?

It has been a record breaking past few months in the currency markets. While the EURUSD, the most actively traded pair in the world, made headlines when it surpassed its all time high late September; the story was quickly overshadowed by the Canadian dollar which reached parity with the US dollar. Six months ago, parity still seemed to be a far fetched idea for loonie traders and now, the Canadian dollar is actually stronger than the US dollar.

Could the same thing happen to the Australian dollar? Why not? The currency pair is closer to parity now than the Canadian dollar was five months ago. Although it is possible for the Australian dollar to be even with the US dollar, the better question to ask is whether it is probable.
The Australian dollar has already made its mark by rallying over 15 percent in the past eight weeks to a 23-year high against the US dollar. Clear similarities between the Australian and Canadian dollar’s advance could raise expectations that one Australian dollar could soon equal one US dollar. Like Canada, Australia’s economy is rich in natural resources; enjoys a strong economy supported by domestic spending; and has a central bank that is leaning closer towards further hikes than any sort of policy easing.

Australian Dollar Rally Contingent Upon Commodity Strength
One of the main drivers of Aussie strength has been its correlation with commodity prices. Shipments of raw materials like gold, coal, and iron ore account for nearly 64 percent of total exports. Although this leverages considerable dependence on one volatile sector of the economy, over the last few years, this influence has proved to be one of Australia’s leading sources of growth. With China sustaining double digit growth rates, their demand for commodities have been extremely robust.

A modernizing economy requires a greater use of energy and coal accounts for approximately 70 percent of China’s total energy consumption. As the world’s largest exporter of coal, Australia benefits significantly from China’s demand. From an economics stand point, greater demand for these goods translates into bigger revenues for Australian producers, stronger capital spending and higher employment.

In addition to coal, prices of gold have also been increasing – Australia is the world’s third largest producer of gold. The correlation between gold prices and AUDUSD can be seen in the graph below. Whether the AUD/USD can make it to parity will be partially dependent upon whether gold will hit $1000 an ounce. With gold trading at a 27 year high, there is no convincing sign that a top is in the making quite yet. Over the third quarter, gold prices climbed 16 percent or approximately $100 an ounce and it is now begging to at least $750..The main reason why gold has been so strong is because people have no faith in the US dollar – they took the greenback down to a record low last month.

Gold is seen as the safety net for many investors which means that the uptrend in gold will not give way until the US economy has hit a bottom. Should $750 an ounce in gold prove to be an unsurpassable barrier however, then so will 95 cents in the Australian dollar.

US Dollar Falters Despite Bullish Retail Sales, Forex Traders Predict Further Declines

The US dollar lost ground against major forex counterparts despite bullish results in the morning’s key Advance Retail Sales report. Such losses were ascribed to renewed speculative currency interest, with many forex traders pouncing on dollar rallies to sell it against the euro and the Canadian dollar. Though the greenback firmed through later price action, it remains relatively clear that risks remain to the downside through short term trade.

The Euro initially slipped against the dollar on the strong Retail Sales figures, but the single currency posted a strong reversal and remained higher against the greenback through later trade. Price action in the British Pound was similar to that of the euro, with the Sterling over 100 points off of intraday lows at $2.0350. The Canadian dollar was unsurprisingly stronger against its US namesake, setting fresh 31-year lows in the moments following the retail sales report.

Positive US economic data seemingly fueled the domestic currency’s sell-off, as strong Advance Retail Sales and Producer Price Index figures were unable to stem dollar declines. The key spending numbers reflected the strongest gain in six months—instantly improving sentiment on the state of the domestic consumer. A simultaneous Producer Price Index report showed that price pressures remain elevated for US industries, as headline PPI showed its strongest year-over-year change since June of 2006.

The net result of both reports was to cut expectations that the US Federal Reserve would reduce interest rates at its October 31 meeting. In fact, Fed Funds futures left the probability of such an event at 32 percent—a substantial change from the 50 percent probability priced in just a week ago. Given that the US dollar has fallen on expectations that the FOMC would cut interest rates further through year end, such a shift in forecasts should theoretically boost the greenback. Yet traders clearly had other things in mind as they continued sending the dollar lower against major forex counterparts. This is the second consecutive day in which the dollar has failed to rally on bullish news, and such trends leave little hope for a substantive rebound for the downtrodden US currency.

The Dow Jones Industrial Average posted a much more positive reaction to morning economic data, trading 0.3 percent higher to 14,060 through mid-afternoon price action. Stock market bulls seemed unconcerned that morning events decreased the likelihood that the Federal Reserve would cut interest rates further, instead focusing on positive signs for the strength of retail consumption. The highly diversified S&P 500 index was similarly bid at +0.3 percent to 1,558, while the tech-heavy NASDAQ Composite added an impressive 0.8 percent to 2,795.

Short term Treasury yields rose significantly on the day’s economic reports, with the 2-year Note jumping 7 basis points in yield to 4.19 percent. Bond traders clearly scaled back expectations that the Fed would cut rates, sending key short-dated debt prices lower in the process. The 10-year yield was less affected, adding 3bp to 4.67 percent.

Introduction to the Forex Market

The Foreign Exchange market

The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of US$3.2 trillion.
"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).
There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is trading for profit, or speculation.
For speculators, we believe the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.
A true 24-hour market from Sunday 5:00 PM ET to Friday 5:00PM ET, Forex trading begins each day in Sydney, and moves around the globe as the business day begins in each financial center, first to Tokyo, London, and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.
The FX market is considered an Over The Counter (OTC) or 'interbank/interdealer' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Trading is not centralized on an exchange, as with the stock and futures markets.

Role of Central Banks

Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, nor any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks, such as the Federal Reserve System in the United States, occasionally intervene to maintain stability in the FX market.
There is no standard definition of instability or a disorderly market—circumstance must be evaluated on a case-by-case basis. Sharp rapid fluctuations of exchange rates and traders’ reluctance to be ready to either buy or sell currencies (maintaining a "two-way" market) may be signs of disorderly market.
To restore stability, the central banks often work together. However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade patterns, interest rate differentials and capital flows.