Aussie and Cable Take Hedging Control

Want some 24 insurance against a falling portfolio, or need to know the best way to trade in-line with the long moves when the regional market is closed? If equity markets drop in value, a Gbp/Usd put may be the vehicle, here’s why;

Although I certainly would not rank it alongside Macro Man's dreaded vacation indicator or the incipient increase in the USD, if and when the Economist finally decides to slot its decline on the front page, I still have the nagging feeling that whenever yours truly sits down at either a dull and difficult econometrics lecture or, as today, camps at school for a lab session in connection with a paper due next month, some event is bound to wreak havoc on markets while your author is busy estimating regressions. I would assume that some US market participants felt the same Thursday as they gave thanks before hauling in the turkey.

In any case, this time around the skeleton that could be kept in the closet no longer is neither Baltic nor Spanish; it is Middle Eastern. At this point, I am of course simply trying to get an overview like the rest of you and not least deciding whether it will have any far reaching repercussions beyond Thursday's theatricals. However, in case you did not turn on your Blackberry Thursday, the story is that the Dubai government has requested investors in the debt of the investment company Dubai World whether they wouldn't be so nice as to accept a wee postponement of the payment of their debt. Especially, a payment due already the 14th of December in the form of $3.52 billion of bonds from property unit Nakheel PJSC looks as if it is near dead in the water.

The term “Black Swan” is used far too often in today’s discussions about the financial markets and it pertains to unforeseen events that cause havoc on the economy or the markets themselves. Last year was called a “Black Swan” event even though the warning signs were there for at least a year, some say since 2006. In today’s discussion the news coming out of Dubai is being hailed as another Black Swan event as they are talking about delaying payment on some of their debt on December 14.

The events in Dubai are the furthest thing from a Black Swan event as we have all known about this problem for the better part of 6 months or more. The country is in poor financial shape and is, basically, insolvent without a bailout from its neighbor Abu Dhabi. The rulers of the two nations are related. I would be willing to bet that the bailout will come in some fashion, but only after an example is made of the smaller nation, but is this a Black Swan event? What is a more relevant question is will a technical default on Dubai’s debt be a trigger for something bigger?

• Most asset markets follow the moves of global stocks, either moving in the same or opposite direction, but deriving that direction from global equities. That’s because equities are the best overall picture of global risk appetite (so much so that the movements of global stocks and risk appetite are virtually one and the same)
• The S&P 500, as the most representative index of the US stock market, still the world’s single largest stock market, is the one chart that best summarizes the prevailing sentiment, be it positive (aka risk appetite or optimism) or negative (aka risk aversion or pessimism).
• In general, in the short term the S&P 500 also drives the direction of currency value, especially that of the most liquid one of all, the USD. In sum, it is truly the One Chart to Rule Them All (yes, yes, of course there are exceptions, qualifications etc. Please, I’m trying to keep this simple for the lay-traders).
• Many commentators wrongly believe the opposite, that a weak USD drives stocks higher, due to cheaper US exports and inflated US multinational earnings from foreign revenues, and a strong dollar drags them lower. By the same logic underpinning this belief, European and Asian stocks should behave in the opposite manner, as a weak USD hurts their exports and earnings. In fact European and Asian stock markets move in the same direction as the S&P 500 relative to the USD. That is, when they rise, the USD falls, and vice versa. So what is the real relationship between the USD and stocks?
• Risk appetite/optimism about economic recovery and growth is best reflected in stocks. When there is optimism, i.e. rising stock markets, that causes traders to buy higher yielding currencies and sell/borrow the low yield USD (and a few others, but especially the USD) to fund these purchases at low interest, hoping to profit on the interest rate differential. In effect they are "shorting" the USD. When fear--aka risk aversion--rises, traders unwind these trades and buy back the USD, causing the USD to rise like a shorted stock. THUS STOCKS USUALLY DRIVE THE USD AND OTHER FOREX PAIRS, NOT VICE VERSA

Many US stock pundits still don’t get it. Many believe the USD is a primary cause of movements in the S&P 500 and other major stock indexes.

For example, look at the US stock market summary of the November 25th US stock market action published on Yahoo! Finance from Briefing.com, which opened with the following statements.

In my last post I indicated that the US Dollar was poised to rally because of excessive bearish sentiment. Many market analysts had opined that the stage was set for a USD rally but any USD reversal needed a spark such as a geopolitical event.

We may have seen that spark. The world awoke Thursday morning to the surprise news of the potential default by Dubai World.

Benchmark Currencies: 16 Dec 2008

click to enlarge

Overall, the sell-off from the equity markets had a major influence on the pound and on the aussie, but interestingly, it had only limited effects on the euro and swissy. Driven by risk-aversion, the yen broke below the 86.00 area, to reach the lowest value since 1995.

Thanksgiving Day has been historically very quiet in the financial markets over the last four years of trading, but today it proves to be a huge exception. Ahead, the market has some major uncertainties since the U.S. session is closed, but the volatility seen throughout the European session might attract some major players into the futures market.

There is something else for which we all should be thankful, foreign central banks. Thanks to indirect bidders (which consist primarily of foreign central banks), this week's treasury auctions (2-year, 5-year and 7-year) went very well. In fact today's 7-year auction was the strongest since last July. Not surprisingly, prices of long-dated treasuries rallied following the auction. What was surprising was the selloff of long-dated treasuries just prior to the auction. Did people really think that the auction would be a flop? For the past two months, predictions of waning interest among foreign central banks have been rampant. These predictions have been based on textbook theory instead of reality.

By Mike Conlon

As I gear up for the holiday invasion and the ensuing gluttony that’s about to transpire, I can’t help but look forward to my next vacation. I’m thinking somewhere tropical, perhaps the Caribbean, enjoying drinks with little umbrellas in them. I lull myself into daydreaming, counting waves and sunsets as island music fills the air. Yet all is not perfect. And then it hits me like a ton of bricks—the calypso music I’m hearing is being played by none other than our esteemed Fed Chairman Bernanke! He’s wearing a Panama Hat and a blousy Hawaiian shirt, playing a version of the Limbo: How low can you go! Only the participants aren’t drunken tourists, but dancing U.S. dollar bills, each trying to squeeze under a rapidly sinking bar to Bernanke’s amusement! The pleasant daydream has now become a nightmare, as I realize that I can’t afford another Painkiller with the mountain of cash I place on the bar. I awake in a cold sweat. Thankfully it is just a dream. Or is it?

This week the US Treasury has been raising money with another record breaking auction, 118B in total. Today 32B of 7 year notes is being sold. The current budgetary deficit, plus the refinancing of maturing debt issues has put the government in a position where they have practically an insatiable demand for more money. With the Fed's callous disregard for the future of the dollar, how much longer will foreign investors be willing to invest in our notes and bonds? Today's yield on the 7 year notes is forecast to be about 2.83%, hardly enough to compensate for a 10% yearly devaluation of the dollar. There is a lot at stake here, and it is hard to know how this is going to play out. Higher rates will dramatically increase the interest bill needed to finance the trillions of debt, derail the economic recovery, and cause unforeseen chaos.

As we said yesterday, this could serve as a turn in the Crude oil futures. We would suggest being long until $75.50 gives way on the January contract. The only disappointment is, prices should have been higher with the dollar falling off a cliff today. Natural gas as of this post is higher by 8.5%; if we were to close at these levels there should be much more left in the trade. $5.40 on the January contract is the 50% Fibonacci level and $5.60 is the 61.8%. We like being long January mini-futures. We may suggest rolling the January spreads out to February for clients…stay tuned.

Sugar is fighting the fight as prices were higher by 1% today; we suggest long March calls. On a trade above 1113 in the S&P we will be cutting losses on short futures, stay with the puts for now.

While large, the deficit is not exceedingly so, considering the economic problems we have faced and those we now confront. In fact, the stimulus program in retrospect was probably too small, all things considered, including the attending deficit.

The U.S. dollar has been sold off today and the European Central Bank (ECB) and the Bank of England (BOE) have added fuel to the fire. They continue to provide dollars to their member banks, which then appear to turn around and sell them.

While longer-dated dollar repos have largely stopped, the ECB and BOE continue with their one-week operations. The SNB had a dollar auction as well, but no bids were turned in.

The combination of the apparent resolution of the West LB situation and the FOMC minutes have conspired to send the US dollar broadly lower today.

The FOMC minutes in particular have been seized upon. On one hand, it is unusual for the FOMC to give so much space to a discussion about the dollar. This is, however consistent with what appears to be a stepped up campaign by both Treasury and Fed officials to cite the dollar in an unsolicited way. The ostensible purpose is likely to demonstrate that there is no "malign neglect."

The history of the dollar is one marked by a dominance unrivaled in history. Following the Bretton Woods Agreement of 1944, which established the dollar as the global reserve currency, Americans have enjoyed an era of unprecedented wealth and prominence.

The impressive growth in America could not have occurred without a stable dollar. Stable currencies are the unheralded but undeniable foundation of any vibrant economy. Stable currencies allow for longer term transactions and help instill confidence in the public, which is critical, since the value of any fiat currency is ultimately a function of public confidence.

Overall, the dollar index moved constantly lower during the overnight session as traders looked to add risk to their balance sheets. This has pulled the dollar index below the 75.00 area, the main swing point of the last two weeks of trading. The major pair’s uptrend was led by the pound, which surged on better quarterly data and by the yen, which fell to the lowest value touched since late January.

Ahead, the U.S. session is loaded with important news reports, which are likely to have an important influence on the currency market. Momentum and volatility are expected to pick up during the U.S. open.

On 26 November 2009 the State Bank of Vietnam devalued the dong by about 5%. This is the third instance of currency devaluation in two years. The FRN$ is likewise being devalued against gold.

A few weeks ago I observed that those buying gold in Vietnam are paying a premium and that:

Following on from our recent article posted that highlighted the short side of oil if 75.50 breaks, the market has got itself down to be able to easily test the 75.50 area on oil that was highlighted as important (did not take long, eh?). Under there, the market may find itself zoning in on the $71.92 area.

Now, if you do not trade the oil futures market, because of paying the cost of carry and then worrying about a few barrels of the black stuff being rolled down your front pathway, the alternative may be in a correlated Option play.