Monday, 16 January 2012

Central Banking: A Study of Policy and Market Effects

Central Banking
Central Banks are institutions are utilized by nations around the world to assist in managing their commercial banking industry, interest rates and currency. The idea of a Central bank is not a new one though. The first examples of a central banking authority were seen in China with the first issuance of paper money nearly 1000 years ago. Other examples date back to the Knights Templar, looking for credit to finance their crusades. Many of the processes being tested in the past have been refined over hundreds of years of practice resulting in today’s modern banking systems.
Examples of Central Banking today include the Federal Reserve of the United States, European Central Bank (ECB), Bank of England (BOE), Bank of Canada, and the Reserve Bank of Australia. There sphere of influence of a central bank may range from a single country such as the Reserve Bank of Australia or, represent policy created for a region or group of countries such as the ECB. To show the effects of Central Banking in a modern society, we will focus on the Federal Reserve of the United States and their policy decisions.
The Fed
The origins of Central Banking developed in the United States as far back as the Revolutionary War. In 1775 the Continental Congress met with the intention of developing a national currency and a plan to finance the developing war effort. The sole value of the “Continental” relied on the future tax collection of the future independent nation. As the revolution drew on with no conclusion, overprinting and counterfeiting brought about the devaluation and ultimate demise of the Continental currency. When the constitutional convention of 1787 convened, one of the first priorities was the discussion of the current financial system. As of 1791 the First Bank of the United States was issued its original charter.
Much has changed since 1787! The Central Banking system of the United States is now known as The Federal Reserve, or simply the “Fed”. The modern Fed was created in 1913 by congress with the intent of providing the United States with a safer and consistently stable monetary system. The Federal Reserve achieves its goals by conducting monetary policy, and supervising and regulating banks.
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Bank Regulations
The primary reason for the creation of the modern Federal Reserve System was to stave off banking panics in the United States. This issue came to a head in 1907 during what has been dubiously called the “Bankers Panic”. During this time, stocks on the New York Stock Exchange fell nearly 50% from their 1906 highs. The end result of this crisis is that many banks and business were forced to either close or declare bankruptcy. As people worried they funds were unsafe at local banks, they would rush to withdrawal funds creating a massive shortage of capital.
The Federal Reserve is setup to avert a crisis such as the one experienced in 1907. A system is set in place where short term needs of small local banks can be handled if a “run” on deposits occurs due to unexpected withdrawals or regional emergencies. The Federal Reserve can easily loan money to small regional banks at a nominal charge called the discount rate. Once a run has been met, banks can then return their obligation back to the Federal Reserve. This policy is one of many tools the fed utilizes assuring the solvency of financial markets and bank depositories.
What Exactly is Monetary Policy
Monetary policy is another tool directly at the Feds disposal to achieve its goals. Monetary policy describes the actions that the Fed takes to control the money supply inside of the United States. Depending on the state of the economy, the fed may select to either take an expansionary or contractionary policy, with the supply of money being influenced by two specific methods.
During times of economic slowdown, the Fed often selects to peruse an expansionary policy in the market. This process begins by expanding the monetary base and decreasing interest rates. The theory behind expansionary policy is to make money more available to banks and businesses in an attempt to increase growth and development. As a byproduct of an expansionary policy, fundamental indictors such as GDP are expected to grow and unemployment decline.
As the economy heats up, the Fed will consider taking on contractionary measures. At this point, the monetary base may begin to be restricted and interest rates can begin to increase. These actions make excess investment capital scares, and place a higher premium on lending. With less capital circulating, the economy is expected to contract and slow down. During a time of contraction, GDP is expected to decline and unemployment to contrarily increase.
Effects on Currency Rates
By controlling the money supply, and interest rates, the decisions mandated by the Federal Reserve System have a direct influence to the strength / weakness of the USD. Previously, we discussed that when an expansionary policy is put in place, the monetary base is increased and interest rates decrease. By supplying more money to the market and banks than what is demanded values increase. This over supply of funds creates a flood of cheap dollars onto the open market, effectively diluting their value. The same holds true with Interest rates in an expansionary environment. As interest rates move lower, it becomes easier to borrow funds and the value of a currency tends to decline.
The opposing scenario holds true when the Fed assumes a contractionary monetary policy. A decrease in money supplied on the open market make capital scare. Scarcity drives up value for remaining funds and increases the value of currency. Increasing interest rates also has the same affect. Higher rates make funds more expensive to borrow, the barrier for lending decreases the availability of funds. Again as capital becomes scarce, currency prices are expected to appreciate.
What this Means to Traders
Knowing which policy cycle a central bank is taking can be a fundamental asset to currency traders. One recent example of a bank taking expansionary measures is the European Central Bank. One policy the European Central bank has employed is the lowering of interest rates. From their peak levels of 4.25% in 2008, the rates have declined 3.25% to an effective rate of 1.00%. Factor this in with an expanding monetary base as new debt is extended and refinanced, the Euro has been in a state of decline versus most major currency pairs. Below we can see the Euros descent against the Australian Dollar from 2008 – present. So far this pair has produced a maximum trend of over 8000 pips. We can use this directional bias in the market to then proceed and trade the strategy of our choice.

Euro Falls on France, Italy, Spain Ratings - Further Declines Likely.?

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Fundamental Forecast for the Euro: Bearish
What a week for the Euro. The single currency plummeted to fresh multi-month lows before surging above key technical resistance. Yet initial calls for a larger reversal proved premature as fresh Euro Zone sovereign credit rating downgrades pushed the EURUSD to new lows. Trading remains difficult amidst such unpredictable shifts in market sentiment, and the week ahead promises similar volatility on any and all changes in news coming out of the Euro Zone.
It seems imprudent to take a strong trading bias amidst such incredibly sharp swings in sentiment, and indeed we advise caution in the week ahead on potentially similar moves. The real question is whether recent deterioration in Euro Zone sentiment will be enough to force the EURUSD pair to fresh lows.
Standard and Poor’s spared almost no one as it downgraded the sovereign credit ratings of major Euro Zone countries. France lost its heralded AAA credit rating, while Italy and Spain both saw two-notch downgrades that leave them at BBB+ and A, respectively. Markets seemed focused on France, but it’s important to note that Italy is now a mere notch above ’Junk’.
One further downgrade for Italy could clearly have a negative effect on market sentiment. Yet perhaps more importantly, many investment funds are barred from holding any bonds below investment grade. Given Italy’s substantial debt load, forced selling of Italian bonds could have substantial effects on broader financial markets.
The immediate fallout from recent S&P downgrades may nonetheless be somewhat limited and short-lived given that traders had been pricing in such a possibility for quite some time now. The most recent CFTC Commitment of Traders report showed Non-Commercial futures traders—typically large speculators—were the most net-short Euro against the US Dollar in history. Commercial traders are likewise at their most net-long on record, and market sentiment is quite clearly extreme. The pronounced Euro downtrend undeniably favors continued lows, but reversal risks are especially high amidst such one-sided positioning.
The clear caveat remains that sentiment and positioning extremes are only visible in hindsight, and we could very well continue lower despite the overhang in short positions. This author has admittedly been warning of a potential bounce for some time now, and calling for a bigger EURUSD bounce proved premature.
Thus we’ll favor Euro declines until we see more clear evidence that price and positioning has recovered from extremes. Relatively limited European economic event risk leaves us trading off of broader market flows. It will be critical to watch early-week trade, as the first trading day often sets the tone for price action through Friday’s close.

Forex Market Outlook January @2012

Well we made it through another weekend after Friday's sell-off in risk currencies despite the fact that the Non-Farm Payrolls (NFP) came in much better than expected.  In Friday's discussion, I mentioned that even if the numbers exceed the official estimates there could be disappointment.  To be honest, the number was extraordinary and the market sold off anyway.  This means that it was very unlikely that any number could have satisfied the market and the Euro debt crisis is still the dominant economic story.

For further proof of this, look no further than the fact that another record was set for banks leaving money on deposit with the ECB, which is a sign of fear.  Another measure of this fear is that German short-term debt no has a negative interest rate.  In other words, there is so much demand for German paper that people are willing to pay to lend them money, and not receive interest.  This last happened here in the US back in 2008 during our banking crisis so the similarities are telling.

Enter Merkozy to the rescue!  Today's meeting between the French and German leaders is intended to hammer out the details of the fiscal rules that they agreed to last month and what further actions need to be taken in order to save the Euro.  Among these topics are the potential to increase the size of the bailout facility and how big of a haircut Greek bondholders may be required to take.  This could exceed the 50% losses that have already been discussed.

Meanwhile, the ECB is going to have their interest rate decision on Thursday and the speculation that Monti may try to emulate Bernanke's maneuvers is starting to pick up, as there is some thought that further monetary accommodation could be necessary to stave off a liquidity crisis.  This doesn't seem likely at this point and perhaps they will wait until the news out of the Merkozy meeting which they claim is going well at this point.

There is not a lot of news coming out of the US this week on the data front, but we are going into stock earnings season, which could have an effect on the US dollar if the correlations remain in tact.  But recently, it seems as though the correlations have been breaking down a bit so the impact could be lessened.

The Japanese markets were closed overnight for a holiday, and in the Euro zone German trade balance figures came in much better than expected on stronger exports, though industrial production figures came in worse than expected.  Later this week we will get the German Real GDP growth report on Wednesday, followed by CPI data and the rate policy decision on Thursday.

The Bank of England will also be releasing their rate policy but are not expected to have made a change.  Recall that the ECB decision also comes with an accompanying statement, whereas the BOE decision does not.

In Switzerland, the unemployment rate ticked slightly higher than expected to 3.3% from an expected 3.2% and retail sales figures came in better than expected showing a gain of 1.8% vs. the expectation of a .2% gain.  This comes in the midst of a minor scandal involving the currency trading prowess of the SNB honcho Hildebrand's wife, which is reminiscent of Hillary Clinton's commodities trading activity.  While this is likely much ado about nothing, there could be changes coming at the SNB.

Lastly, the Fed has the "dog and pony" show this week with a lot of Fed speak from various officials in different venues essentially trying to allay fears but you never know when one wrong statement can send the markets spinning.

And of course let's not forget the noise coming out of Iran and the potential oil supply disruptions that they threaten but likely won't act on.  Should the scene over there escalate then we could see oil spike higher.

So the markets are flat to slightly higher this morning, with US dollar weakness and the Euro bouncing off of lows that saw the Euro trade a 1.26 handle vs. USD.  If the Merkozy meeting produces positive results than this could quell the markets for a bit as the focus shifts to corporate earnings and the potential good economic story taking place here in the US.  So it may be risk-on again until the weekend where investors may want to lighten the load.