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INTEREST RATE DIFFERENTIALS & THE MAJORS P. 6

CPI & the PCE

deator p. 13

Will Bitcoin

be a tradablecurrency? p. 10

Strategies, analysis, and news for FX traders

July 2014

Volume 11 No. 7

Lower for

longer risksination

p. 14

Ination &currencies

p. 20


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2 July 2014 CURRENCY TRADER

CONTENTS

Contributors.................................................4

Global Markets

The big three central banks: Interest rate

differentials and the majors .......................6

While July and August may deliver the

typical summer doldrums for traders, a mix

of factors could inject volatility into the forex

markets this fall.

By Currency Trader Staff

On the Money

Bitcoin far from being a

tradable currency .....................................10

A viable currency must satisfy three

basic criteria. Bitcoin is 0 for 3.

By Howard L. Simons

CPI and the PCE defator...........................13

Is ination really lurking around every corner?

By Marc Chandler

Behind the curve on purpose ............14

Lower for longer risks ination.

By Barbara Rockefeller

BarclayHedge Rankings........................18

Top-ranked managed money programs

Advanced Concepts

Additional currencies and infation

expectations .............................................20

Expected monetary policy responses

overwhelm differentials in expected ination.

By Howard L. Simons

Looking for an

advertiser?

Click on the company

name for a direct link to the

ad in this months issue.

Ablesys

Ninja Trader

FXCM

Questions or comments?Submit editorial queries or comments to

[email protected]
mailto:[email protected]:[email protected]


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CONTRIBUTORS


Editor-in-chief:Mark Etzkorn

[email protected]

Managing editor:Molly Goad

[email protected]

Contributing writers:

Barbara Rockefeller, Marc Chandler

Contributing editor:

Howard Simons

Editorial assistant and

webmaster:Kesha Green

[email protected]

President:Phil Dorman

[email protected]

Publisher, ad sales:

Bob Dorman

[email protected]

Classied ad sales: Mark Seger

[email protected]

Volume 11, No. 7. Currency Trader is published monthly by TechInfo, Inc.,PO Box 487, Lake Zurich, Illinois 60047. Copyright 2014 TechInfo, Inc.

All rights reserved. Information in this publication may not be stored orreproduced in any form without written permission from the publisher.

The information in Currency Trader magazine is intended for educationalpurposes only. It is not meant to recommend, promote or in any way implythe effectiveness of any trading system, strategy or approach. Traders areadvised to do their own research and testing to determine the validity of atrading idea. Trading and investing carry a high level of risk. Past perfor-mance does not guarantee future results.

For all subscriber services:

www.currencytradermag.com

A publication of Active Trader

CONTRIBUTORS

qHoward Simonsis president of Rosewood

Trading Inc. He writes and speaks frequently

on a wide range of economic and nancial

market issues.

qMarc Chandler ([email protected]) is the

head of global foreign exchange strategies atBrown Brothers Harriman and an associate

professor at New York Universitys School of

Continuing and Professional Studies. Chandler

has spent more than 20 years analyzing, writing,

and speaking about global capital markets. He is the author of

Making Sense of the Dollar: Exposing Dangerous Myths about Trade

and Foreign Exchange(Bloomberg Press, 2009).

qBarbara Rockefeller(www.rts-forex.com) is an interna-

tional economist with a focus on foreign exchange. She hasworked as a forecaster, trader, and consultant at Citibank

and other nancial institutions, and currently publishes two

daily reports on foreign exchange. Rockefeller is the author of

Technical Analysis for Dummies, Second Edition(Wiley, 2011), 24/7

Trading Around the Clock, Around the World(John Wiley & Sons,

2000), The Global Trader(John Wiley & Sons, 2001), The Foreign

Exchange Matrix (Harriman House, 2013), and How to Invest

Internationally, published in Japan in 1999. A book tentatively ti-

tled How to Trade FXis in the works. Rockefeller is on the board

of directors of a large European hedge fund.
http://clk.atdmt.com/FXM/go/475240343/direct/01/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.rts-forex.com/http://www.rts-forex.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


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GLOBAL MARKETS

The big three central banks the U.S. Federal Reserve, the

European Central Bank (ECB), and the Bank of Japan (BOJ)

are all boasting extremely accommodative monetary

policies. The high levels of liquidity from these policies are

sloshing around in the global currency markets and have

created extremely low levels of volatility and stability in

the major currency pairs. There havent been a lot of strong

trends for currency traders to ride in 2014.

Whats really behind the prolonged period of easy mon-

etary policy in the major advanced economies? Is there

light at the end of the tunnel or has secular stagnation

gripped hold of the developed worlds economies? The

Fed is scaling back on its monthly bond purchases, but the

target policy rate remains stuck at 0-0.25%, where it has

been there since 2008. Who are the currency winners and

losers this year based on global interest rate differentials?

How will monetary policy changes this year and next

impact the majors? Lets take a look.

Big picture

According to Nomura, global gross domestic product

(GDP) is estimated to grow at a 3.2% pace in 2014 vs. a

2.9% rate last year. That breaks down to 1.8% for devel-

oped nations and 4.6% for emerging markets. While the

rate of growth is positive and improving slightly, the pro-

longed period of sluggish growth in the advanced econo-

mies begs the question are we mired in secular stagna-

tion or an extended long-term period of slow growth?

The argument of secular stagnation suggests the major

economies will grow very slowly by post-war historical

averages, says Cary Leahey, senior advisor to Decision

Economics. It has happened for the past two decades in

Japan; the worry now is that its spread across the devel-

oped world. The economic downturn from the collapse of

the financial services industry around the globe created a

situation where banks are trying desperately to come up

with unconventional means to get stated interest rates as

close to zero as possible. The actual rates of interest are too

high relative to what the economies need.

Currently, the U.S. Federal Reserves official policy rate

stands at zero to 0.25%, the BOJs rate lies at 0.10%, and

the ECB policy rate is 0.15%. Also, in early June the ECB

shifted to negative deposit rates when it slashed the rate

on bank deposits parked overnight with the central bank

to -0.1% from zero. Market watchers continue to expect

additional moves from the ECB with the potential for full-

scale quantitative easing in efforts to boost the eurozone

economy. Currently, both the BOJ and the Fed are still

engaging in quantitative easing policies or buying assets to

keep interest rates low.

Secular stagnation

There are differing views on whether the U.S. and major

economies have actually entered so-called secular stagna-

The big three central banks:Interest rate differentials

and the majorsWhile July and August may deliver the typical summer doldrums for traders,

a mix of factors could inject volatility into the forex markets this fall.

BY CURRENCY TRADER STAFF
http://www.ninjatrader.com/


7/23

CURRENCY TRADER July 2014

tion, and its likely only time will tell.

Weve had a long period of slow growth, says JayBryson, global economist at Wells Fargo Securities.

Business fixed investment hasnt been strong. One of the

things that drives long-term growth is the growth of the

labor force and productivity growth.

Slow business investment in turn leads to slower pro-

ductivity. Currently, U.S. productivity growth stands at

1.4% on a year-over-year basis, notes Bryson. That com-

pares to an average of 2.3% per year during the last expan-

sion cycle in the U.S. from 2003-2007.

Nonetheless, Bryson is optimistic that the outlook is

improving. His firm forecasts global growth at 3.4% thisyear and 3.8% in 2015, which

compares to the long-term

global GDP average of 3.6%

over the last 40 years. During

the 2004-2007 period, global

GDP was growing about 5%.

That [was] a boom, Bryson

says. We arent booming, but

we are growing.

Ryan Sweet, director at

Moodys Analytics, weighsin. We dont subscribe to the

idea that the U.S. economy

is headed for a long period

of secular stagnation, he says. In order to buy into that

argument, Sweet notes that policy makers both fiscal

and monetary would need to step back from efforts to

boost demand. It would be politically unpopular to take a

laissez-faire approach, he says.

Nonetheless, Sweet admits that weve been in this rut

for a long period of time with U.S. GDP growth stuck at

about 2.0%. We have a significant shortfall in demand.U.S. businesses are still very cautious in hiring. Consumers

are spending, but not as they did in the past. Theyre

working through the deleveraging process, he says. He

says the demand issue extends globally as well, with

Europe now emerging slowly from its second recession

and the slowdown seen in the Chinese economy. From

the U.S. perspective, we arent getting demand needed

from abroad to support exports, he explains. Over the

last several years, pessimism has become very popular.

People have forgotten that the U.S. economy can grow

north of 4%. Sweet is optimistic that housing will contrib-

ute to economic growth this year and over the next two

years helping to drive the overall GDP rate higher.

Interest rate differentials

With expectations for U.S. growth to pick up, the Federal

Reserve is seen as being on auto-pilot in its reductions

of monthly bond purchases. It is estimated that the current

program of quantitative easing will wind down this fall.

Through late June, the Feds balance sheet stood at $4.368

trillion and will continue to grow until the QE program

officially ends.

However, even once the official bond purchases con-

clude, the Fed still faces a historically unusual monetarypolicy exit. The Fed is in uncharted

territory, Sweet says. This tighten-

ing cycle will be significantly differ-

ent from the past cycles. He laid out

the steps the Fed will need to under-

take in the months and years ahead,

which include reducing the size of

the Feds balance sheet, locking up

excess reserves to prevent them from

flowing out into the economy too

quickly, and normalizing interestrates.

Also, there are many questions

about how the Fed will move for-

ward with this tightening cycle. Currently, Sweet pegs

the odds at 50-50 that it will switch away from the federal

funds rates as its primary policy rate. He points to other

options such as the repo rate or the IOER (interest on

excess reserve rate) as other key tools. The Fed will have

to be crystal clear about how it will use its various inter-

est rates, he says. If the Fed switches its primary lever, it

will increase uncertainty.With the Fed attempting to navigate a likely complicated

exit strategy, other central banks around the world are also

in various stages of their monetary policies. Forex traders

will be watching for signs of impending policy shifts to

gauge potential impact on the underlying currencies.

Forex action

Looking ahead, the relative trajectory of central bank bal-

ance sheets could be a key driver for currency movement.

Currently, the Fed is tapering by $10 billion per meet-

ing, says Richard Franulovich, chief currency strategist at

The Federal Reserve

is seen as being on

auto-pilot in its

reductions of monthly

bond purchases.


8/23


GLOBAL MARKETS

Westpac Banking Corp. There is a steady pace of buying

by the BOJ and the pedal is on the floor as far as the ECB

is concerned. The ECB could see an expansion of their

balance sheet by $500 billion euro. With the euro trading

around 1.36 in late June, Franulovich sees potential for the

currency to fall to the low 130s this year.

Of the three, the Fed is the one that is moving toward

a less accommodative stance, as it continues to pare backbond purchases, Bryson says. The ECB is probably years

away from hiking rates. They could become more accom-

modative this fall. They could go to full bond purchases

this fall. The bias has become more accommodative. The

BOJ continues to expand its balance sheet. There is a lot

of volatility in the economic data as a result of the recent

consumption tax hike, but they wont be moving to a less

accommodative stance anytime soon.

Vassili Serebriakov, forex strategist at BNP Paribas,

pointed out that monetary policy differentials remain

important drivers in forex trade: Looking at the curren-cies that are doing well this year, New Zealand is the best

performer since the start of the year and its central bank is

raising rates. The British pound has been doing well over

the past several weeks, a reflection that markets are start-

ing to anticipate a rate hike by the end of the year. It will

be important for the dollar as well especially if the Fed

were to hike earlier than markets are expecting, he says.

Winners and losers

Market watchers have been anticipating the expectation of

U.S. Fed rate hikes to strengthen the dollar for months, and

that remains a key forecast going forward. The dollar has

eked out some modest gains, Sweet says. But, markets

are watching central banks to see which starts to exit first.

Right now, it seems like it will be the Bank of England, the

Fed, and the ECB; the Bank of Japan will be well behind

everyone else. The dollar will do fairly well over the next

couple of years as we start to see interest rate differentials

swing in favor of the U.S. as the Fed begins raising rates.

Serebriakov points to the pound and New Zealand

dollar as currency winners and the euro and yen as cur-

rency losers based on the interest rate differential outlooks

ahead.

Bryson agrees. The euro should be a loser; the yen

should be a loser. In the near term, with Fed rates at zero,

the Brazilian real and Mexican peso will strengthen vs.

the U.S. dollar. But as we get closer to the Fed pulling the

trigger and hiking rates, we should see those currencies

weaken, he says.

Volatility ahead

Currency markets have been mired in one of the longest

periods of low volatility seen in years.

Volatility is continuing to grind lower to multi-year

lows. Its clearly unsustainable and below long-run aver-

ages, Franulovich says, noting that as of late June, the

one-month implied volatility rate in the euro had fallen

to its lowest levels since mid-2007. However, he saw the

potential for volatility to pick up as the Fed approaches the

end of its tapering. The end of the program could dam-

age risk appetite, he says. Markets are not as forwardlooking as we think they are. The reality that the Fed is no

longer effectively underpinning markets could give the

dollar a further boost. The reality of it could be a rocky

program. The Fed is expected to bring its monthly bond

buying purchases down to zero around October.

If the expected pace of Fed rates hikes moves forward,

it could also inject some volatility into the forex markets.

The markets have the fed funds rate south of 2% at the

end of 2016. But the Feds projections have it closer to

2.5%, Sweet says. Inflation has accelerated over the past

few months. Inflation is going to overshoot the Feds target

at 2%. The Fed will quickly have to get aggressive, because

the economy will be at full employment by 2016.

So, dont be surprised if Fed rate hikes materialize

sooner than expected. Given the economys near-term

prospects, the Fed will have to raise rates more aggres-

sively than they are leading on right now, Sweet says. He

pegged the fed funds rate at 1% by the end of 2015 and

north of 3% by the end of 2016.

While July and August may deliver the typical summer

doldrums for traders, a mix of factors could inject volatility

into forex markets this fall.y


9/23

CURRENCY TRADER July 2014 9
http://www.activetradermag.com/http://www.activetradermag.com/http://www.activetradermag.com/


10/23

Enron had a trading platform called Enron Online during

its glory days of the late 20th and early 21st centuries. The

company held itself out as a market maker across all man-

ner of exotic options, most of them hard to price and many

of them at the 200% or so volatilities for which power mar-

kets are famous.

One of these markets was bandwidth, which can be

thought of as a service where the buyer exercises a fixed-

price call option on the seller. It was a

difficult market to understand, since youcan keep adding bandwidth, it cannot be

stored, and its value turns to zero once

demand drops. I decided then, what-

ever the bandwidth market would do, it

would do without me. My thoughts on

Bitcoin are similar, even though I have

some philosophical sympathies for it.

Money

Money is supposed to represent three

broad purposes: a medium of exchange,a store of value, and a unit of account.

Essentially, people create economic value and then want to

swap their creation for those of others. Barter was the first

way of doing this, but if you have an economy of N goods

and services, you need to establish (N2-N)/2 barter rates

between them.

However, if you create one good money in which

all other goods and services can be priced, you only need

N prices. Moreover, if the supply of that money can be

aligned with the quantity of goods and services, you can

achieve some measure of price stability.

Two other issues arise. First, those words on a Federal

Reserve note (aka a dollar bill) This note is legal ten-

der for all debts public and private actually mean

something. The seller of goods and services mustaccept

it in payment if offered. Second, just as we entertain the

fiction a share in a money-market mutual fund has a $1

fixed value and therefore triggers no capital gains and

losses when bought and sold, we entertain the fiction

that a dollar today is the same as one

yesterday and one tomorrow, to avoidtaxation.

We all know matching the money

supply to the growth of the economy

is easier said than done, and has been

forever. People thought gold an

almost magical commodity in the sense

it is rare, durable, easy to work with,

and readily distinguishable from other

metals was the perfect store of value.

It could be adulterated to a point, but

unless someone found new gold mines,the supply could not expand at officials

whims.

You should not cry for either Argentina or the gold

standard. While central bankers could not print gold,

miners could find it or conquistadores could steal it; both

produced inflationary pressures. In between these supply

shocks, deflationary pressures reigned as the supply of

goods and services could expand far faster than the money

supply could.

Money does not have to be state-issued. Banknotes

were used frequently in the 19th century, but they had an


Bitcoin far from being a

tradable currency

A viable currency must satisfy three basic criteria. Bitcoin is 0 for 3.

BY HOWARD L. SIMONS

ON THE MONEY
http://www.activetradermag.com/


11/23

information-cost problem: You had to know the credit

quality of each bank, and you had an incentive to pay with

lower-quality notes and to get paid with higher-quality

notes. Hence the famous Greshams Law: Bad money

drives out good.

Because the government can mandate legal tender, andif the government ceases to exist its citizens have other

problems, the notes issued by the central bank have the

lowest cost of information and the lowest risk in transac-

tions.

Offsetting these attributes, of course, is the risk of the

government trying to repudiate its debts by debasing the

currency. Today you hear Federal Reserve officials speak

of debasing the currencys value by more than 2% per year

as a national goal as opposed to prima facie evidence of

sociopathic behavior.

Is Bitcoin money?

A guy walks into a bar. He orders a drink and tries to pay

with Bitcoin. The bouncer indicates this thought process is

unsound. After all, the bar does not have to accept Bitcoin

and the patron has no legal standing to compel it to do

so. Bitcoin fails the medium of exchange part of moneys

definition and will continue to do so until laws are passed

making it legal tender.

What about the store of value part? Volatility, as every

trader learns the hard way, can be your best friend or

your worst enemy. Bitcoin has some real problems in this

area, as evidenced by its price history since May 22, 2013,

when the Federal Reserve began discussing tapering its

quantitative easing program. If we accept the fiction that

a dollar has a fixed store of value whose daily changes in

purchasing power are small enough to ignore, we place

its standard deviation of daily returns at some level nearzero. For the sake of intellectual honesty, if we ever enter a

period of hyperinflation, that standard deviation of daily

returns will rise.

Lets add gold and the U.S. dollar index to the compari-

son. Their standard deviations of returns over this same

period (since May 22, 2013) were 1.15% and 0.36%, respec-

tively. The dollar index is less volatile than gold because

we are measuring the dollar relative to other paper curren-

cies managed by similar-thinking central banks, while the

dollar price of gold measures absolute changes in the old

barbarous relic. The standard deviation of Bitcoins returnswas a lusty 8.73%. This is far closer to a commoditys real-

ized volatility than a currencys.

We can illustrate Bitcoins wild ride in two related ways.

The first is by charting its price and that of gold and the

dollar index on a common logarithmic scale reindexed to

May 22, 2013 (Figure 1). The dollar index, a popular trad-

ing vehicle, looks flat on this basis while golds volatility

is at least visible. Bitcoins volatility has been large and

two-way. (Notice the two missing days in the Bitcoin price

series. When was the last time the dollar had a missing

day?)


FIGURE 1: BITCOIN TOO HOT TO HANDLE: PRICE


12/23

ON THE MONEY


Mapping the 30-day close-to-close realized volatility ofthese three markets over the same period shows Bitcoins

realized volatility is more than one order of magnitude

larger (Figure 2). This high and two-way volatility cre-

ates an oscillation in Greshams Law unanticipated by Sir

Thomas Gresham in the 16th century: If you think Bitcoin

is in an uptrend, you do not want to spend it but rather be

paid in it, and vice versa for periods when you think it is

going down. Restated, if Bitcoin is accepted more widely

and its price starts to rise as golds did from 2001-2011, it

will quite literally disappear from commerce because its

fans will hoard it. An unseen currency fails the unit of

accounting aspect of money.

Signaling

Just as the real value of 19th century populists call for

cheaper money, exemplified in William Jennings Bryans

1896 Cross of Gold speech, was a signal to authorities

the persistent deflationary pressures of the gold standard

might cost them their jobs, their heads, or both, the real

value of Bitcoin and other virtual currencies might be to

signal to authorities we cannot allow central banks to keep

engaging in de facto monetization of government debt.

This is a real value; whether policymakers and centralbankers will respond to it is uncertain.

Will Bitcoin become a viable currency? I doubt it, for

the simple reasons it is not legal tender, has tax issues, is

a poor store of value and unit of account, and it is simply

too volatile to avoid unmanageable incentives either to

hoard it or unload it. (I assume some of Bitcoins unmen-

tioned snafus will be solved over time.)

Finally, please ask yourself why you dont use gold

coins, always alleged to be a stable store of value. The

answers are simple and go right back to the difficulties

involved in commerce, taxation, your physical safety, and

the divisibility of gold into small units of exchange. If

gold a tangible commodity that is universally recog-

nized, everywhere coveted, and understood completely

is not used as a currency, why should you expect a digital

phantasm with none of those historic advantages to suc-

ceed?y

An alternate version of this articles appears in the August issue

of Active Trader magazine (www.activetradermag.com). Howard

Simons is president of Rosewood Trading Inc. For more information

on the author, see p. 4.

FIGURE 2: BITCOIN TOO HOT TO HANDLE: VOLATILITY
http://historymatters.gmu.edu/d/5354http://historymatters.gmu.edu/d/5354http://historymatters.gmu.edu/d/5354http://historymatters.gmu.edu/d/5354


13/23


Recently, observers have been warning of inflation risks

lurking around every corner. With the consumer price

index (CPI) rising above 2%, could they finally be right?

Not so fast. The Federal Reserves 2% inflation target

doesnt apply to the CPI. Since mid-2012, the Fed has iden-

tified the core PCE deflator as its preferred inflation mea-

sure, and theres a significant difference. The PCE measure

of inflation tends to be lower than the CPI measure.In part, the two measure different things. The CPI is cal-

culated by the Bureau of Labor Statistics of the Department

of Labor. The PCE is calculated by the Bureau of Economic

Analysis at the Commerce Department. An important

methodological issue is the weights for the different com-

ponents. The CPI uses the same weights for several years,

while the PCE deflator uses current and preceding expen-

ditures to calculate the weights. One implication of this is

that the PCE measure also allows for substitution of goods

with rising prices for similar goods with stable or falling

prices.

When it comes to health care expenditures, which played

a large role in the sharp downward revision of Q1 GDP,

CPI and PCE measure somewhat different things. The CPI

calculus includes only the expenses employees pay, while

the PCE deflator also includes money that employers

spend for their employee health care.

The CPI is calculated based on surveys of more than

14,000 families and 23,000 businesses they patronize

some 80,000 consumer items. Sales tax is included too.

The PCE deflator calculation is completely different,

though both the producer price index (PPI) and CPI mea-

sures are used. Essentially, and at the risk of over-simplify-

ing, the PCE deflator is derived from production, which is

at the producer price level. The PCE methodology converts

the producer priced goods/services into consumer prices,

adding profit margins, taxes, and transportation costs.

Other data is incorporated, too. For example, it incor-porates the monthly retail sales report, and the price

of food grown and eaten on the farm comes from the

U.S. Department of Agriculture. The dealers margin on

used vehicles is pulled from the National Auto Dealers

Association.

The core measure strips out food and energy, mostly.

Restaurant meals have been redefined to be food services

and are now included in the core PCE measure. Pet food

is also included, seemingly as part of the pet expenditures

rather than as part of the food budget.

Over the past 10 and 20 years, headline CPI has aver-

aged 2.4%. The PCE deflator has averaged 2.1% and 1.9%

for the 10 and 20 year periods respectively.

It is widely documented that for at least the past half

century, headline inflation converges to core inflation (and

not the other way around). This may help explain why the

Federal Reserve prefers core measures.

Figure 1 shows the core CPI (white) and core PCE defla-

tor (yellow) over the past 20 years. Over the past five

CPI and the PCE deflator

Is inflationreallylurking around every corner?

BY MARC CHANDLER

continued on p. 19

ON THE MONEY


14/23

The European Central Bank cut rates in early June,

as expected, and the Federal Reserve Open Market

Committee continued tapering on the path toward nor-

malization, i.e., higher rates. Recently, the majority of

Bloomberg survey analysts had the euro at 1.2500 by year-

end. But in Figure 1 a weekly chart of the EUR/USD

from the peak in May 2011 at 1.4939 to the third week of

June 2014 the euro fell to the lowest low (1.2040) on the

European peripheral sovereign debt issue near the end ofJuly 2012. Relative growth and differences in monetary

policy had nothing to do with the exchange rate. The

euros recovery has not been a straight line, to be sure, but

technically, its a classic uptrend over nearly two years

characterized by a series of higher highs and higher lows.

We can draw a red support line and a projected resistance

line, and they are nearly parallel with the linear regression

channel. Fans of Fibonacci will enjoy seeing the retrace-

ment of the down move exceeding the 61.8% retracement

line.

The important point is that this does not look like the

chart of a currency about to take a tumble down to 1.2500.

Monetary policy vs. economy

The euro rising when it should be falling is one of those

often-seen instances of perversity in the FX market. Onepotential explanation is that while we have divergence in

monetary policy, we have a different divergence in eco-

nomic growth trajectories. European growth momentum

is on the rise, if barely above stall speed, while growth

may well be on the downswing in the U.S. European gross

domestic product (GDP) growth is tepid at best only

0.20% quarter-over-quarter in Q1 but accelerating to 1.2%

for the 2014 year, according to

the Organisation for Economic

Co-operation and Development

(OECD). Meanwhile, U.S. 2014GDP should end up at least at

2%, according to the International

Monetary Fund (IMF), but this a

downgraded estimate from earlier

forecasts of 2.8%. Even the Fed

downgraded the 2014 growth fore-

cast from 2.9% to 2.2%. But keep

in mind that after the 1% contrac-

tion in Q1, the implication is that

the remaining three quarters will

be quite strong. If Q1 is revised

On the Money


ON THE MONEY

Behind the

curve on purpose

Lower for longer risks inflation.

BY BARBARA ROCKEFELLER

FIGURE 1: EUR/USD, WEEKLY

Source: Chart Metastock; data Reuters


15/23

to -1.5%, to get a full year at 2.2%would require 3.4% over the rest of

the year.

European growth accelerating,

U.S. growth decelerating is this

a recipe for a rising euro? It looks

that way. Emerging from recession

is more currency-favorable than

having reached recovery but then

faltering.

Euro recovery?Figure 2 supports the idea of a euro recovery, but its

tricky. The hand-drawn support line is broken to the

downside. The breakout comes after a double top that was

confirmed when the price fell below the center low of the

M formation (topmost horizontal gold line). But traders

declined to test the most recent lowest low from February

(bottom horizontal gold line). We might think its touch-and-go at this point in time another retracement exceed-

ing the Fibonacci 61.8%, too, by the way but the real

message of this chart is that the euro/dollar is only a little

under the green 200-day exponential moving average and

it may end up being a coin-toss which way it goes now. We

FIGURE 2: EUR/USD, DAILY


THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS

DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKETFACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATIONIS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN. THE TESTIMONIAL MAY NOT BE REPRESENTATIVE OF THE EXPERIENCE OF OTHER CLIENTS ANDTHE TESTIMONIAL IS NO GUARANTEE OF FUTURE PERFORMANCE OR SUCCESS. TECHNICAL ANALYSIS OF STOCKS & COMMODITIES LOGO AND AWARD ARE TRADEMARKS OF TECHNICAL ANALYSIS, INC.

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ON THE MONEY

can write equally plausible scenarios for a renewed drop,

or for recovery back to near 1.4000.

The net non-commercial position as of the June 16, 2014

Commitments of Traders Report is indeed a short one

(61,835 contracts), and increasing in the prior few weeks,

but this pales in comparison to the net short of 155,066

contracts the week of July 23, 2012.

See Figures 3 and 4. The deduction

is that the sovereign debt situation

was a crisis and it takes a crisis to

propel the savvy hedge funds trad-

ers into really short positions. What

we have now is divergence and

befuddlement, but not a crisis.

No answers from the Fed

We have a distinct lack of clarity

from the Fed. The primary messagein the Feds statement was lower

for longer and Chairwoman Janet

Yellen made a point of saying that

inflation was not a worry because

the data was noisy, nor was mis-

pricing in asset markets (i.e., bubble

denial). The members estimates of

when rates would rise and by how

much did show a bigger, faster rise,

but Yellen brushed off the dots on

the forecast charts, too. The com-mittee sees the median Fed funds

rate higher in 2015 at 1.125% from

1% in earlier forecasts. For 2016,

the forecast is 2.5% from 2.25% in

the March forecast. But the median

projection for the longer term is

3.75% from 4% earlier. This is not

really hard to grasp rates will

be higher initially but not reach

the 4% long-term average as fast

as earlier thought, due to slowergrowth. Some analysts say the

bias toward higher rates sooner

arises from just a few hawks (who

understand the averaging process

and could have written down a

higher number to get exactly this effect). We never get

identifiers for the dots.

Within hours of the Yellen press conference, the yield

on the 10-year note fell 7 bp to 2.58%. This is not as low

as 2.40% seen on May 29, which surpassed the Oct. 23,

2013 lowest low at 2.471%. Its also quite far from 3.03%

FIGURE 3: COMMITMENT OF TRADERS NON-COMMERCIALSEURO FUTURES

Source: Oanda

FIGURE 4: COMMITMENT OF TRADERS NET NON-COMMERCIALSOVER FOUR YEARS

Source: Oanda


17/23


seen at year-end. The yield hasbeen wobbling along under 2.70%

for several weeks, even spending

three days below the 200-day mov-

ing average (Figure 5). Clearly the

bond market thoroughly believes

lower for longer.

Inflation concerns

Increasingly, however, the bond market also thinks the

Feds dovish stance is behind the curve. Labor market

slack and barely rising wages are indeed a constraint onthe Fed, but inflation is not zero. In fact, inflation is a real

worry. When the latest CPI hit exactly 2% the Feds

target it was dismissed as just one months worth of

data. Besides, the Fed prefers the Personal Consumption

Expenditure (PCE) deflator, and thats only 1.6%, although

its expected to rise to 1.8% in June. Its conceivable that

secular stagnation will morph into stagflation. Secular

stagnation is worse than a regular recession because its

not open to monetary policy fixes, and stagflation is worse

than secular stagnation because only one side can win.

Its a zero sum game in which the monetary policy fix of

higher rates may cure inflation but also drive the economy

back into recession. If the Fed doesnt address inflation,

recovery may proceed but if inflation rears its ugly head

its very, very hard to kill.

How much fear should we have that inflation is coming?

One good fear measure is, of course gold. The gold gang

famously got it wrong on the Feds QE causing inflation,

since it takes the multiplier effect to convert an increase

in the money supply to activity and

we didnt get that the velocity of

money sank and remains low. But

oil price rises due to the geopoliti-

cal problems in Russia/Ukraine and

the Middle East have the potential to

drive inflation higher everywhere

not just in the U.S. In the gold chart

(Figure 6), prices jumped above the

green 200-day moving average and

are nearing the April intermediate

high ($1331.40, Comex futures basis).

It remains to be seen whether gold

will continue higher on the geopoliti-

cal story and draw hedge funds and the public alike back

in.

The price of oil

That makes the price of oil a centerpiece. Periodically,

we get a flurry of stories asserting that oil price rises

dont have the same effect now as they did in the 1970s

because oil consumption is a smaller percentage of GDP,

and besides, the U.S. is nearing self-sufficiency in energy.

These denials of the correlation between oil prices and

inflation are true, but not always useful. For one thing,

not every country became more energy efficient, and the

U.S. imports vast amounts of goods from everywhere.

Also, oil is the starting point for a long supply chain that

runs to chemicals and plastics, asphalt and road materials,

synthetic fibers, and so on. Granted, 74% of oil is used in

the form of gasoline, distillates, and jet fuel, so transporta-

tion heads the list, but transportation is a big industry in

the U.S., affecting everything from eBay to getting build-

ing supplies from Point A to Point B, not to mention food.

Its simply ridiculous and patently not valid to assert that

a giant rise in the price of oil will not have an inflation-

FIGURE 5: REUTERS 10-YEAR NOTE YIELD INDEX


FIGURE 6: GOLD FREAKING OUT (COMEX FUTURES BASIS)



18/23


ON THE MONEY

ary effect. The economists problem is figuring out how

much of one, and truth be told, the models today are not

very convincing. The Cleveland Fed, for example, has an

ivory-towerish paper saying you can forecast actual future

inflation better by excluding oil prices. This is more likely

an indictment of modelling, not of the role of oil prices in

inflation.

Moreover, the fallout will harm the working and middle

classes disproportionately in the form of higher gasoline

and heating oil costs. The

share of gasoline and heat-

ing oil could rise from 4% on

household income to 6-10%.

Considering that wage growth

is less than 1% p.a., this means

the consumer will feel even

more strapped, pulling the

economy down. We already

saw this effect during this

past exceptionally cold winter,

which accounts in part for

the 1% drop in GDP. In other

words, energy costs can be justas bad for production and pro-

ductivity as bad weather.

So, if oil is such a horrible

threat to the U.S. economy,

why is the Fed sticking to

lower for longer? Probably

because it feels it has no

choice. This is the same reason-

ing behind dividing CPI into

headline and core versions,

core excluding energy andfood, since the government,

including the Fed, cant affect

those prices unless it imposes

price controls. Nobody in the

U.S. today would stand still

for price controls, which are

seen as suitable only for war-

time (and notably failed when

Nixon tried them in 1973).

Talk of inflation and the Fed

behind the curve is possibly

premature, but not unrealistic. Inflation fear is scattered

and limited so far. But if it were to become more main-

stream and widespread, the dollar will surely become the

subject of sell-offs.y

Barbara Rockefeller (www.rts-forex.com) is an international econo-

mist with a focus on foreign exchange, and the author of the new

book The Foreign Exchange Matrix(Harriman House). For more

information on the author, see p. 4.

BarclayHedge Rankings:Top 10 currency traders managing more than $10 million

(as of May 31 ranked by May 2014 return)

Trading advisorMay

return2014 YTD

return

$ Undermgmt.

(millions)

1 P/E Investments (FX Aggressive) 4.67% -2.70% 3400.0

2 CenturionFx Ltd (6X) 4.57% -11.77% 30.0

3 First Quadrant (TCA L/S USD 20%) 3.85% 15.31% 40.0

4 ROW Asset Mgmt (Currency) 3.66% 9.54% 11.0

5 Presagium Master Fund LP 3.43% 1.10% 25.0

6 P/E Investments (FX Standard) 3.08% -1.71% 3400.0

7 Gables Capital Mgmt (Global FX) 3.00% -7.58% 42.0

8 Cambridge Strategy (Asian Mrkts) 2.93% 1.20% 75.0

9 Civic Capital (Curr. Fund Ltd) 2.85% -3.13% 1141.0

10 Cambridge Strategy (Emerging Mkts) 2.84% 2.14% 560.0

Top 10 currency traders managing less than $10M & more than $1M

1 MFG (Bulpred USD) 19.60% 18.23% 1.7

2 Whitmore Capital LP 5.32% -8.25% 6.1

3 Hartswell Capital Mgmt (Athena) 4.10% -2.08% 1.0

4 Hartswell Capital Mgmt (Apollo) 2.64% 0.47% 3.1

5 TrueAlpha Capital Mgmt (Gl Currency) 1.82% 1.47% 2.4

6 KSA Consulting Network (Delta FX) 1.62% 2.01% 6.8

7 JP Global Capital Mgmt (Troika I) 0.81% -4.12% 1.0

8 Rhicon Currency Mgmt (Sys. Curr.) 0.16% -2.30% 10.0

9 MDC Trading 0.16% 1.53% 2.5

10 Investment Capital Adv (Managed Accts) -0.04% 3.56% 3.9

Based on estimates of the composite of all accounts or the fully funded subset method.

Does not reflect the performance of any single account.

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.


19/23


years, the core PCE has undershot core CPI by

0.2% on average. Over the past ten and 20 years,

the undershoot has been 0.2% and 0.4% respec-

tively. The persistent lower estimates of the PCE

deflator means the Federal Reserve is likely to

tolerate what may appear to be an overshoot ofCPI.

There appears to be two elements that pro-

duce a more subdued rise in the PCE measure.

One is the substitution effect that is not incorpo-

rated into the CPI measure. The other is the way

hospital expenses and airfares are calculated.

The consensus calls for the May core PCE

deflator to rise to 1.6% in May from 1.4% in

April. If accurate, it will keep this measure 0.4

percentage points lower the core CPI. It is con-

sistent with the Feds assessment that the econ-

omy is evolving toward the Feds mandates.

Some observers will make hay of the substantial

contraction in Q1 GDP, but this too should not

alter the outlook for Fed policy. The Feds eco-nomic mandates are on employment and prices

and both did indeed move in the (Feds) desired

direction in Q1 and appear to have done so fur-

ther in Q2.y

Marc Chandler is head of global foreign exchange strate-

gies at Brown Brothers Harriman. His blog is called

Marc to Market (www.marctomarket.com). For more

information on the author, see p. 4.

CPI and the PCE deflatorcontinued from p. 13

FIGURE 1: CPI (WHITE) AND CORE PCE DEFLATOR (YELLOW)


20/23

20 October 2010 CURRENCY TRADER

TRADING STRATEGIES

Additional currencies andinflation expectations

Expected monetary policy responses overwhelm differentials in expected inflation.

BY HOWARD L. SIMONS


TRADING STRATEGIES

ADVANCED CONCEPTS

The principal conclusion reached last month (see Major

currencies and inflation expectations, June 2014) regard-

ing currency movements and inflation expectations is

that what should be a simple and straightforward rule

countries with inflation expectations higher than those of

a base country such as the U.S. should have a weaker cur-rency is actually honored far more often in the breach

than in practice. The relationship is surprisingly anecdotal

and defies the simple precepts of both the interest rate par-

ity model and Fishers Law.

To refresh, the fundamental equation for calculating a

currency forward against the U.S. dollar is:

As there can be only one real interest rate globally for

any maturity, the difference in the two nominal interest

rates has to be the difference in expected inflation. All

other considerations and caveats are the same as used last

month.

A set of five national inflation swap markets and their

associated currencies will be examined here. Two of these

inflation swap markets belong to euro-bloc members

France and Spain; the others are the Swedish krona (SEK),

Israeli shekel (ILS), and South African rand (ZAR). In each

case, the one-year inflation swap differential to the U.S.

dollar (USD) will be mapped against the currency itself

along with a correlelogram extending backward and for-ward nine months to see whether the changes in expected

inflation lead the currency movement or vice versa. The

correlations when the currency leads the inflation swap

differential are depicted in magenta; the correlations when

the inflation swap leads the currency are depicted in

cyan. The correlelograms are calculated with the currency

expressed in USD per terms so that a higher value is

associated with a stronger currency against the USD.

A strong prior expectation here should be the inflation

swap differential leading the currency with a negative cor-

relation value by 126 to 189 days, or the six- to nine-month

time frame often seen in relative short-term interest rate

differentials. If the currency leading the inflation swap

differential occurs, we have evidence changes in currency

levels affect expected relative inflation differentials.

Individual currency analyses

The SEK-USD inflation swap differential appears to have a

general relationship of a wider differential being associated

with a weaker SEK and vice versa (Figure 1).

Forward= Spot*[1+ rfor* (

90

360)

1+ rU.S.* ( 90360

)

]


21/23

CURRENCY TRADER October 2010 2


The relationship is a strange one, however (Figure 2).

The SEK has a positive leading relationship to the inflation

differential at a seven- to nine-month lag, but this relation-

ship becomes negative as it approaches contemporaneous

lags; this is equivalent to saying a stronger krona leads to

narrower inflation swap differentials. The opposite occurs

for the inflation swap differential. Here, wider differentials

lead the currency strongly at contemporaneous lead times,

which then start to dissipate rapidly after a three-month

lead. The Riksbank apparently has trained the market to

believe it will react very quickly to falling inflationary

pressures with lower short-term interest rates, but that its

memory is short. Neither are admirable attributes for a

central bank.

The Israeli shekel continues the anecdotal parade. Just as

in the case of the Star Warsplanet Tatooine and actual dis-

coveries made by NASAs Kepler satellite of planets orbit-

ing two stars, the ILS trades against the EUR just as much

as it does against the USD (see A currency of Biblical

proportions, Currency Trader, May 2012). A map of the ILS

against the inflation swap differential shows how a weak

but discernible relationship between mid-2008 and mid-

2011 broke down entirely after mid-2011 as the inflation

swap differential collapsed toward zero (Figure 3).

Simple visual inspection tells us the lead/lag relation-

ship between the ILS and the inflation swap differential

should be an odd one, and we are not to be disappointed

(Figure 4). As with the SEK, the currency shifts from a neg-

ative correlation at lags of seven to nine months to a posi-

tive one. The inflation swap level leads the ILS negatively

FIGURE 1: THE SWEDISH KRONA ANDINFLATION SWAP DIFFERENTIALTO THE USD

5.75

6.25

6.75

7.25

7.75

8.25

8.75

9.25

9.75

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

Feb-07

Aug-07

Feb-08

Aug-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Dec-11

Jun-12

Dec-12

Jun-13

Nov-13

May-14

SEKPerUSD,InverseScale

One-YearInflationSwapDifferential,SEK-USD

InverseScale

SEK Inflation Differential

SEK

FIGURE 3: THE ISRAELI SHEKEL AND INFLATIONSWAP DIFFERENTIAL TO THE USD

3.20

3.40

3.60

3.80

4.00

4.20

4.40

-9%

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

Feb-07

Aug-07

Feb-08

Aug-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Dec-11

Jun-12

Dec-12

Jun-13

Nov-13

May-14

ILS

PerUSD,InverseScale

One-YearInflationSwapDifferential,ILS-USD

InverseScale

ILS Inflation Differential

ILS

FIGURE 2: MIXED RELATIONSHIP BETWEENINFLATION SWAP DIFFERENTIAL ANDSWEDISH KRONA

-189-168

-147-126

-105-84-63

-42-210

21426384

105126147168

189

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

Correlation

FIGURE 4: REVERSING RELATIONSHIPBETWEEN INFLATION SWAPDIFFERENTIAL AND ISRAELI SHEKEL

-189-168

-147-126

-105-84-63

-42-210

2142

6384105

126147168

189

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

Correlation


22/23

22 October 2010 CURRENCY TRADER

ON THE MONEY

ON THE MONEY


ADVANCED CONCEPTS

out to lags of five months, at which point the correla-

tion starts to rise toward zero. This, too, appears to

describe a situation in which the Bank of Israel has

trained the market to expect a credit-relaxing response

to narrower inflation expectations.

Visually, the South African rand had a strong coin-cidental relationship to the inflation swap differential

through mid-2013 (Figure 5). This is something of a

surprise given the ZARs susceptibility to news events

such as miners strikes and internal political problems.

The ZAR fell sharply during the second half of 2013

and during the emerging market downturn of early

2014 irrespective of the relative inflation outlook.

We should expect this visual relationship to pro-

duce a negative and relatively symmetric lead/lag

relationship between the ZAR and the inflation swap

differential. This is the case, although the leading rela-

tionship of the ZAR starts to rise more slowly after a

four-month lag (Figure 6). The strong negative correla-

tions near lag zero in both directions are indicative of

the same phenomenon observed for both the Riksbank

and the Bank of Israel: The South African Reserve

Bank has created expectations it will react swiftly to

any change in inflation expectations.

Now lets move to the two Eurozone members

whose inflation swaps exist separately from a national

FIGURE 5: THE SOUTH AFRICAN RAND AND

INFLATION SWAP DIFFERENTIALTO THE USD

6.25

6.75

7.25

7.75

8.25

8.75

9.25

9.75

10.25

10.75

11.25

11.75

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

Feb-07

Aug-07

Feb-08

Aug-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Dec-11

Jun-12

Dec-12

Jun-13

Nov-13

May-14

ZARPerUSD,InverseScale

One-YearInflationSwapDifferential,ZAR-USD

InverseScale

ZAR Inflation Differential

ZAR

FIGURE 6: RELATIVELY SYMMETRICRELATIONSHIP BETWEEN INFLATIONSWAP DIFFERENTIAL AND RAND

-189-168

-147-126

-105-84-63

-42-210

2142

6384105126

147168189

-0.50

-0.45

-0.40

-0.35

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

Corre

lation

FIGURE 7: THE EURO AND FRENCH INFLATIONSWAP DIFFERENTIAL TO THE USD

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

1.65-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

6.5%

Jul-04

Mar-05

Nov-05

Jun-06

Feb-07

Oct-07

Jun-08

Jan-09

Sep-09

May-10

Dec-10

Aug-11

Apr-12

Dec-12

Jul-13

Mar-14

USDPerEUR

One-YearInflationSwapDifferential,FFR-USD

InverseScale FFR Inflation Differential

EUR


23/23

CURRENCY TRADER October 2010 23


currency. Neither the French (Figure 7) nor Spanish (Figure

8) inflation swap differentials bear much resemblance to

the EUR, nor should we expect either of them to. Countries

without direct control of their own monetary policy and

fettered to partners with widely divergent fiscal policies

and growth trajectories have limited capacity to affect their

own inflation expectations.

In consideration of the above, our prior expectation

should be the euro leads both sets of inflation swap dif-

ferentials more than vice versa. This is accurate, with the

French case being the more direct in this regard (Figure

9). The Spanish case is rather odd in that the correlations

of higher inflation swap differentials to the euro become

increasingly positive with a longer lead time (Figure 10).

This can be interpreted as saying troubles in Spain affect

European Central Bank policy, but only after a delay wor-

thy of the ECBs committee nature.

The overwhelming conclusion from this set of curren-cies is both the interest rate parity theorem and Fishers

Law are trumped by the expectation of central bank policy

responses. This is the downside of living in a world where

central bankers have become central planners first and

foremost, trying to respond to every development with a

tool (monetary policy), whose outcomes are anything but

deterministic and that operates with those famous long and

variable lags. Is it any wonder we live in a world of rolling

financial crises, bubbles, and busts?y

FIGURE 9: EURO LEADS FRENCH INFLATIONSWAP DIFFERENTIAL MORE THANVICE VERSA

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

-189-168

-147-126

-105-84

-63-42

-210

2142

6384

105126

147168

189

Correlation

FIGURE 8: THE EURO AND SPANISH INFLATIONSWAP DIFFERENTIAL TO THE USD

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

1.65-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

6.5%

Jul-04

Mar-05

Nov-05

Jun-06

Feb-07

Oct-07

Jun-08

Jan-09

Sep-09

May-10

Dec-10

Aug-11

Apr-12

Dec-12

Jul-13

Mar-14

USDPerEUR

One-YearInflationSwapDifferential,ESP-USD

InverseScale

ESP Inflation Differential

EUR

FIGURE 10: SPANISH INFLATION SWAPDIFFERENTIAL AND EURO LEADEACH OTHER AFTER LONG LAGS

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

-189-168

-147-126

-105-84

-63-42

-21021

426384

105126147168

189

Correlation

currencytrader0714-1310cb

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