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Tuesday, 30 October 2007

Does The Fed Need To Cut?

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Although my letter tends to be forward looking I do occasionally look at what I consider might be inflection points, a current event that may have a long term impact. As you can see from the title, I suspect The Fed meeting, ending tomorrow, has this possibility.

I am not a share tipster and rarely call direction on the markets unless I see a set up that could have the potential to damage wealth. I can see such a set up today.

Now is a good point to do a reality check. Is the US heading for hard times? Well, looking at some of the figures for Housing, Consumer Retail and Financials you can make a good case for impending recession. I wouldn't disagree with that. Trouble is, in the face of a lot of bad news, the stock markets are still getting bought.

In basic terms, someone sees value in holding US shares. We can't hide from that, in spite of what seems to be bearish fundamentals, lets not blind ourselves to the obvious. So who is buying?

Simply put its anyone who can take advantage of leverage and a depreciating Dollar. Yes, its the carry trade. Its not just the Japanese either (or Swiss) its also US Institutions who borrow (sell) yen, convert (buy) dollars to then buy $ denominated assets, hoping the yield difference and capital gains exceed the any devaluation, inflation and costs, boosting the profits by leveraging the deal. The leverage is important as it magnifies the profits. Its a huge one way gamble involving truly massive amounts

Right now its balanced, the carry trade is good. Its so good that even on an intraday basis moves in the Yen are matching moves in the Dow, especially last week.

I'm focusing on Yen/Dollar here and although the real elephant is the Euro I am ignoring it for a simple reason. It makes the charts look messy. I have a couple of charts (thanks to to show what happens to the Dow when the $ and Y move:

You can see the relationship, Yen (blue) is inversely related to the Dow (red). The dollar (green) is in a downtrend and looks sickly. So yen down, Dow up, looks pretty good to me. Hang on a minute though, look at the recent action in October (the chart covers the past 200 days) yen up, Dow up. Okay, we can see the relationship worked at first, the Dow dipping as the Yen rose but since the 19th even though the Yen has remained at the recent high, the Dow has rallied. This is unusual.

Here is a chart from 2004/05 showing the same relationships:

Ahhhh, maybe the truism isn't as good as was thought? Or there is a message being screamed out, loud and clear. Those who looked at the green line are on the path to enlightenment. Its the $. Its that relative value between the $ and Y that makes it all work. The Dow can go up when the Y rises, as long as the $ keeps depreciating or holding a lower value.

Look at what happened to the Dow (sorry for the hindsight view here readers but sometimes history can teach lessons to those who listen) in 2004/5 when the $ appreciated against the Y. Now look at the current situation.

You can see why I called this an inflection point.

Lets get down to it. What can The Fed do tomorrow?

The Fed could raise rates, saying the turmoil in the credit markets has stabilised and inflation needs to be addressed. The $ would scream higher against the Y and the stock markets would swan dive.

The Fed could stay pat, saying inflation is okay and its ready to move if any deterioration in the data warrants. The priced in 0.25% cut would be unwound, stock markets would have a bad hair day or 5.

The Fed cuts by 0.25% saying conditions require a flexible approach. The cut is priced in and the wording of the statement will be taken as a sign more cuts are on the way. $ drops and the Dow has a 200 point move up.

The Fed cuts 0.5% saying conditions in the economy and the credit markets are cause for concern. After an initial spike and run higher, markets reverse as reality hits home or - the carry trade is reinvigorated and the Dow heads for 15k.

The Fed does have a problem though. Before the meeting is over, 3Q GDP will be out. If GDP is strong and the Price Index shows inflationary pressure stock markets might take fright as the expected 0.25% cut is endangered.

If you are positioned in the markets into tomorrow you may want to re-examine your risk level.

Do the Fed need to cut tomorrow? If they want to save the stock markets then yes a cut of 0.25% is essential. Although this is a short term fix (and is related to my last letter), longer term the Fed maybe about to commit a mistake that will haunt them for years to come.

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