03 July 2006

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Global asset markets (including the Sensex) have shown signs of recovery recently, accelerating at the end of last week when the U.S. Fed raised its key rate by the 17th straight quarter point to 5.25%. While the rate hike had been all but expected, analysts saw the associated commentary as suggesting that the Fed was very close to being at the end of its tightening cycle than had been expected - Fed funds futures, which reflect market expectations, showed that the chance of a hike in August had fallen from 93% ahead of the meeting to some 60%. And since it seems that dollar rates may not rise as much as expected, asset markets took great cheer. The dollar, of course, slid rather sharply, as the other world central banks are still seen to be in a tightening mode, particularly as inflation is - finally - showing signs of life.

U.S. growth, which hit a 3-year high of 5.7% in the first quarter, is expected to decline to somewhere north of 3% in the second quarter, and stabilize around that level for the rest of the year. Of course, the market's growth targets, certainly 2 or 3 quarter forward, have been way off for the past year or so. This is reflected in the fact that U.S. growth has become much more volatile over the past one year, which, compounded by the uncertainty over the Fed's plans, is, in my opinion, one of the main forces that has been creating the recent nervousness in asset markets.

Thus, it is difficult to understand why an increase in uncertainty - certainly measured by the high volatility of the Fed funds rate right after the Fed announcement - should lead to a rally in asset prices. Which is why I remain convinced that this is really a relief rally or a sucker punch.

Don't buy anything. Yet.

I don't know why but I've been fixated on copper. I feel that the uncertainty in global markets will not subside - i.e., that markets will not really turn - till the copper falls and stays below $ 5000 tonne. It has fallen, by about 13% from its peak of 8500. Other high fliers, like gold and the Sensex, have also fallen, by 14% and 16%, respectively. But as the charts show, copper has risen much, much more since January 2005 than either gold or the BSE. Gold hovered between $400 and $ 500 an ounce before it took off for the rarer heights; the Sensex bounced around between 6,500 and 9,000 before heading for the skies. Copper was between $ 2,500 and $ 3,500 before it caught the fever. Gold has come down to below $ 600 before getting caught again, and the Sensex fell below 9,000 before jumping with false hope. Copper is still hovering above $ 7,000 dollars a tonne!

And, I don't know about you, but I just know that that's much too high. It was great while the party was on - buy at any price, everything's going up.

But the party's over. And even if you find a half-drunk beer or a cigarette butt on the carpet, it's time to go home, take an aspirin and a long, hot shower.

Unless you're a punter. Then you could sell gold at $ 650 or the Sensex at 11,000. And copper, well, any price is a good price to sell (just like any price was a good price to buy not so long ago).

The dollar, well, its always tricky. 54% of traders, strategists, investors, what have you surveryed by Bloomberg from Sydney to New York recommended selling the dollar (this week) against the Euro - clearly, the market is not very sure of itself. Incidentally, this gang of forecasters were soundly wrong in 2005 - their average prediction for year-end EUR/USD was 1.31, when in reality it ended up at 1.18. So, if you don't know what's going to happen, you're in good - well, let's say large - company.

If I'm right and this rally is really a sucker punch, the dollar will slide for a bit and then shoot higher. A young technical analyst I was interviewing said to me very confidently, the dollar will be weak for the next two months, breaching its most recent low (around 1.2970), after which is will surge strongly. I gave him the job.

Meanwhile, check out our derivative of the week section on the website for some ideas on how to play such a view.

Currency Market View - Rupee and Majors

USD/INR

Fortnightly movement: O-45.8900 H-46.4600 L - 45.8675 C-46.0450.
Sentiment: Range bound with a positive bias.
Expected range for 1 Month: 45.25- 46.25
Expected range for 3 Months: 44.75- 46.25

A volatile session was witnessed this fortnight for the domestic unit as it touched a high of 46.46 and a low of 45.8675 a movement of 60 paise. The rupee weakening was seen primarily due to demand from oil companies, buying from importers and fall in Asian stock indices. A stronger dollar in the offshore non-deliverable forwards market also provided investors an opportunity to buy dollars onshore and sell them overseas.

The Indian rupee rose back during last few days of the fortnight against the dollar as the U.S. Federal Reserve indicated it might pause its two-year tightening campaign in the months ahead. The dollar slid across the board, including against Asian currencies, as markets largely expected a hawkish policy statement from the Fed and strong indications of a possible further rate rise in August. The gains made by other currencies triggered the rupee's rise. Encouraging current account data and sharp gains in Indian shares boosted sentiment for the rupee. India's current account unexpectedly swung into surplus in the final quarter of 2005/06.

The forex reserve position stood lower at $161.96mn as against $162.87mn previous fortnight. The 6-month benchmark forward premium, which stood around 1.0% last fortnight, closed at 1.09% this weekend.

With Fed indicating a likely pause in its interest rate raising policy stance, we may see dollar weakness across. . Strong Asian currencies may act as a positive factor along with strong looking domestic stock exchange is likely to add to the rally; However importers and oil demand may hold back any sharp appreciation. Premiums are likely to stay high as participants are expecting a possibility of another rate hike on July 25th domestic monetary policy review. Overall markets to operate in a range bound movement with a bias toward appreciation.

EUR

Fortnightly movement: O-1.2635 H- 1.2796 L-1.2478 C-1.2789
Sentiment - positive
Expected range for 1 Month: 1.2300 - 1.2975
Expected range for 3 Months: 1.2000 - 1.2975

During the week ended June 23, despite some mixed US data, the Euro's decline extended all the way to about 1.2480 on speculation about the outcome of the FOMC meeting on June 29 both as to the magnitude of the rate hike and the hawkishness of the accompanying statement. However, the Euro recovered thereafter initially on some customary caution as also an unexpected rise in the German IFO business climate index. The Euro's rally accelerated after the FOMC meeting slightly on disappointment over a 25 bp hike and largely on a perception that the Fed would pause at the next meeting on August 8. Consequent to a change in sentiment, the market shrugged off an improvement in the US consumer sentiment and instead reacted to a larger than expected decline in the Chicago PMI.

From a technical perspective, the Euro's 3-cent recovery could have sufficiently corrected the preceding 5-cent decline and the Euro may be poised to resume its medium-term decline. However, with key Eurozone and US data this week beginning today and US holiday today and tomorrow, market movements could get exaggerated. A break over 1.2850 could lead to a strong test of 1.30 but only a sustained rise over 1.30 will likely abort our medium-term bearish view of the Euro.

GBP

Fortnightly movement: O-1.8517 H- 1.8518 L-1.8089 C-1.8494
Sentiment: positive
Expected range for 1 Month: 1.8000 -1.8650
Expected range for 3 Months: 1.7650 -1.8650

The minutes of Bank of England's MPC meeting last month were released on June 21 and showed that the members voted 7-to-1 to maintain the status quo. Again, one MPC member Walton was the lone dissenter, voting in favour of a 25 bp rate hike. Sterling slipped as the minutes were not more hawkish but recovered later as a rate hike later this year was not ruled out. However, the sudden death of the Walton - the sole 'hawk' - the very next day sent Sterling reeling down all the way to touch 1.8090 on June 29 before a sharp recovery to about 1.85 which was also aided by upward revisionof UK Q1 GDP growth.
Still, Sterling's corrective rally could be limited to 1.8650 before resumption of the medium-term decline.

JPY

Fortnightly movement: O-115.30 H- 116.68 L-114.17 C-114.42
Sentiment: positive (for yen)
Expected range for 1 Month: 112.00 - 117.50
Expected range for 3 Months: 112.00 - 119.50

Speculation about Fed rate hikes and public demands for the resignation of Bank of Japan Governor following his ivestment in the scandal-ridden Murakami fund, pushed the dollar higher against the yen to reach 116.68 last Tuesday before the fall-out of the FOMC meeting and upbeat Japanese inflation and unemployment data caused the dollar to fall back by over 2 yen.

The yen could extend its recovery to 113 or even 112 due to persistent expectations of a BoJ rate hike this month as also a comment by a Chinese central bank monetary policy board member that the yuan may be allowed to appreciate faster. The dollar may then resume its medium-term uptrend. Only a sustained decline below 112 yen is lkely to abort this dollar bullish view.

Dr. Risk's Prescription

Are market swings caused by misrepresentation or misperception?

Nearly 3 decades ago when I was studying contract law, I came across a very nice definition of misrepresentation. A little said that ought not to have been said or a little not said that ought to have been said constitutes misrepresentation. Going by this definition, one might be inclined to think that the new Fed Chairman, Bernanke has mastered the art of misrepresentation? But on second thought, that is, perhaps, too harsh and hasty a judgement. What seems more likely is that market sentiment and market-determined prices are wont to swing, like a pendulum, from one extreme to another through a recurrent transitional phase called mean reversion.

Having reached a 13-month high of 1.2977 on June 5, the Euro slid quickly in response to Bernanke's anti-inflation speech. It fell to about 1.2478 on June 23 only to rally again and recoup most of the losses in just one week and finish last Friday just under 1.28. Ahead of last week's FOMC meeting, some players feared or expected a 50 bp hike as against the widely expected 25 bp hike and now the Fed's accompanying statement which has been perceived to be less hawkish or more dovish than expected, has prompted some players to expect that the Fed will pause at the next FOMC meeting on August 8. The market-perceived chance of an August rate hike, that had risen as high as 93% in the week before last has since dived to 65% by the end of last week. What a turnaround in sentiment! So then, are the market swings caused by a market misperception of the likely course of events? No matter how tempting it would be to so conclude in a 'righteous' manner, it would be very risky from a practical viewpoint since the market is always the final arbiter and most of the time like a punch-drunk lorry driver going and accelerating straight ahead and ignoring traffic lights most of the time until some unexpectedly strong force causes him to reverse course! Surely, Sir Isaac Newton must be having a hearty laugh in heavens since his famous laws of motion appear to be applicable even to market motion. But that is not at all surprising since market motions appear to be ultimately influenced by recurring cycles of market emotions viz. worry, greed, euphoria, hope, fear and panic.

Next week begins with the release of Bank of Japan's quarterly Tankan survey on Monday. This will be followed later in the day by the release of Eurozone manufacturing sector PMI and then the US manufacturing sector ISM index despite a long holiday weekend in the US. The Eurozone service sector PMI and its US counterpart follow later next week which will end with the US employment report. Naturally, market expectations about a Fed rate hike in August may wane further on weaker than expected US data or alternatively get reinforced due to better than expected US data. The same could also be true about rate hikes by the European Central Bank and the Bank of Japan.

From a technical perspective, the Euro has marginally exceeded the 61.8% Fibonacci correction target of the 1.2977 - 1.2478 decline and could be ideally poised to resume its decline. A sustained rally over 1.2850 might, however, mean another shot at the high 1.29s. On the other hand, the Japanese yen's recovery has been quite feeble. The dollar's decline against the yen from 116.68 to 114.17 has not corrected the 108.93 - 116.68 rally by even 38.2% thanks to public demands for the BoJ Governor Fukui's resignation following his investment in the scandal-ridden Murakami fund. However, the yen could catch up as Japanese annual core CPI was up 0.6% in May after being up 0.5% for the previous 4 months. Japan's unemployment rate also fell to a 7-year low of 4% in May. If the Tankan survey is as good as or better than market expectations, the yen could strengthen further to 113 or perhaps even 112 to a dollar on increasing speculation of a BoJ rate hike this month itself.

This phase of dollar weakness is, in our view, corrective before renewed dollar strength and our medium-term bearish view of the Euro will probably be aborted only with a sustained Euro rally over 1.30. Likewise, only a sustained dollar decline below 112 yen may abort our bullish view of dollar/yen.