Thursday, March 08, 2007

Coast Clear???
Or Skeletons In The Closet Still???

So, you want to hear good glowing stuff or things in the closet? No point just looking at bullish things, let's look at potential traps for the markets.

US Hard Landing - The whole thing was started by Greenspan saying that there was a 30% chance of the US economy getting a hard landing in 2007. When very old people speak, people get scared. The 30% scenario is scary because in a lot of economic models (which predicts soft/hard landing and economic cycles based on almost every single available economic indicator), the chance for a hard landing is ten percent to ZERO. Hence for Greenspan to come out and say 30% is a big deal, maybe he knows more than the rest, maybe he's getting senile, maybe he has forgottent to take his medicine - but in a true economist way, his opinion cannot be wrong, can it??!! If you get a hard landing, aha, he was right after all. If you get a soft landing, he is not wrong either (he said 30%, not 60%!!). That's how an economist always get to keep his job. That's how you keep being called superman! The hard landing scenario had more weight when the release of recent data stated that demand for US made manufactured goods dropped 5.6% last month, its steepest decline since July 2000. Consensus wise, economists were expecting only a 4.5% decline. In a separate report, the Labor Department said productivity went up an annualised 1.6% in Q4, revised from 3%, while the cost of labor soared 6.6%, well beyond the previous 1.7% estimate. There is concern that the implied upward pressure on wages could feed inflation. So you have a scenario for raising rates in one and dropping of rates in another. At the end of the day, I would see job security as a major indicator. You have jobs, you will spend, .... drop in manufacturing orders is more likely an adjustment in inventory cycles ... you have jobs, you will have houses, you can ride out subprime debacles ... you have jobs, you can ride out inflationary pressures... I would view employment data very closely, there's one this Friday (read below)!!!

Interest Rate Differentials & Carry Trade - Well, I have almost talked this one to death. But this will be the determinant to whether we have a massive reversal of yen/swiss franc carry trade or not. Today, the European Central Bank will meet and is more than likely to raise interest rates a quarter percentage point to 3.75%. The Bank of England will also meet, but is anticipated to keep rates steady this time around. But just how big is the yen carry trade? A report by JP Morgan's Tokyo office said the amount is around US$340bn, much the same as the figure I obtained from other sources in an earlier blog. However, JP Morgan said that about 3/4 of these carry trades invest in foreign bonds (and not primarily in foreign hot equity markets as many were led to believe). Hence, the fears over carry trade might be a tad overdone. That is to be expected because of the microscopic focus of the media on all issues - you give them ONE TOPIC and they will analyse it from all angles, promote it before each commercial to stay tuned to hear further opinions on the SAME bloody topic. The over-exposure of the same one topic led everyone to believe that its REAL, A PRIORITY and IMPORTANT. It must be important cos they mention the bloody thing every other minute on CNBC or Bloomberg channel... right??! Lack of information causes uncertainty, excessive information causes irrational fears to multiply (good things become very good, bad things become very bad).

Employment Data - Three very important data bits will come on Friday. February nonfarm payrolls are expected to grow by 95,000 jobs, while unemployment is anticipated to match the 4.6% rate seen in January. Average hourly earnings are expected to show a rise of 0.3% from January. What we don't want to see is a massive drop in jobs' growth or a dramatic rise in unemployment. What is massive? Well, if nonfarm payrolls grew by less than 60,000 or unemployment breaches 5.0%, then be VERY WORRIED. The scenario for a hard landing would increase dramatically. Plus this would signal the start of an "easing trend" for Fed funds rate, which would then NARROW the interest rate differentials = reversal of yen carry trade!

Liquidity Driving Markets - No one is denying that excess liquidity is driving most markets. The good thing is we are seeing some action being taken to soak up some of the liquidity. You cannot have excess liquidity as the major driving force as that would always lead to over-valuation and market excessive behaviours. The recent scare on yen carry trade reversal may have eliminated a portion of the liquidity from the system. This would have brought better sanity and clarity for the markets. Not just the BOJ, in fact, other central banks have been trying to rein in liquidity as well. Over the last few weeks, the People’s Bank of China raised reserve ratios on financial institutions to 10%, the fifth hike since mid-2006. The Reserve Bank of India raised reserve ratios by 50 basis points to 6.0%, the second since December 2006. We can expect China to continue with this form of tightening as a better way to reduce liquidity. The China Economic Review says analysts expect reserve ratios in China to go as high as 11.5% in 2007. And analysts expect more hikes in India given domestic inflation of 6.5% and forecasted GDP growth of 9.2% (highest rate in 18 years). What this could mean is a bumpy uptrend ride for the rest of the year, so you will have to work harder to earn money in 2007. Have to look for curveballs, winding roads, traffic danger signs, ... and not over-gear.

Could The Yen Be Undervalued? - While we yak on about yen carry trade. There are two main reason for investors to indulge in them, one is the interest rate differentials, and two, that the fundamentals actually point to a weaker yen! But there is a growing voice that says that the yen is in fact undervalued and not the flip side as most would be led to believe!!! The yen hit an all-time low against the Euro last month, and its trade-weighted value was at its lowest since 1970. According to the Economist's Big Mac Index, the yen is undervalued by approximately 28%. At some point, this imbalance must be corrected and the yen has to rise. Then we have the recent raise in interest rates, what this could mean is that MONEY is no longer FREE or CHEAP in Japan. Though it will probably be in 4Q 2007 before we see BOJ raising rates again, it could be the start of a long term trend. As almost everyone expects the BOJ to raise rates very slowly, the BIGGEST potential market correction will come should BOJ decided to raise rates again anytime in 2Q or even 3Q 2007, as that would set off panic buttons. Watch the old foggies in Japan closely. This has happened before. When hedge funds reversed their yen carry trade positions after Russia defaulted on its debt in 1998, the yen appreciated by 20% in two months. Just imagine, a 10% appreciation now would have spelt catastrophe even! Then at another instance, the Japanese government announced a plan to recapitalise its crippled banks, the yen jumped 13% within three days. Yen carry trade catastrophies are not new, nor are they rare. The BOJ has been holding onto the near 0% interest rate policy for more than 10 years, and yen carry trades have been around for as long as that. To me, its the gap and trend of interest rate differentials that will dictate matters in the end. So, watch things that will narrow or widen that gap to get a better read on markets for the rest of the year.

Oh... do I believe the yen is undervalued? Yes actually but only slightly, I do see Japanese corporates competing very well already at 120-125, I think they will be able to compete even at 110 or even 105. So, if I was running a hedge fund, I would still borrow in yen to invest, but I would hedge the position so that I lock in yen rate but maximise on the low interest rates.

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