Irrational Variation Of Taylor Rule May Affect Inflation, An Opportunity For Gold?

Crude oil price continues to trade below 74 in European morning as stock markets weaken. In the UK, the FTSE 100 Index slides -0.2% to 4887 while Germany's DAX and France's CAC 40 lose around -0.1% to 5512 and 3648. In Asia, stocks also fell amid worries about credit tightening in China.

Currently trading at 947, the benchmark contract for gold maintains its sideways trading. The yellow metal has been moving below 1000 since February and the trading range has narrowed from 850-990 to 900-980 in recent months. Volatility has obviously reduced and the phenomenon is even more apparent in non-USD terms.

Rise in risk appetite and diminished inflation expectation are the main reasons for the recent boring gold price movement. As global economic outlook has turned brighter, investors tend to allocate more capitals to higher-yield assets such as stocks. Their interests in gold appear to have slowed down.

In 1Q09, the market talked about hyper-inflation which is expected to be brought about by the massive monetary and fiscal stimulus worldwide. However, very few people seem to care about it after policymakers including Fed Chairman Bernanke reinforced that inflationary pressure remained subdued.

For many years, analysts and policymakers have been using 'Taylor Rule' as a gauge for interest rate decisions. John Taylor, the economist who developed the well-known rule, said that too much variation in the rule may affect interest rate policy and the inflation outlook.

Taylor said that, using the original formula (interest rate = 1.5* inflation rate + 0.5* GDP gap + 1), the US inflation rate is about 2% and the GDP gap is about -8% while the interest rate should be 0%. This is similar to current Fed funds rate of 0-0.25%. Should inflation rise and GDP gap narrows, the Fed will increase interest rate early next year.

However, Fed Governor Laurence Meyer believed the rule should be amended from '0.5 * GDP gap' to '1*GDP gap' which implies an interest rate of -4%. In this case, the Fed will not raise its policy rate until end of 2010. Moreover, as policy rate is non-negative, the Fed may want to adopt additional stimulus measures in order to help 'revive' the economy.

If the Fed really underestimates economic outlook and keeps its policy rate too low for too long, this will affect inflation. That is, future inflation will be much higher than what is currently anticipated.

Trade Idea: GBP/USD - Hold Short Entered at 1.6440

GBP/USD - 1.6383

Most recent candlesticks pattern : N/A
Trend : Near term down

Tenkan-Sen level : 1.6432
Kijun-Sen level : 1.6482
Ichimoku cloud top : 1.6556
Ichimoku cloud bottom : 1.6466

Original strategy :

Sold at 1.6440, Target: 1.6290, Stop: 1.6500

New strategy :

Hold short entered at 1.6440, Target: 1.6290, Stop: 1.6455

Despite intra-day anticipated rebound back to the Tenkan-Sen, the British pound did meet renewed selling pressure there and has retreated again, bearishness remains for the decline from 1.7044 top to resume for a retest of 1.6275 support, break there would bring a stronger correction of recent up move to 1.6241 (50% projection of 1.7044 to 1.6275 measuring from 1.6225, however, reckon 1.6150 (61.8% projection level) would hold from here.

In view of the above analysis, we are holding on to our short position entered at 1.6440 but one must book profit on such a move. Only above the Kijun-Sen (now at 1.6482) would prolong choppy trading and rebound to the Ichimoku cloud (now at 1.6556) cannot be ruled out but resistance at 1.6625 should remain intact.

Obama renominates Bernanke for Fed chief

President Barack Obama renominated Ben Bernanke on Tuesday to be the head of the U.S. central bank. Here is the text of the president's remarks as prepared for delivery at 9 a.m. EDT (1300 GMT):

"Good morning everyone. I apologize for interrupting the relaxing I told you all to do, but I have an important announcement to make concerning the Federal Reserve.

"The man next to me, Ben Bernanke, has led the Fed through the one of the worst financial crises that this nation and this world have ever faced. As an expert on the causes of the Great Depression, I'm sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage, and his creativity, that's exactly what he has helped to achieve. And that is why I am re-appointing him to another term as Chairman of the Federal Reserve.

"Ben approached a financial system on the verge of collapse with calm and wisdom; with bold action and outside-the-box thinking that has helped put the brakes on our economic freefall. Almost none of the decisions he or any of us made have been easy. The actions we have taken to stabilize our financial system, repair our credit markets, restructure our auto industry, and pass a recovery package have all been steps of necessity, not choice. They have faced plenty of critics, some of whom argued that we should stay the course or do nothing at all. But taken together, this "bold, persistent experimentation" has brought our economy back from the brink. They are steps that are working. Our recovery plan has put tax cuts in people's pockets, extended health care and unemployment insurance to those who have borne the brunt of this recession, and is continuing to save and create jobs that otherwise would have been lost. Our auto industry is showing signs of life. Business investment is showing signs of stabilizing. Our housing market and credit markets have been saved from collapse.

"Of course, as I have said before, we are a long way away from a completely healthy financial system and a full economic recovery. And I will not let up until those Americans who are looking for jobs can find them; until qualified businesses, large and small, who need capital to grow can find loans at a rate they can afford; and until all responsible mortgage-holders can stay in their homes. That is why we need Ben to continue the work he's doing, and that is why I've said that we cannot go back to an economy based on overleveraged banks, inflated profits, and maxed-out credit cards.

"For even as we have taken steps to rescue our financial system and our economy, we must now work to rebuild a new foundation for growth and prosperity. We must build an economy that works for every American, and one that leads the world in innovation, investments, and exports.

"Part of that foundation has to be a financial regulatory system that ensures we never face a crisis like this again. We have already seen how lax enforcement and weak regulation can lead to enormous wealth for a few and enormous pain for everyone else. And that's why even though there is some resistance on Wall Street from those who prefer things the way they are, we will pass the reforms necessary to protect consumers, investors, and the entire financial system. And we will continue to maintain a strong and independent Federal Reserve.

"We will also keep working towards the reform of a health insurance system whose costs and discriminatory practices are bankrupting our families, our businesses, and our government. We will continue to build a clean energy economy that creates the jobs and industries of the future within our borders. And we will give our children and our workers the skills and training they need to compete for these jobs in the 21st century.

"Much like the decisions we've made so far, the steps we take to build this new foundation will not be easy. Change never is. As Ben and I both know, it comes with debate and disagreement and resistance from those who prefer the status quo. And that's ok, because that's how democracy is supposed to work. But no matter how difficult change is, we will pursue it relentlessly because it is absolutely necessary to lift this country up and create an economy that leads to good jobs, broad growth, and a future our children can count on. That is what we are here to do, and that's what we will continue to do in the months ahead. I want to congratulate Ben on the work he's done this far, and wish him continued success in the hard work ahead. Thank you."

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Markets Will Continue To Rise

If economic data along with the Fed can be used as a guide, there was no reason to see global stock markets retreat to any appreciable degree going forward and to expect that the market rally will continue over the third and fourth quarters. However, there’s another important reason which has me even more convinced the rally will continue.

For improving markets really comes down to an exercise in logic, so follow my thinking. As I’m sure you’re aware of, we’re in the middle of the largest fiscal and monetary expansion in history, one that is globally coordinated. These policies are designed to do one thing-reflate asset values in order to counter the dangerous effects of deflation.

Now, one of the big concerns among some economists is that policymakers will be too slow to withdraw all this liquidity once the global economy shows signs it can make significant improvements, as it’s starting to do at this time. The reason for this is because monetary policy that’s overly expansionary has the potential to create asset bubbles. Indeed, it’s generally accepted by most major economists, including Nouriel Roubini, that an important factor in the development of the housing bubble was the Fed keeping rates too low for too long after the 2001 recession and then raising them only gradually (in 25 basis point increments) once they did begin to tighten policy in 2004. At this time, because those policies have been implemented in conjunction with fiscal stimuli that risk is likely to be even more pronounced.

But what we also saw at the Federal Reserve’s annual retreat in Jackson Hole over the weekend is that policymakers are of the belief that the global economy is far too fragile at this time to even begin thinking about tightening policy, with the Financial Times reporting that “in private and in public, most officials indicated they believed that rates could be maintained at ultra-low levels for a considerable time without generating excess inflation, in spite of better economic data and a return of “animal spirits” in financial markets. “

ECB President Trichet, who warned against “a return to complacency,” went so far as to say that talk of economic conditions returning to normal made him “a little bit uneasy.”

“Because we have some green shoots here and there, we are already saying: ‘Well, after all, we are close to back to normal,’ he said. “We know that we have an enormous amount of work to do and we should be as active as possible,” a strong implication that ECB monetary policy will remain accommodative for an extended period.

Harvard economics professor Martin Feldstein, the first prominent voice to call for rate cuts at the 2007 meeting, thought it would be possible to have “two years or more of very low interest rates” without risk of excess inflation, given the spare capacity in the economy.

The most recent FOMC statement reiterated that policymakers continue “to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.“

So, here’s where the exercise in logic comes in; if expansionary monetary policy is known to have the potential to create asset bubbles, and if we have a historic amount of liquidity being provided on a global scale, and if, as every indication shows, policymakers intend on keeping policy expansionary for an extended period of time, doesn’t it then follow that markets pretty much have to go up absent a catastrophe?

We’ve all recently learned just how dangerous bubbles can be, but what we as traders should also have learned is that these bubbles take a long time to grow and that they can persist for many months and sometimes even years. And shouldn’t the goal as traders be to ride that bubble (if one is even occurring now) as best we can with trades in currencies, futures, options etc that are liquid and therefore easy to close out of?

So, that’s why I continue to believe that equity markets and commodities will continue to rise over the rest of this year and probably well into 2010. And with that occurring the dollar will depreciate against the better-yielding currencies (Aussie especially) as those continue their months-long appreciation against the yen.

Forex Market News – Dollar makes come back against majors after Fridays lows

US Dollar:
A recovery in stock markets late last week saw the dollar slip against the euro and pound as safe haven currencies rallied back from their recent highs.
This dollar moves seems to have come on the back of comments by the Federal reserve Chairman Ben Bernanke that the economy was leveling out. The greenback has now taken nearly town cents off the pound after its lows of $1.6623 on Friday, to rally to $1.6367 this morning. There was a smaller recovery for the dollar against its European counterpart, with nearly one cent taken back since Friday, for EUR/USD to trade at $1.4290. Currency dealers will keep paying close attention to equity markets in Europe and the US later in the day in the absence of other significant trading cues such as economic data.

Sterling:
Sterling closed out the week on a rallying market last week as once again we saw the pound rise in line with stock markets. Cable hit $1.6623 on Friday as risk appetite grew in the markets, pushing up the higher yielding currencies. The FTSE 100 index, which has soared almost 40% since its low point in March, closed at a 10-month high of 4,850 last week. Some fund managers believe that it could break through the psychological important 5,000 level this week. However, it was the turn of the euro to push itself above the pound in the race off against the dollar, with both currencies usually doing well against the buck when risk returns to the markets.
The pound dropped over a cent against the single currency to fall below the 1.15 level, only dragging itself off that floor this morning to pick up slightly to 1.1524. This morning we have seen some weakness for cable as comments from the US fed Chairman filter through the markets, where he spoke of the economy was leveling out. This has seen a fight back for the buck as it took nearly two cents off the pound. Forthcoming UK figures may show that the economy performed slightly better than initially expected in the second quarter. Some economists believe revised figures due on Friday will show it shrinking by 0.7%, rather than the 0.8% that was originally estimated.

Euro:
The euro rose again today as risk appetite continued in Asian trade, following on from last weeks bull run in the equity markets, increasing buying of risk sensitive currencies with the euro being one of them. This saw the single currency take nearly two cents off the dollar from Friday to hit $1.4373. A slight fight back from the dollar has now been seen as comments from the Fed chairman boosted the dollar. The euro did fair better than its UK counterpart in the run off for the rally in less risk sensitive currencies. We saw a gain for the euro against sterling of 1.5% for EUR/GBP to hit 0.8700.

General:
The Aussie and Kiwi dollars both took full advantage of a strong rally in the equity markets to make significant gains against both the pound and US dollar. Sterling/Aussie has now fallen down to AUS$1.9631, nearly equaling its low point two weeks ago where it reached AUS$1.9585.

Weekly Technical Strategist

EURUSD: Switches Focus To The 1.4446 Level

EURUSD- With a reversal of most of its losses off the 1.4444 level, its Aug 03’09 high seen the past week, risk for more upside gains targeting that level continues to be envisaged. Beyond that level will put the pair in position to head further higher towards the 1.4719 level, its Dec 18’08 high and possibly higher towards the 1.4875 level, representing its Sept 21’09 high. Both its weekly and daily RSI have turned higher suggesting further upside strength. Immediate support lies at the 1.4326 level, its Aug 13’09 high ahead of the 1.4044 level, marking its Aug 17’09 low with a turn below there creating further downside pressure towards its MT rising trend line at 1.3968. Decisively invalidating that level will mean additional losses towards the 1.3747 level, its Jun 16’09 low. On the whole, having reversed almost all of its declines off the 1.4446 level, EUR now looks to target further higher level prices and possibly resume its MT uptrend.

Directional Bias:
Nearer Term Bullish
Short Term Bullish
Medium Term Bullish

Performance in %:
Past Week: +0.14%
Past Month: -0.83%
Past Quarter: +5.89%
Year To Date: +1.65%

Weekly Range:
High -1.4776
Low -1.4207

Detailed Forex Trade Instructions on Eur/Usd

We just had a good week trading the Eur/Usd and I think that we are headed for some more great moves coming this week and beyond. Forex trading slows down in the month of August and we should see some more volume in September.
On Monday we have key levels that the Eur/Usd will be challenging, and if we break the resistance levels we may see some big moves.

For resistance levels we1.4377, 1.4448 and 1.4721 both of those levels are key and if we see them broken we could see serious trend momentum. The level at 1.4721 is the pairs high price of Dec 7, 2008

The Support levels are 1.4274, 1.4200 and 1.4050

The current trend is in favor of the Euro so we will be looking for that trend to continue but we will be ready to adapt if the pair gets stopped by key resistance levels.

Trade Setup and Rules:

First we will be watching the first resistance level of .14377 and if that level gets taken out the target is 1.448. So the plan is to enter long somewhere around 1.4385 and put a stop at 1.4356 which is 31 pips. Make sure that you are only risking %2 of you account value. The target level is 1.4448 which is 63 pips. That gives us a 2 to 1 risk to reward ratio which is important to maintain in your trading to help increase profitability long term.

IF the pair bounces of the 1.4377 level look at the support level of 1.4200 and watch for the pair to bounce off of that level and continue to move up. If the support level of 1.4200 does not hold look for a target of 1.4050.

Another idea for trading is to open two lots and let the first lot hit your target and then you can take profits and at that point move your stop on the other lot but keep it open to enable the pair to continue to run and you can gain more pips if the pair will have a longer run.

Why the Dollar Will be Get Stronger?

The whole market is currently short the dollar right now but I think that could be a big mistake. I know this is a completely contrarian view and that the outlook for the dollar is not good. However, I have 5 good questions and 5 good answers why I think the dollar is headed for a reversal and that this is the perfect time to go long.

1. What good is a strong Euro? I believe a strong Euro will do more damage to Europe than a weak dollar will hurt the U.S. Recently, our weak greenback has been beneficial in two different ways. First by boosting exports and discouraging imports which provides a shot in the arm for our weak economy; not good for the Euro. Second, it helps shrink our trade deposit in goods and services which in turn slows the endless flow of dollars abroad; not good for the Euro.

2. Is there a currency that can replace the dollar as the world’s reserve currency? To this I have to say… into what? Recently China suggested it would diversify away from the dollar to a likely candidate the Euro. However, the Euro doesn’t have enough liquidity to handle the demand. It is still an experimental currency that not one government can invest in with total faith. Also, with more than two-thirds of foreign reserves in dollars, it would most likely take a decade to replace the dollar as the world’s reserve currency.

3. Is there anyone a weak dollar helps in the long run? Even though many countries somewhat dislike Americans, they dislike a really weak dollar even more. Why? A weak dollar makes U.S. exports attractive and forces foreigners to patronize that which they despise. Their manufacturing industries suffer and their unemployment rises. So don’t expect foreign governments to fight a modestly stronger dollar or even encourage it when the reversal begins.

4. What about the stock market? The stock market loves a strong dollar because a weak dollar is NOT beneficial to the stock market. Historically, the average return of the S&P 500 – during times when the dollar was strong – was a gain of 86.6% which is over five times the average return of 16.4% when the dollar was weak.

5. When is the best time to reverse positions in a market? The best time to take a contrarian position in a market is when the most unlikely and unsophisticated are speculating. Give me a break… when corner store owners and housewives start trying to earn extra income by speculating in the Forex, something they know nothing about, we’re near a bottom. The smart money knows that and now you do to.

Yes, the dollar will get strong again; at least moderately. In the near term there will probably be more pressure to the downside. However, a turn is coming and when it does the change will come swiftly.

The NFP and The Markets

The Non-Farm Payroll and Unemployment Reports are considered by most economists to be about the most important economic indicators, and certainly, their immediate aftermath creates a high level of volatility. However, as any trader will tell you, a consistent trend is much easier to profit from than immediate short term movements, so let’s look at the numbers and see if they truly are a help in this regard. The answer will probably surprise you.

As currency traders we of course look at the dollar’s movements but remember, the S&P 500 has a huge amount of influence over where the dollar is going. Actually, the dollar’s relationship with equities is rather a chicken and egg affair-either one can definitely drive the other given the right set of circumstances. For example, the stock market crash which ensued after the Lehman bust last September certainly helped drive the dollar far higher against the higher-yielding currencies while Bernanke’s infamous “electronic printing” comments during his March 15 60 Minutes interview helped push it in the opposite direction and spark a rally in equity markets.

What it really comes down to is investor’s appetite-or lack thereof-for risk. When the investors are risk-averse they move into the dollar and Treasuries as they move away from stocks and commodities while the acceptance of risk has the exact opposite effect. So the real question we need to answer is what if any effect the NFP has on investor’s risk tolerance.

First, the unemployment rate has followed a consistent pattern; it’s worsened each month at a level about as expected. The only exception has been in July when the 0.1 percentage point increase was less than expected. That’s significant because of the way unemployment is measured; workers who are not actively looking for work are not counted in the headline unemployment rate but as they re-enter the job market, they are.

Over January and February, the markets were in risk-averse mode; the S&P 500 lost 9.03% and 10.69% while the dollar index gained 5.46% and 2.53%. The NFP, while certainly bad, was basically about as expected in both reports. In March, the amount of jobs lost continued to worsen but the number was better than what the market was looking for. The S&P gained 9.36% while the dollar index fell 2.92%. The April loss of jobs worsened about as expected as the S&P gained 10.52% and the dollar index fell 0.94%. The tide turned in May when the loss of jobs declined for the first time, beating market expectations. The S&P gained 5.21% while DXY fell 6.22%. The June loss of jobs was far better than expected while the S&P was basically flat and the dollar gained 0.84%. Finally, in July the job loss was far worse than the market was looking for, but he S&P still managed to gain a very healthy7.22% while the dollar fell 2.27%.

The only conclusion that I can draw from the numbers is that the NFP itself is actually a poor predictor for market risk tolerance over the subsequent month, with the proviso that the market is betting that job losses peaked in April at -663k. It seems to be that the unemployment rate carries more weight with investors, especially given what happened in July when stocks rose when the loss of jobs accelerated as the unemployment rate grew less than expected.

Meanwhile, the latest data on unemployment claims shows a decidedly mixed picture when you look a bit deeper into the data. The number of people continuing to claim benefits rose by 69,000 to 6.31M while the 4-week moving average decreased by 148,500 to 6.427M. Economists prefer to use the 4 week averages in this series because they smooth the data however, the number of workers continuing to claim benefits will fall as they run out unemployment insurance, which is happening now.