by Patrick Patterson, Chief Strategist and Administrator of Education

Money Supply

Understanding some basic concepts about money supply and its potential effects on pricing is important to understanding market sentiment and determining market sentiment is the key to making winning trades. The money supply is the total amount of money available in an economy at a particular point in time. Money in this sense is generally defined as the currency in circulation and demand deposits (e.g. a checking account).

Central banks have the authority to increase and decrease the money supply to battle the impact of inflation. Their monetary policy instruments can include:

· Interest Rates – the cost for borrowing money

· Open Market Operations – buying securities

· Capital Requirements – the percentage of assets banks are required to hold

· Reserve Requirements – the percentage of deposits banks are required to hold

· Exchange Requirements – restriction on the ways local currency can be exchanged

· Margin Requirements – limit on lending

It is therefore important to understand at a basic level that the ebb and flow of the money supply is artificially controlled to keep economies stable and that those controls impact market sentiment directly and indirectly.

Here are two key things to remember: (1) an economy’s money supply affects the value that economy’s currency; (2) central banks artificially control the money supply of an economy in an effort to keep the economy stable and these controls greatly impact sentiment.

Inflation

Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. When prices rise in an economy, the currency for that economy buys fewer and fewer goods and services. This loss of purchasing power is a decline in the actual value of the currency for that economy.

Inflation can have both positive and negative effects on an economy. The negative effects of inflation include: uncertainty about an increase in inflation and that may cause risk aversion by investors; high shortages of goods caused by consumer hoarding; and loss of economic stability in the real value of an economy’s currency. In some cases, economies may experience hyperinflation (inflation out of control) caused by rapid and excessive growth of the money supply.

One of the worse real world examples of hyper inflation is the economy of Zimbabwe. Rampant inflation has caused their economy to collapse. 1 US Dollar = 4,672,634,610 Zimbabwe Dollar. A loaf of bread in Zimbabwe now costs about 300 billion Zimbabwean dollars. The new 100 trillion dollar bill would be worth about $300 in U.S. currency.

Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.

In the United States, the Consumer Price Index (CPI) and the Producer Price Index (PPI) are used to measure inflation. CPI – is a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. PPI – is a family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.

by Dr. Patrick Patterson, Chief Strategist & Administrator of Education

Background…

A reserve currency is a currency that is stored in large quantities by foreign central banks and financial institutions as part of their foreign exchange reserves as a means to pay off international debt obligations, or to influence their domestic exchange rate.

The U.S. dollar is the primary reserve currency. A reserve currency is generally the international pricing currency for goods on the world market. A large percentage of commodities, like precious metals and energy are usually priced in U.S. dollars. Other countries are compelled to hold the U.S. dollar in reserve in order to pay for these commodities and avoid transaction cost.

Importance…

China’s central bank has stated repeatedly that a new international currency should replace the U.S. dollar as a reserve currency. The People’s Bank of China said the country will push reform of the international currency system to make it more diversified and reasonable.

China currently has approximately $2 trillion in reserves, mostly from the purchase of U.S. treasuries. The current U.S. economic crisis and the resulting quantitative easing along various new monetary policies has the Chinese concerned about the devaluation of the U.S. dollar.

Ramifications…

The International Monetary Fund (IMF) has acknowledged that China’s proposition is a possibility. If the a number of key countries supported the proposition and began selling dollars for an international currency, the U.S. dollar could depreciate dramatically.

At the moment, the U.S. dollar represents about 70% of the worlds foreign currency reserves, so we are several years from an international currency at best. Even the strongest proponent for this idea, China, would not want this move to an international currency to happen too quickly, or they’ll lose their investment in U.S. treasuries.

However, if sentiment were to shift on the news that an international currency was likely, then U.S. dollar devaluation would increase exponentially and the currency markets would be chaos and the U.S. economy would face collapse.

by Patrick Patterson, VP of Operations

Back in October 2008, then US Treasury Secretary Henry Paulson met with CEOs of the 9 largest US banks. During that meeting, it was reported that Paulson required the CEOs to take TARP money whether they wanted the money or not.

In May, Judicial Watch released talking points taken from official documents from those meetings. The talking points used by Paulson in that meeting include the comment that “we don’t believe it is tenable to opt out [of TARP] because doing so would leave you vulnerable and exposed.” “If a capital infusion is not appealing,” the memo continued, “you should be aware that your regulator will require it in any circumstance.”

These comments make it clear that the US Treasury Secretary required both private and publicly owned institutions to take government monies under the guise that his actions would necessarily promote additional lending. The concept that was pushed was that healthy institutions, now having greater liquidity, will be encouraged to lend even more money to non-credit-worthy loan applicants. This notion is preposterous even on its face! Certainly, the US Treasury Secretary understands the basic tenants of both supply and demand and the importance of a credit worthy borrower. The poor quality of the idea is especially evident in light of the poor lending practices that make up the root cause of the current economic recession. So this begs the question, what was Paulson actually doing by requiring the banks to take the money? 

Today, 10 US banks won (after some struggle) approval to repay TARP funds. These banks are: American Express Co, Bank of New York Mellon Corp, BB&T Corp, Capital One Financial Corp, Goldman Sachs Group Inc, JPMorgan Chase & Co, Morgan Stanley, Northern Trust Corp, State Street Corp and U.S. Bancorp. Interestingly enough, there has been no discussion about increased lending on the part of these banks. In fact, the number of bankruptcies are at levels that haven’t been seen since 2005 and it more difficult than ever to get a loan, even if your credit score is 700 or better.

President Obama immediately used the news about these 10 banks repaying bailout money to suggest that TARP is working. In reality, the government forced healthy institutions to take government funds and then made profit on the interest from those banks and is now “allowing” some of those same banks to pay back money they didn’t want in the first place and calling the TARP program a success. This is akin to offering one type of food on a menu and then claiming that it is the favorite food choice of all patrons.

We need the government to stop helping the economy, so we can begin addressing the causes for our current economic situation and stop chasing shadows.

FX Trader’s Corner…

As an FX trader, I am flat during the Asia session and looking to short the US dollar in the Euro session. Some key pairs I’ll be watching during the Euro session are: USD/CHF, EURUSD, and GBPUSD.

by Patrick Patterson, VP of Operations

Timothy Geithner goes to China (June 2nd 2009)
Story: US Treasury Secretary Timothy Geithner visited Beijing in order to discuss US debt.
As the US economy declines and the dollar continues to devalue relative to world currencies, China is increasingly nervous about their $2 trillion dollars worth of treasuries.  In March, the Chinese floated the idea of changing the reserve currency from the greenback, which is primarily why Geithner had to get on a plane to Beijing. Instead of focusing on the state of the dollar, Geithner suggested that China change their monetary policies in order to achieve sustained growth. It isn’t entirely clear what China will do, but we know that they weren’t completely receptive to Geithner’s suggestions or his point of view on their economic situation. However, we also know that China must approach this situation delicately or they will increase the speed of dollar devaluation exponentially and ensure exactly what they are desperately
trying to avoid.
Relevance: This is a situation that is important to monitor carefully! China’s economy is booming (too fast) and if the Juan is made the world’s new reserve currency, the US will face financial collapse. This is closer to reality than most market pundits want to admit and since dollar devaluation is continuing at a near similar rate to the speed of the printing presses at the Federal Reserve and the Treasury, the dangers are very real.

Bernanke’s Testimony on June 3rd 2009 on Budget and Economic Outlook
Story: Federal Reserve Chairman Ben Bernanke was quoted as saying “Unless we (the US) demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.” He also said “Maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance”. However, he was not specific about how the central bank would accomplish these goals.
Relevance: I interpret this non-specific language as a way to hedge against the hard uestions about the devaluation of the dollar and expect to see more money pumped into the economy, specifically through large corporations, until the government can influence the markets through corporate entities.

How to trade this fundamental news…
Both these stories speak to the peril of the greenback! The markets are extremely risk averse, which is corroborated in the price of gold, as market participants make a flight to quality (a commodity with intrinsic value). As FX traders, we are cautiously bullish the dollar in the short term, but we are decidedly bearish the dollar in the long term and actively look to sell rallies. We also look for breaks of key resistance areas for oil and gold prices and look to buy the correlated commodities.