ECB interest rate decision

Updated with the current ECB decision and Mr. Trichet's statement

With the approaching of the ECB meeting on Thursday it seems the markets are getting more nervous and volatile. EUR lost more than a percent against USD on Monday and regained that percent back in Tuesday. US equities followed suit although their movements were far bigger and the changes were about 3% in both directions. The "fear index" VIX moved about 10% up and down for the first two days of the week.

The US equity markets finished strongly upward on Tuesday as FED's chairman Mr. Bernanke assured the markets "he’ll push forward with further expansion of monetary stimulus if needed ". After the strong selling during the last weeks and rebounding from the new low for the last two months made on Tuesday, the market seems hungry for good news. Mr. Bernanke's speech fitted well into such market expectations.

On the other side of the ocean Europe is still struggling with its sovereign debt problems. The Moody's Investor Service cut Italy's credit rating to A2 from Aa2 which at first made European equity markets to stay behind the increase of the US market from Tuesday. Later during the day the EU stocks advanced. Such an increase amidst credit rating downgrade (although possibly expected), an unexpected drop in EMU Retail Sales (YoY) of -1% and a decrease in Purchasing Manager Index Services in EMU could speaks of a strongly oversold sentiment. The same sentiment seems to be present in the US equity markets also.

So if everyone is focused on the ECB decision on the interest rate on Thursday, let's elaborate a bit on the possible outcomes.

Chart 1. Inflation in euro area, annual, non-seasonally adjusted; Source: ECB

The market consensus is that the ECB would leave its rate untouched at 1.5%. Any deviation from that consensus could sparkle market movements in both directions. Even if the ECB does not change the rate, the language it would use in the press release could signal the bank's further intentions.

In general ECB is strongly concerned with price stability. The last data on inflation in EMU showed an increase to 3% on annual basis after previously decreased a bit. Thus the market consensus that ECB would leave the rate unchanged seems reasonable enough as any further increase in the money supply by lowering the rate has the potential to increase the inflation pressure.

On the other hand data from October 5, 2011 show the growth in euro area slowed significantly to 1.6% (YoY) from the previous 2.5%. The combination of a high inflation and a slow growth does not seem to be in favor of any further increase in the ECB interest rate in the short-term. Such a combination however, does neither support a strong decrease in the rate which the currency markets seem to be hoping for as that would boost inflation. So basically that puts the two extreme options – an increase in the rate and a strong decrease out of the table for now.

We are then left with those two – rates unchanged as is the market consensus and a small decrease which would be a surprise given the consensus.

If the interest rate is left unchanged that would not have any significant direct effect on the markets as this outcome seems already priced in. The markets could continue to be moved mostly by oversold moods and short rallies. Not lifting the rate given the present weakness of the euro combined with the sovereign debt problems in EU however, could signal the ECB is not so strongly on the euro defensive position at the moment. That could increase the short-term confidence in the EU common currency or at least not hurt it further. All that however does not seem so strong to present a long-lasting and deeper change in the market sentiment if we account for the sovereign debt problems as well.

The second option which seems possible given the slowing growth, is a decrease of .25 basis points to 1.25%. Such an decrease would not hurt so much the interest rates differential between USD and EUR as to strongly send the Euro further down. Such a strongly weaker euro scenario does not seem a desirable outcome for the EU officials either.

A small decrease in the rate would be a surprise given the consensus and could give equity markets confidence the ECB is concerned with growth in EU at least as much as it is with price stability. That could more possibly result in EU markets increase than in US but in general both markets follow suit. The current negative sentiment resulted in a bit oversold market condition on both sides of the ocean and lead to a series of bullish divergences in EU stock markets on a short-term scale. In this light such a decision could lift up the world equity markets for a while as it would mark a possible shift in risk taking. In a longer perspective however, the commodities prices should be watched as they are able to present a big pressure on a macro level and limit growth while increasing inflation.

-----UPDATE-----

The ECB decided to leave its main refinancing rate unchanged at 1.5% so basically there were no surprises. Still the bank sees the situation as worsening concerning the EU growth prospects in the following months. ECB officials believe the inflation will continue to float above the 2% threshold but it will eventually calm down further on the line. Given the growth continues to be sluggish and inflation calms down, a coming decrease in the rate of at least .25 basis points could not be ruled out in the months till the end of the year.

You may also want to check the full text of Mr. Trichet's statement concerning the ECB decision on its rates.

EURUSD currency pair on the brink

Despite some expectations EURUSD currency pair remained relatively stable during the recent market turmoils. As the equities and commodities were drown, one should expect the US Dollar to gain strength as it has almost always did in history. Instead the pair remained range bound.

Let's look at the graphs. You may click on them for a bigger version.

EURUSD Monthly Chart

EURUSD Weekly Chart

On the monthly graph we can see the long term trend hasn't changed. The Euro is still in an upward mode against USD. The bullish divergence seen between the MACD indicator and the currency value seems still valid. Usually the pair has to go above its previous high which hasn't happened till now. The Moving Averages are still pointing upward and MACD is on a positive side.

When will the pair break out of the range seems to be the question now.
Maybe tomorrow's speech of Bernanke would give us a key. Or maybe not. We'll wait and see.

Another factor which could trigger the movement is an improvement in the situation in Europe in the form of more political will to cooperate and occurrence of structural changes like common fiscal policies.

What is interesting is that on the weekly graph (graph below) is seen a clear triangle formation. This could signal a continuation of the previous trend and is in line with the bigger time-frame graph.

Anyway, given this breakout occurs in the next months we could see a value of at least 1.53 for EURUSD pair.

A movement in the pair would be a signal for commodities (mostly crude) to rise again on the hopes of improving economies as such a scenario most probably would be accompanied by stronger equities.

==Update Aug 26, 2011==

Some important events took place today.

Date	(GMT)	Country	Event	Actual	Cons.	Previous
Aug 26	08:00	EMU	M3 Money Supply (3m)	2.1%	2.3%	2.0%
Aug 26	08:00	EMU	M3 Money Supply (YoY)	2.0%	2.2%	2.1%
Aug 26	08:30	UK	Gross Domestic Product (QoQ)	0.2%		0.5%
Aug 26	08:30	UK	Gross Domestic Product (YoY)	0.7%		1.6%
Aug 26	08:30	UK	Index of Services (3M/3M)	0.5%	0.6%	1.2%
Aug 26	12:30	US	Gross Domestic Product Annualized	1.0%	1.1%	0.4%
Aug 26	12:30	US	Gross Domestic Purchases Price Index	3.3%	2.3%	3.9%
Aug 26	12:30	US	Real Personal Consumption Expenditures (QoQ)	2.2%	0.2%	2.1%
Aug 26	13:55	US	Reuters/Michigan Consumer Sentiment Index	55.7	56.3	63.7

M3 money supply in European Monetary Union (EMU) decreased a bit on annual basis which would mean the probability of higher inflation in EU is getting smaller. Hence the pressure on ECB to lift interest rates in order to fight any higher inflation decreases.

In the same time in US the Gross Domestic Purchase Price Index (GDPPI) is lower than previous reading although still far above the consensus. The inflationary pressure in US is getting weaker but not as fast as economists expected. Looking at that index the FED could rest assured its promise to keep the rates low does not induce higher inflation. For now.

Reuters/Michigan index value could signal a further decline in consumer spending. It however does not measure the real money spent. An expectations sometimes differ than reality.

On a quarterly basis the Real Consumer Expenditures grew and the current reading is far above the consensus.What this could signal is a widening gap between consumers' expectations and their real spending. Their spending might be more not because they are willing to spend more but just because prices got higher. Which gets us back to the GDPPI which does not fall as much as economists expect.

If inflation kicks in the consumers will have to spend more no matter if they are expecting it or no.

Bernanke's speech didn't reveal anything new in particular which itself is an interesting hint. FED's chairman continues to believe the markets impact economy and not that markets reflect economy in advance. Like he said they are actually on a stand-by.

FOREX markets reacted as sending down the Frank (CHF) both against US Dollar and the Euro (more than 2%). The one currency that has moved steadily up during the current crisis. Till a couple of weeks ago. At first after Bernanke's speech both currencies appreciated against the Frank. At the end of day only the Euro continued to advance. What is interesting is that it advances against the US Dollar also. Is the Euro breaking out of the triangle in line?...

US stocks indexes advance a bit for the day also. Do the market participants bet on higher inflation?

If markets continue in this direction Bernanke's waiting would come to be justified. Even if he'd did it for different reasons.

Cool Way to Follow World Debt in Real Time

Impressive! :)

http://www.economist.com/content/global_debt_clock

At the moment, 18:50h, 14 July 2011 it goes to $39 845 906 800 408. Will check later in some days to see the change :)

Have a nice day!

Investment Thoughts

"The most crucial out-of-sample test is future investment success. If the strategy becomes known to other investors, prices may adjust so that the strategy, however well tested, does not work in the future"
(Level I Volume 1 Ethical and Professional Standards and Quantitative Methods , 6th Edition. Pearson Learning Solutions p. 571)

But people always want a strategy that works best for everyone... The best strategies are kept secret not because of pure selfishness but simply because of common sense. Knowledge transforms reality and that knowledge may then become obsolete. Eventually everything slips away at some moment. That's why we live and work in a constantly developing environment.

EURUSD, GOLD, Crude Oil, Rates, Inflation

As we happen to live in a global world and the financial markets are so much interconnected, it's nice to take a step back and try to observe the whole picture.

There were reports this month about FED and ECB taking different roads. At least on a first sight. The former seems more concerned with unemployment while the latter worries about the raising inflation. Hence the steps the market participants expect from both parties are different. There is a rate hike expected from ECB while the same seems not in line concerning FED. The ECB is expected to raise rates mostly because of higher Crude oil prices inducing higher inflation. That inflation is not a consumer based one (although there might be a consumer part in it). That expectancy of higher rates in Europe keeps driving the Euro higher against the US Dollar. At the same time the Crude (priced in Dollars), conquers new heights helped by the Libyan war and supply fears. And not to forget the hopes of improving economies. This improvement in turn happens to be at danger just because that same high Crude price. So what are the options?

There is no point for the Crude to rise if there won't be improving economies which to initiate the expected-to-grow demand for it. Provide there is a rate hike soon in Europe. My expectancy is for an increase for the year of .25. Higher ones could hamper further the still struggling economies of Europe resulting in even higher Euro and further difficulties for Europe exports. At the same time such a rate increase could happen to be already priced in the EURUSD rate and signal a decline in the Euro/USD pair. The expectations then could be shifted towards a needed US rate hike. Talks of such (as the one of Wharton professor Jeremy Siegel) already started to appear. Meanwhile the Oil resources of Libya could be available again. That combined with the higher Dollar and some profit taking in Crude trading would bring down or at least stop for considerable amount of time the increasing of Crude oil price. And yes, that way the higher prices of Oil would not present a big inflationary danger to the US economy (in line with the hopes expressed by the FED).

The lower crude price would ease to some extend the producer induced inflation in Europe which combined with lower Euro would help it boost its production and exports. At the same time the effect of lower Crude in US on the consumer spending could be zeroed because of decrease in prices and increase in quantities traded. Still that would leave more disposable money for any other types of spending.

All that (together with the increasing demand from Japan for recovering the country from the earthquake) would contribute to the nominal recovery of both Europe and US and bring back the risk appetite. With seemingly departing danger of another shrink of economies the need for hedging would decrease. That includes hedging through Gold. Which brings us to the next point.

GOLD now seems more and more a speculative trade as many more people of all types are getting into it. More volatility is expected and there could be turmoils at least in short to middle term. Generally it stands out nice on the face of every devaluating currency but since it was only a sideway traded metal once, now almost everyone from the big to the small is inviting you to enter Gold. Which itself creates a dangerous environment. This could prove to be a profitable but more risky situation and devaluates to a great extend the hedging characteristic of Gold.

Global YEN Intervention After the Earthquake

The Japan earthquake took the YEN to its highest level against US Dollar in the post-war era. Today G7 group intervened on the FOREX market selling YENs. The selling was started by BOJ and is reported to be followed by other members of the group. The YEN lost about 2.9% for a day. This could be only the start of it. Let's get technical.

The monthly graph shows the YEN is on a strong support level (shown by the blue horizontal line). The level sustained for several months as seen on the graph. The more important thing seen on the graph are the bullish divergences between the price and MACD indicator. The same type of divergences are seen during 1993-1995 years. Divergences of such magnitude could result in a multiyear downtrend for the YEN against the US Dollar. That would have positive effect on the Japan export economy, could result in even greater Japan dominance on the world markets of goods and eventually get the country again on the rapid development road.

Is CAPE of above 23 extraordinary for a bullish stock market?

In his article "Has the Nearly 2-Yr-Old Bull Market Topped Out?" the respected by me Mark Hulbert speaks about his concerns that the current bull market might be surpassing its sound valuation levels and it might be near its end.

The author uses a CAPE measure to prove his point. CAPE is a modified P/E ratio which was made popular by Robert Shiller, a Yale University professor who uses it in his book "Irrational Exuberance". CAPE stands for "Cyclically Adjusted Price Earnings" and it differs from the general P/E in that its denominator (the E) is average inflation-adjusted earnings over the trailing 10 years. The data the article cites could be found on the Mr. Shiller's website. It's a very complete data set in the Excel file format.

According to Mr. Hulbert's calculations the current CAPE of 23.7 (as of the date of his article) is considerably higher than the average CAPE of 18 for the bull markets of the last century which he examines. The conclusion is that it would be hard to argue that the market is undervalued or even fairly valued.

Now my remarks.

• What Mr. Hulbert is missing is that as a rule of thumb a bull market could surpass a lot its sound valuation levels especially in its extreme points before it tops out and converts to a bear market. And such a conversion doesn't happen overnight. We know a bull market will stop but we usually don't know exactly what time will pass ebfore it really happens. Exiting too early could save your money but also would mean a lot of unrealized profits. Usually choosing one over the other is a matter of personal preferences and attitude.
  
  
• Now as we stand on the understanding that a higher CAPE is a normal phenomenon for a bullish market, it would be nice if the article of Mr. Hulbert shows at what ratio the average CAPE the author calculated was overrun by the real CAPE for the years of the bull markets it discusses. But it doesn't. It just states the current CAPE is higher than the avegare one.
  
  If we dig the data from Mr. Shiller's file we see that the current month CAPE is 23.69 and it's indeed higher than the average 18 Mr. Hulbert calculated. But during 2007 there was noticed a CAPE of above 27 (50% above the average value of 18), during 2004 - above 26-27 (again about 50%), during 1999-2001 - above 40 (122%)! In all the period between the late 1995 to 1999 CAPE values were above 24 with an average value of about 31.5 (75%).
  
  So the current CAPE is 30% above the average of 18 but we've seen even higher differences during the past 15 years. Seen in that light a 23 CAPE doesn't seem so extraordinary.
  

If you are a strictly value oriented investor I understand that leaving your money in a market that you believe is overvalued is hard and against your logic. Not everyone in the market is such a type of investor though. That makes the market move and the imperfections present opportunities.

EURUSD possible trade on the sale side

During the day the EURUSD pair has generally been up for the Euro with its value going twice to 1.3665. Still it was unable to break or even reach the barrier at 1.3680. But the more upward it goes the more favorable the risk/reward ratio seems measured toward that level. The longer time-frame graphs suggest there could be an upward movement of the US Dollar soon of roughly 100 pips or even more.

If entered on the sell side at the current level of 1.3645 with a stop at 1.3685 and a first target 1.3600, the risk/reward is slightly above 1 which is not very profitable. However the higher the pair goes toward 1.3670/80 area, the more profitable and less risky the R/R ratio gets.

VAR, Risk / Reward ratio and money management

A positive risk/reward ratio is the heart of a successful trading.

Some thoughts derived from the yesterday possible trades.

The trades:

1. sell @ 1.3830, risk/reward (r/r) = 0.42 (losing 30 pips, gaining 70pips), closed @ 1.3780, 50 pips gain
2. sell @ 1.3805, r/r ratio = 0.28 (risking 10 pips, gaining 35), stopped out @ 1.3815, 10 pips loss

Total: 40 pips gain

Put that way the above figures mean almost nothing because they don't translate into real money. How they will translate depends greatly on the invested amount and its portion of your whole portfolio. So if you decide to put 5% of your portfolio in a deal and risk it, basically that's your Value at Risk (VAR). In general the greater the VAR, the faster the movement of your account (growing or vanishing). If you decide to have a VAR of 50% in a simple move you might double the account or zero it.

Let's say you are willing to risk 5% of your capital (your whole portfolio). The VAR is 5%. Simply this means that you might have 20 wrong trades in a row before you zero out your account. So if you want to have a greater number of tries, lower the risked amount. 1% VAR = 100 wrong trades in a row.

Where is the risk/reward ratio here? The risk/reward rule basically says that the amount of profit you expect from a deal should be greater than the amount you are willing to risk! As we deal with future events that ratio happens to be an imaginary variable strongly dependent on our own ability to successfully expect the correct future events! Thus the risk/reward ratio is often used to distinguish between possible bad and good deals.

Both the value of VAR and the risk/reward ratio have a direct impact on the level of stops you choose. Let's look again at the examples above. In the first trade the possible loss in pips was set to 30 by the stop being 30 pips away from the entry level. If the account was of $1000 and the player was willing to risk 5% of it that would translate to a possible loss of $50. $50 loss for 30 pips is achievable by trading almost $16500 which means the player had to open a position of $16500. The important point is that the player has chosen that deal because he or she is expecting the gain from the trade to be bigger than the possible loss.

The level of the stop could vary depending on the expectations of the player but if the value of VAR stays the same all other variables could be changed accordingly bearing the same risk (measured by the amount of possible loss) to the portfolio. It doesn't matter if you trade a position of $33000 and put a 15 pips stop-loss or a position of $16500 and 30 pips stop-loss. The VAR in both cases is $50. What changes is the probability of successfully striking your stop with the relation being that closer stops get hit more often. That probability could shorten the life-span of your account which means that in general the wider the stop, the better.

Combining winning and losing deals which have had a positive risk/reward ratio the player might successfully manage the growth of his or her account.

EURUSD on the hour

The EURUSD pair ended the hour at 1.3778 - 50 pips below the possible entry level at 1.3830. Still there is some room for a fast drop to 1.3750 or even to 1.3730/20 (50% of the Fibo retracement). Depending on the client risk attitude the short USD trade could be closed now. Another strategy is to put a stop at 1.3780 in order to preserve the profits till now.

EURUSD Short-term possible trade

The upward movement of the Euro shows some signs of exhaustion and a possible retreat to 1.3750/60 could be formed. The European currency failed twice for the last hour to break above the 1.3845 level and there is a bearish hidden divergence formed on both the 15m i 30m graphs. An entry at the moment (at 1.3830) has a positive risk/reward ratio of 0.42 which translates to a twice bigger gains than the possible losses. An even more favorable entry could be formed at the 1.3845 level if the pair gets there again before dropping down.

EURUSD Short-term Technical Analysis

The technical EURUSD (Euro / USD) picture for the day and current situation (15min graph) is as follows:

• main direction (daily) - Up (Euro rises as US Dollar falls)
• current situation - on the edge, possible reversal in the way following a last upward movement.

 The 15 min graph shows the EURUSD pair is in the middle of its upward movement. The danger presented by the negative MACD values could be temporarily offset by the oversold condition (shown by the lower values of Stochastic at the moment). This could lead the pair to new highs above the previous high at 1.3836. The negative MACD however could signal the end of such upward movement and a fail to probe strongly that level would prove such possibility. At that point the Stochastic might well be in overbought condition and further ease the going down.

The great danger to any continuation of the upward movement of the Euro are the negative MACD divergences seen on the 1h and 4h graphs. Still there is a space to go up and any down movement could be followed by a strong reversal.

Having in mind the above conditions a fall to at least 1.3790 is to be expected soon. Having that level broken, 1.3770 is the next target.