Thursday, June 22, 2006

State of the financial markets - June 22

How should one play the financial markets going into the next 2-3 months?

Lets start with the US markets. The key here is the direction the Fed takes in its interest rate tigtening campaign. Two scenarios are possible:

A) Inflation readings keep coming high, so the Fed keeps on increasing rates beyond 5.5%. This would cause markets to go down - in the US and abroad.

B) Fed stops at either 5.25% or 5.50%. This would likely cause the US markets to move up. And as all asset classes have recently become correlated with the US markets, this would also push up commodities, emerging markets (for most of whom commodities are the main exports) etc.

This would also cause the dollar to start weakening against the Euro and Yen - where the central banks have indicated that they could raise the rates soon. As commodity prices are inversely related to dollar, this would cause them to go up, further pushing up commodities and emerging markets. So the world markets best hope is that Fed stops.

However, if prices of commodities start rising, inflation expectations are going to start to creep up again. Also, a weaker dollar would increase import prices, further fueling up inflation concerns. These could be offset by slower growth in US in the coming months due to the past Fed rate increases, which take effect with a lag. If Fed stops raising rates but US economy keeps its strong trajectory, then inflation would again raise its head tomorrow, prompting rate increases. So the best hope for world markets is that Fed stops, and the US economy slows sufficiently (which would reduce demand for commodities and imports) so that inflation remains contained.

To the extent that a weaker dollar hits export oriented Japan, Nikkei might take a hit (which could bring emerging markets down). However, if the dollar decline is smooth rather than abrupt, it is possible that the incipient economic growth and domestic consumption in Japan is able to offset weaker exports. It would enable the Japanese central bank to raise rates - which is essential for the long-term health of that country. How does that impact the so called carry trades is a billion dollar question.

Could the past 10 day rally have been predicted? The rally started the day futures started pricing in a 100% probability of rate increase on June 29th. The US economy grew at 5.8% rate in 1Q06. Add in 3.6% inflation, and the nominal growth rate was 9.4%. To the extent some of it carried over in 2Q06, the earnings numbers are going to be beat estimates - as has been shown by all brokerages, Fedex etc. So if I had an earnings calendar with me, I might have been able to play it. But what now?

The Fed meets next week on June 29th, July 4th is a 4 day weekend, and after that the CPI report that will be out around July 9th would again enchant everyone. Considering that interest rate futures are not pricing in a 100% probability of rate increase in August, the markets might again stall till these futures price in a 100% probability. This time however, corporate earnings announcements might act as a buffer. Lets see how this plays out.

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