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The interest rate “conundrum” and
impact on the dollar

What is driving long-term rates?

Are historically low long-term yields
signaling recession?

Is the market underestimating the Fed?

Does it matter for the dollar?
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
The economic and financial world is changing in
ways that we still do not fully comprehend.
Fed Chairman Alan Greenspan, 6 June 2005
Of course we know what Mr. Greenspan was
referring to--it’s the “conundrum.”
Why are long-term interest rates so low?
 Are low long bond yields signaling
economic weakness i.e. global deflation
and recession ahead?
 Or, is there something else going on here
that we haven’t seen for a while?

Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
10-year US Treasury Note yields;
they are back in the 4.0% range…
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
…4% on the 10-year after eight
Fed rate hikes since Jun ‘04
Source: The Wall Street Journal
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Long rates lower and short rates higher: It has to
be a sign of economic weakness—right?
Maybe!

The Economist magazine recently published an article
examining a paper done by HSBC economist Stephen
King. Mr. King believes low bond yields are NOT
signaling weakness. He says we have seen this all
before—déjà vu again…

“In the 1950’s and early 1960’s, at time of relatively low
inflation and robust economic activity, yields were well
below nominal GDP growth rates,” says Mr. King. And
here’s a chart to prove it…
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
For years, long bond yields were consistently lower than
GDP growth rates.
Source: The Economist
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Here is what is driving long bond yields lower,
according to Mr. King—and it makes a lot of sense:

Globalization – Global mobility of capital and low-cost labor

Demographics – As baby boomers age there is shift to

God-like central banks – Investors now believe central
are dampening inflation.
bonds for reliable sources of income instead of a need for growth
through volatile stocks.
banks can maintain stable prices i.e. keep inflation in check. So,
buy long bonds!
Bottom line: Long yields are going even lower, says Mr. King. He sees
10-yr Note yields at 3.5% by mid-2006.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
The Fed has to slowdown in this environment—
don’t they? Maybe not!

“Fed officials have said in every way
except via the language in the policy
statement that they're more concerned
about accelerating inflation than
slower growth,” writes Bloomberg
columnist Caroline Baum.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Source: JP Morgan
This supports Mr. King’s contention that God-like central
banks are still actively fighting the inflation battle.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
The Fed is still believes there is plenty of money in
the system—and has signaled it will continue to
drain punch from the bowl… and let us not forget
the bubbles!
A bubble the Fed was very instrumental in
creating—Real Estate. Why?
The Fed made a conscious choice: asset bubbles in
order to help stave off deflation. It did this by
pushing the Fed Funds rate down to 1%--an
“emergency rate.” This juiced domestic and
global liquidity—the Fed is the global central
bank.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
This chart shows the massive amount of credit engineered
by the US Federal Reserve Bank alone…it represents US
debt held by the rest of the world i.e. outside the US… it is
why they are the world’s central bank.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
The Fed’s worried. A good reason why they will continue to
do what they can to drain liquidity from the market…
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
The Fed Funds rate drove
liquidity…now it taketh away!
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Yes, we do believe the market is
underestimating the Fed.
So what does this all mean for the
dollar?
We think the dollar will go higher
from here.
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Four reasons why the $ goes
higher:
1.
US economic growth still relatively strong
2.
Rising positive US yield differential
3.
Carry trade being unwound
4.
Trouble in Asia will lead to funds flowing
back into the US dollar
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
1) Low long-term yields are not signaling recession
for the US. The US should continue to grow relatively
quickly compared to its competitors. And in the end—
growth comparisons are all relative:
Average 2005 GDP

US

Australia

Canada

UK

Japan

Euro area

Switzerland
forecast % Growth
3.5
2.6
2.6
2.4
1.4
1.4
1.2
Source: The Economist (June 11th ’05)
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
2) Positive and growing yield differential favoring
the buck! Dollar deposit rates will continue to
outshine Canada, Europe, Switzerland, and Japan…and
possibly soon catch up to the UK and Australia
3-month money market rates %

Australia
5.67

UK
4.81

US
3.25

Canada
2.43

Euro area
2.11

Switzerland
0.75

Japan
0.02
Source: The Economist (June 11th ’05)
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Interest rate stance of global central banks:







Reserve Bank of Australia
Bank of Canada
European Central Bank
Bank of England
Bank of Japan
Switzerland National Bank
Federal Reserve Bank
Q&A: FXStreet.com 15 Jun ‘05
On-hold/Housing & Comod.
On-hold
On-hold/May cut soon
On-hold/Considering a cutting
On-hold
On-hold
Hiking
Black Swan Capital
www.blackswantrading.com
3) The carry or reflation trade is being
unwound. When the Fed Funds was sitting at
1%, it was an easy game…borrow short and
lend long…or leverage long into bonds, or
stocks, or real estate or commodities…when
the cost of money was basically free…why not
take it…
 But as we see, now that the Funds rate has
tripled, and is due to go higher, this game is
over…but there is still plenty of leverage to be
unwound in the system…we think the next
chart tells the story….
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Carry trade in trouble!
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
4) Trouble in Asia will lead to funds flowing
back into the US dollar. We believe China will
land hard, possibly even crash…and that will
probably be good for the dollar and probably
good for Treasury bonds on safe haven…

Trouble in China will likely exaggerate the break
in global commodities, beyond what would be
normal based on rising interest rates and
slowing global demand…and you can see the
mirror image commodities and the dollar have
played based on the last chart….
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com
Just maybe we could be entering a virtuous
circle for the dollar.
Stranger things have happened!
“The strong dollar attracted imports, which
helped to satisfy excess demand and to keep
down the price level. A self-reinforcing process
was set into motion in which a strong economy,
strong currency, a large budget deficit, and a
large trade deficit mutually reinforced each other
to produce non-inflationary growth.”
George Soros, Alchemy of Finance
Q&A: FXStreet.com 15 Jun ‘05
Black Swan Capital
www.blackswantrading.com