by Kevin Klombies, Senior Analyst TraderPlanet.com

Friday, August 17, 2007

Chart Presentation: Fed Governor AUD

Aug. 16 (Bloomberg) — William Poole, president of the St. Louis Federal Reserve Bank, said the subprime mortgage rout doesn’t threaten U.S. economic growth, and only a “calamity” would justify an interest-rate cut now.

Poole, who confers regularly with regional business contacts and votes on rates at the Fed this year, said in an interview yesterday that “no one has called up and said the sky is falling.” The best course is for officials to assess economic figures, including the August jobs report, when they next convene on Sept. 18, he added.

We suppose that Mr. Poole has not received a telephone call from CNBC’s Jim Cramer whose infamous ‘rant’ last week clearly indicated that something in the nature of a calamity was currently taking place. For those willing to wade through 3 or so minutes of very memorable hysteria Cramer’s scene can be viewed at http://www.youtube.com/watch?v=SWksEJQEYVU

If we had our way we would replace the Fed’s CSI-like rooting through the ‘evidence’ for signs of weakness in lagging indicators with something as simple as the trend for the Australian dollar futures.

The chart shows an overlaid view of the Aussie dollar (AUD) in black and the Fed funds futures rate in red.

The idea is that when the AUD is weak and falling the Fed should respond by easing credit conditions by lowering the target level for the overnight funds rate. Conversely when the AUD is strong and rising the Fed should tighten credit and increase the cost of borrowing.

The chart shows that on a regular basis the Fed remains on hold in search of some sort of economic epiphany while the economic trend powers forward or backwards. For example, the AUD was falling like a rock through 1997 and 1998 as the Fed funds rate remained flat. It took a calamity to convince the Fed to ease in the autumn of 1998.

In early 2000 the AUD turned lower once again while the Fed held the funds rate at the highs as they assessed economic figures. Eventually the Fed cut the funds rate in the midst of a full-scale calamity.

On the other side the AUD swung higher in early 2002 while the Fed held the funds rate flat right into 2004. We strongly suspect that this two year lag in policy response had much to do with the size and extent of the real estate bubble, the momentum created in the commodity markets, and the resultant weakness in the U.S. dollar.

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Equity/Bond Markets

Our point on today’s first page was that before the Fed has any reason to cut the funds rate currencies like the Australian dollar have to show weakness. The AUD is a commodity currency so as long as it is strong and rising there is no doubt that the cyclical trend remains robust.

Our fixation with the Canadian dollar of late is an extension of this view. Our sense was that it was time for the Fed to ease but the markets kept ‘saying’ that this was not the case. As long as the U.S. dollar was declining and the commodity currencies were rising… the Fed would either hold the funds rate flat or move to increase it.

One of our arguments has been that WHEN the Fed cuts the funds rate stocks like Boston Scientific tend to do well. That, at least, has been the tendency through past cycles.

The charts compare BSX today with BSX through the second half of 2000 and into 2001. The Fed cut the funds rate in early January of 2001 and BSX turned upwards through the balance of the first quarter.

The Aussie dollar’s weakness certainly argues that we are closer to a Fed rate cut than we were at the start of the week. We have also been using the price of 3-month eurodollar futures as a guide because in mid-December of 2000 (chart below) the yield on 3-month eurodollar futures declined below the funds rate (funds rate at 6.5% so any price higher than 93.50 for eurodollars indicated a yield below 6.5%). A couple of weeks later the Fed held an emergency meeting and started to ease.

3-month eurodollar futures prices rose and closed above 94.75 yesterday (chart at bottom right). If prices continue to rise then the market is telling us that in the very near future the Fed funds rate will be reduced which, of course, makes the BSX idea a bit more timely.

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