Summer's Over

-- Posted Thursday, 31 July 2003 | Digg This Article Digg It!

July 31: Many of us sense that we are living through a crisis of the international system. [The Iraq war and more recent crises in Africa] force us to ask ourselves whether the institutions and methods we are accustomed to are really adequate to deal with all the stresses of the last couple of years. . - UN Secretary General Kofi Annan

It's month end today which signals a few things to me. One, there is only one month left of the "summer trading doldrums." Two, the August refunding is just around the corner, about which I will opine more later. Three, yet another month has passed without a return of Iraqi oil to the market in any substantive quantity. Finally, we are one month closer to the annual Sept/Oct crazy season in financial land.

After a brief respite, the US military is once again reporting casualties in Iraq as two US soldiers have died in the past 24 hours. While Bush and Blair continue to assert that they will not be deterred by such resistance, public opinion, as evidenced by,

	US Economic Calendar	EST
Mon
Tues	Consumer Confidence	10:00
Wed	Quarterly Refunding	9:00
	Beige Book	14:00
Thurs	ECI, GDP	8:30
	NAPM-Chi	10:00
Fri	Employment, PI, PS	8:30
	CC, ISM	10:00

	@ 10:40AM	% chg
Gold	356	-0.56%
Euro	1.127	-0.84%
$/Jpy	120.4	0.17%
USDX	96.72	0.68%
US 10 Yr	4.38
3M Libor	1.11
DJ Stoxx 50	2457	0.53%
N225	9563	-0.73%
Oil	30.93	0.81%

inter alia, Tuesday's dismal consumer confidence report, is flagging. Yes, the consumer confidence report does not poll opinion on the War in Iraq but as previously noted, I tend to think that these polls are related. Faith in economic prospects tends to be coincident with faith in our leaders, etc. and vice versa.

More troubling for the men in charge, given the oligarchic leanings in the US, Iraqi oil is not yet flowing on world markets. The NYTimes is reporting on a new plan to bring Iraqi oil production back up to pre-war levels by year end. From the article, "The goal is for Iraq to be producing 2 million to 2.5


million barrels a day by year-end, Mr. Faraj said, and to reach its prewar output of 2.8 million barrels a day by spring." While the press focuses on the failure to find promised WMD, I imagine even more pressure is being brought to bear behind the scenes to produce the promised flood of oil. With US inventories quite low by historical standards, and with many other nations finding their budgets squeezed due to the need to keep oil prices low, it seems to me that a few more weeks of sabotage in Iraq and the oil issue will move front and center. Summer trading was not my favorite thing back when I plied my trade as an FX options dealer. Markets tended to be thin both due to dealer vacations and a slowdown in buy side demand. Of the two months of the doldrums, July tended to be calmer in volatility terms, while August tended to produce events which roiled the markets. Whether due to the thinness of the markets or severity of events, I learned the hard way not to stay short volatility (a position which will profit if the market in question stays within a limited range) during the month of August. Among the August events which spring to mind, Iraq invading Kuwait in 1990, Yeltsin climbing on a tank during a coup attempt in 1991, and the early indications of trouble in ERM land in 1992 stand out as events which taught me to be careful. However, refreshing my memory with a few google searches recalls quite a few August events of note. While officially beginning in July of 1997, the Asian crisis bloomed in August of that year. A year later in 1998, the Russian and LTCM crises began to emerge. Looking back a bit, August 1987 brought the debate between US and German monetary authorities to a head, which was followed by the October crash. Nixon resigned in August of 1974 three years after he closed the gold window in August of 1971. As I used to remind myself when reluctant to buy back my short vol and thus positive time decay (presuming no move in the underlying, options decay in value each day) trades, summer is over on July 31. In addition to the events listed above, August is one of the quarterly refunding months for the US Treasury. While these auctions are not necessarily volatility causing events, given current conditions, notably the recent blood bath in bond portfolios, next week's auction of $60B of 3s, 5s and 10s might		be a bit dicey. More interesting, the Treasury will stick with its decision to stay in the short end of the curve and eschew the 30 year due to the higher interest costs. Let's spend a few moments and think this one through. To the extent that the yield curve remains at current levels, it is obviously better to borrow short than long. However, given last month's move in the bond market, one would think the notion of higher rates would begin to sink in. Bringing the issue into a more common frame of mind, if you have a mortgage, are you borrowing at a fixed or floating rate? This, in essence, is the question the Treasury faces. Should they borrow at 30 years for 5.25% or try something shorter at risk that rates will rise? Given that even the Fed has moved away from the deflation argument, and the historical record, if I was John Snow, I would borrow as much as I could out as far as I could. Then again, while the termination of the 30yr was sold as a US decision perhaps it is the rest of the world that has no interest in the security at anything near current levels. Food for thought. In closing let me answer a question I received about the monetary base statistic and tie it in to next week's refunding. While it might seem that the Fed merely states its preference for the Fed Funds rate they actually have to work each day to ensure that their chosen rate prevails. This work comes as they add or drain reserves from the system based on their estimates of primary dealer funding requirements. Stripped of some of the jargon, there is a difference between the natural rate of interest and the Fed's chosen rate which varies over time. To the extent that the natural rate of interest is higher than that set by the Fed, they will need to keep injecting funds beyond normal systemic needs to enforce their rate on the market. This in turn means that the " repo float" will be larger than usual. Starting with next week's refunding the pressure will be on the Fed to keep over night rates at their desired level, which is likely, presuming my sense that the natural rate of interest is higher than the fed funds rate and climbing proves correct, to result in an increase in the monetary base. To the extent you agree with me that the Fed's balance sheet is the true measure of monetization, a rapid increase in the monetary base should provide quite a lift to Gold. Summer's over gang, it's time to get back to business.


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