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06-06-2011 10:27 AM A Converation Between a Sell-side Rates Trader & Buy-side Equities Trader Interesting take, well defined

reasons for your trade. I'm with you in the turn around in July and resume in declines in the US$ by then. Your analysis provides support for the US$ carry trade and anticipation of higher interest rates outside the US. A side note, the possible unwinding of the US$ - Equities pairs trade (short equities, long US$) that I was considering, I don't think it will unwind anymore meaning I think the US$ won't move in step with a declining equity market as there is still near-term upside (good for longer term US$ shorts), which is why I recommend being flat US$ that technically is in a wide trading range, but shorting it here (73-74 handle) doesn't provide a good RTR, unless you think its risk on in the equities markets. That said, there are other sources of opportunities, like you mentioned: long AUD and GBP. I'd add the Singapore currecny as well. A few thoughts... >I would add that USD weakness seems to be also a rates story in addition to a >traditional safe haven theme.< I agree, it's all about a rate story this year, that why traders ideas are increasingly centered around what the central banks are doing, as you know when rates change so do people's risk approach. And since rates moves can be tied with currency moves, it's funny seeing equity traders trying to sound like currency analysts, with constant mention of appreciating currencies due to potential rate hikes. With the timing of tighter rates becoming increasingly difficult for central bank policy makers, the forces for keeping rates lower & rates higher are gaining equal strength for US & Euro-zone, those forces being slowing growth & inflation fears. The Fed & ECB have a more difficult task than China & Japan's central banks in regards to timing of monetary policy, as China, aside from interest rate and reserve requirement hikes, can appreciate the Yuan, and Japan has G7 coordination to help devalue the Yen as it approaches the 80 handle in the spot market, without having to loosen up in wake of economic recovery from unforeseen events. Asia has more near-term problems compared to the US & Euro-zone who are faced with challenges that aren't fixed with a linear rate policy because of an uneven growth environment admits inflation concerns, and now fiscal stability is becoming a growing crowd once again. FED Challenges: Structural Unemployment, Muted Housing Recovery, Lagging Large-cap Financial Sector (Regulatory Risks pressuring Loan Demand), Cyclical Slowdown, Commodity Inflation seeping into core (less food & energy) US$ Safe Haven Theme: Risk rotation out of equities into US$ (fundamental flight to safety) Risk rotation out of US$ into Gold, Treasuries, Yen, Swiss Franc on macroeconomic concerns (traditional) US$ Rates Story: Low Yields -> US$ Weakness [When money's cheaper you stretch it out sell it to buy into higher yielding currencies and bonds (carry trade)]

ECB Challenges: Peripheral Euro-zone Debt & Austerity Slowing Growth Central Euro-zone Inflation Euro Rates Story: Higher Yields -> Euro Strength [When money's more expensive you take advantage of those rates and buy into them] The ECB faces a polarity problem, while the FED faces a double edge sword in its own manner, with its controversial monetary polices (QE Installments). Tightening provides challenges that can choke off demand and prematurely stall the recovery by compressing & eventually peaking margins. Loosening provides challenges as banks benefit from a steeper yield curve not flat one, and continued flattening shows defensive risk-averse crowd formation and thus liquidity drying up. And with oil prices at this $100 level seeming to be problematic for sustainable growth with companies passing risks to the consumer potentially choking demand, as well as cutting payrolls to hedge energy costs, what's really going on amidst the noise is that the inflationary effects of federal stimulus in an already low interest rate environment is opening wounds central banks are trying to heal. Monetizing the national debt to sustain growth harnesses inflation, which eventually finds it way to risky assets such commodities and equities (ex. technology) and risk spilling over to other asset classes in core sectors. Evidence of this is shown in ticks up in CPI & core CPI, pressing even more significance to upcoming central banks meetings and inflation data points. Transitory inflation can be proven with a market correction that further reprices commodities with it, which I think is the likely case for a 'healthy correction' to prolong this bull market. With that scenario, the US$ will likely rise in the near-term, as a flight to safety mechanism as it has patterned in the past. Note when the US$ unwinds, it unwinds hard. So intermediate-term, I would stay flat US$ and let it trade in this wide trading range ever since it broke from it's recent lows on a weak Jobless claims numbers several weeks ago. History shows inflating an economy out of recession is only a temporary solution which is why I believe equities are in yet another primary bull market with a secular bear market until we get fundamental changes that allow for self-sustainable growth form a micro and macro perspective. 'Kick the can down the road' in forms of stimulus is what will keep asset prices up, and the evil "i" effects of inflation will eventually force developed economies to tighten. What if growth is not sustainable? That remains to be seen, but the bond market and Fed funds futures is pricing in that uncertainty to this day. I remember when the markets were fretting about emerging markets tightening while US & Europe remained loose, and all this speculation about interest rate hikes and timing became crowded trades. Just shows how market psychology continues to repeat itself. It's amazing how one man can have such power to move these markets that run deep. > 1) US yields showing longer lower trend as seen by 2,5,10 yr bonds (bull flattening since April) and Fed Fund futures are pricing in just a 38% chance of a 25 bps rate hike from the Fed for June 2012. That is down from 78% a week and a half ago. Just an interesting indication of how rapid yields are falling.<

With long-term and short term yields spreads narrowing, this rapid decrease in yields is not random. It's quite divergent from the view of eventually higher interest rate environment going forward. This is happening because the broad markets are pricing in a slower than expected economic recovery with rising energy prices from $100 oil. Evidence is showing up that the recovery at this time cannot support these oil prices, and let that not be overlooked, as this is the same issue during the start of the last bear market, pre-Lehman, pre-Bear Stearns. You mention you noticed the flattening of the long end of the yield curve started April, that's when the geo-political risk form MENA (Middle East North Africa) really unfolded, pausing the trend line strength seen in equities, and most notably, breaking out the price WTI crude passed $100. Why does that matter with yields? With low-rate environments making the US$ easier to borrow, it forms a fundamental support for commodities to get bid up, and with supply chain disruption fears (whether irrational or not) acting as catalyst for bullish oil, there are multiple forces in play that support long-term rising energy prices, not to mention emerging market demand. These recent events are creating an uncertain environment regarding the pace of the US economic recovery and thus global growth story, as market participants begin pricing in a more uneven economic recovery and potential need for more stimulus, basically tuning down their expectations for growth and increasing their expectations on inflation. You mention the Fed fund futures pushing back tightening estimates for June 2012 from a 78% chance just 1.5 weeks ago, that's because of the the weak us macro data (housing, productivity, and jobs data) putting doubt in global recovery which in turns drive speculation of continued low-rate environments with possibility of further stimulus such as assets purchased to remain on the FED's balance sheet longer then expected, and additional bond purchases. Inflation is a problematic for that theory as Ben Bernanke hinted in the last fed meeting, but cannot rule anything out and neither is the fixed income markets. The long end of the yield curve has been an excellent indicator these past few months of where equity prices are heading and what rate environment traders are pricing in, and it appears that evidence for pushing back tightening and correction in equity prices are what markets are ultimately headed towards. > So a lot of these next few months with USD, esp as US debt ceiling continues to get hit (tho obviously no default will ever occur) and lower yields USD continues to be sold for higher yielding ccys such as AUD (4.75% policy rate), EUR (1.25% target EONIA), GBP (50 basis point policy rate), and other high yielding such as EM space ccys.< Classic shift in carry trade away from the normal yen carry trade, so as long Fed keeps rates this low, I'm bullish on high yielders. > I like the timing of July to start really seeing the USD fall even more, or start rapidly accelerating. I think last two weeks and even now I guess are still good time to catch this longer trend move, given that bearish news have made it's rounds in the market. Why July? I expect Trichet this Friday to start showing ECB's cards that rate hike to 1.50% policy rate will be set for July ECB meeting. This will make USD weaker and make other countries such as GBP and AUD to start signaling rate hikes for Q3 or Q4 this year, adding to further USD weakness.<

I like the timing of July as well, as a point of acceleration of US$ weakening. From an equities perspective that is when I think broad markets will get a lift from clarity on global slowdown and Q2 margins, and possible stimulus as a catalyst for another leg in the bull market. That will go hand in hand with a weaker US$, inflating asset prices, etc. Keep in mind that with rates this low and continuing to decline, there's a huge spring of cash in bonds waiting to be deployed back in the equities market, and a bearish US$ will continue to act as a tailwind for higher oil prices which means potential return of commodity inflation, and global growth fears (another cycle). Since I believe evidence for a further commodity and equities correction is underway, near-term that is bullish for the US$ causing it to trade in an already established wide range, making range-bound strategies as well as short term momentum trades to the top of the range (76 handle) good hedges for subsequent additions for longer term short positions. One must not underestimate catalysts for US$ bounces, which makes those trying to short now for the long-term, susceptible of being stopped out in the near-term. As far as Trichet goes, he has shown he's not afraid of stimulus just as he was last summer with the Euro bail out package, and again this year with his hawkish tone in balancing the polarity problem that exists with central & peripheral euro-zone. That said, his actions speak for themselves, with ECB rates tightened to 1.25% to then remaining unchanged, forcing traders to wonder when the next tightening phase will be. And with the ECB meeting coming up Thursday, this event is being priced in with traders starting to bid up the Euro anticipating increases in ECB rates sooner than later, not to mention the recent details relieving the latest euro-zone stimulus package (and successful peripheral euro-zone bond auctions), as stimulus provides relief which is again bullish Euro in a market obsessed with inflation, growth, and debt scares. Since rates are going down this rapidly because the market is anticipating that growth is slowing down, to go along with fact of a continued loose monetary policy by the Fed, to the contrary, like you mentioned, anticipating ECB rate hikes is a tailwind for the Euro, and headwind for the US$. But, I expect further headline risk coming from Euro-zone, mainly with peripheral debt concerns, as these events take time to unfold with clarity acting as catalyst for more uncertainty in situations involving debt & stimulus, a lesson learned last summer. I suspect a reversal in the near-term uptrend in the Euro, thus a catalyst to again bounce the US$. I think this ECB meeting Thursday may provide the event for a setup to sell the rumor of a possible hike this July, as rates are likely to remain unchanged near-term due to contagion fears resurfacing in Euro-zone and a global slowdown with despite growing inflation that's becoming clearer with recent macro data. The rips in the Euro since the 1.40 handle this entire year have been related to ECB tightening. I stand by the idea with a market correction going hand in hand with a weaker Euro. I think it anybody's guess about Trichet and his hawkish comments or not, as he has the best poker face amongst central bankers while still inspiring confidence, though has been inconsistent with his comments. He has also been inconsistent with his rate policy this year and will keep interest rates unchanged again this upcoming meeting with most recent core CPI data giving him no reason to do so right now, until we see more upticks in forecast on inflation which is highly likely. So near-term I expect long Euro positions start to unwind, only to return back to the table around July when clarity on

growth, inflation, and stimulus concerns have settled in this market, and traders prepare for an actual rate hike which will provide further weakness to the US$. That said, with all these central bank uncertainties it just makes gold a more attractive to buy as markets are realizing that an economy built on leverage may struggle to return to its full capacity, which long-term also makes emerging markets a prime source of opportunity for equity bulls. Final thoughts, regarding the S&P 500, I continue to watch for liquidation in defensive sectors in a declining tape (de-risking environment), which suggests risk rotation into other asset classes instead of classic sector rotation. It is difficult timing a bounce to fade when risk just rotates from speculative sectors to defensive sectors, where a decline from liquidation in one sector creates a false top, with risk then transferring to another sector within the market, thus resuming the trend. But when defensive sectors start leading an overall decline in the broad market, that suggests the mass crowd is raising cash (leaving room more for wider spreads and more volatility from quants) or, just rotating into other defensive asset classes like bonds, and also currencies. Though interest rates in the US continue to remain low which like we mentioned pressures the US$, in the intermediate-term, in order for this decline in equities to be a 'healthy' correction, US$ needs to trade higher to pressure commodities & relieve inflation, before this stress cycle eventually returns. These are very complex relationships, which is what makes markets difficult to forecast and trade, but hope this provides clarity on why I think the the FED & ECB have backed themselves in a corner thus broad markets will have to reprice equities back to fair value. There are many analytics for fair value, I like looking at the investors average (200-day EMA), and we're still clearly above that so the trade is to remain short S&P 500 heading into the summer.