FOREX TRADING

Two stories rippled through the currency markets this weekshocking the euro into a four percent decline versus the US dollar and a threepercent drop against the yen. On Tuesdaythe FOMC statement offered a view of diminishing American economic growth,underlined by its decision to reinvest the proceeds of maturing Treasuries backinto the government bond market. The bond purchases will keep the Fed balancesheet at $2.3 trillion and will not contract the money supply, which increasedin May and June after four months of minor contraction.

Despite the initialnegative reaction in the dollar to the Fed announcement, the euro rose from1.3110 to 1.3234, continuing the trend of benefit to the euro of poor USeconomic developments of the past several weeks, reconsideration began in the Asianmarket Wednesday morning. Tokyo soldthe euro to 1.3080 a figure below the New York close and London pushed on to1.3020 by the New York open. In the American session the dollar ascendancybecame more pronounced, with the euro sinking to 1.2860 by early afternoon,even as the equity averages suffered major losses. The Dow closed off 256 pointson the day. In the blink of a Fed eye riskavoidance and volatility came roaring back into the markets.

The second theme was the re-emergence of the European debt situation,with widening spreads over German bunds, more loans to troubled Anglo-Irish Bank,Spanish provincial government debt problems and a poorly subscribed Italianbond auction.

The FederalReserve decision on Tuesday to reinvest its maturing asset portfolio inTreasuries is a message to Washington and the political class as much as it isa notice to the markets. This is the policy action side of Mr. Bernanke’srecent warning to Congress that the current deficit and fiscal policies of thegovernment cannot be sustained without serious damage to the American economy.

The FederalReserve Governors are not so naive that they expect changes from theadministration and the Democratic majority in Congress. With the Democrats inclose to panic over the November election any substantive changes in policywould be an admission that the agenda of the past 19 months has failed. That cannot be expected. The Fed’s warning is twofold:

1) Thecentral bank, will, if it deems necessary expand its balance sheet to supportthe economy and head off deflation

2) Marketsand the government should prepare for the possible consequences of such adrastic action: including perhaps a much lower dollar (recall the currencymarket reaction to the original QE program last March); complications for thegovernment funding necessities and Treasury sales.

The questionthe currency markets may soon have to answer is does the fear of worldwideeconomic slowdown and the need for a safe haven asset and currency play trumpthe devaluation effect of monetization of vast new Treasury purchases. Thedollar action of the past two days means that it probably does.

Productivityin the US economy fell far below expectations in the second quarter,registering a 0.9% fall instead of the 0.1% gain predicted in the Bloombergsurvey of economists. Productivity inthe first quarter was revised higher to 3.9% from 2.8%. The figures areannualized results based on quarter to quarter changes. Productivity in bothquarters was driven by the alterations in economic output. American economic output fell 1.3% from thefirst quarter to the second, pushing the output per worker, and thusproductivity lower in the second quarter. GDP in quarter one was recentlyadjusted 1.0% higher to 3.7% the increased output instilling a correspondingupward move in worker productivity.

Unit laborcosts gained 0.2% in the second quarter far below the 1.5% forecast. Costs in the first quarter were revised muchlower to -3.7% from -1.3%. The extremelyweak labor market gives employers the incentive and ability to offer workersless in pay and benefits for employment.

The NationalFederation of Independent Businesses (NFIB) economic optimism index dropped to88.1 in July from 89.0 the prior month. This is the lowest level sinceFebruary. According to David Rosenbergat Gluskin Shefff the Canadian brokerage, the average level during recession is91.8, in recoveries it is nearer 100. The all time low for this index was 81.0 in March 2009.