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Monday, August 07, 2006

Trading Strategy for Tuesday's Fed Meeting- Short 10-Year Bonds, SPY & Long US Dollar Spread Trade

By Yaser Anwar, CSC of Equity Investment Ideas

I strongly believe they will raise rates & hence i'm thinking of going short the 10-year bonds & long the US$. The reason i'm taking this contrarian spread trade is: the 10-year has been rising for 6 weeks, US$ falling alot & more data is pointing towards an inflationary environment than vice versa.

With wages increasing YOY to 3.8%, big ticket orders for durable goods were stronger than expected, the ISM # was 78.5 vs 76.5 in June & the PCE also being above Fed's comfort level. All this points towards Fed raising rates, hence i believe 10-year bonds which have been rallying on thoughts of Fed pausing will have a rude awakening & on tuesday the aforementioned spread trade presents a good day trade, if all goes like i believe it will.

If you want a triple play, for the risk taker in you (like myself), i would go one step further and short the SPY too. So that's short the 2, 5 & 10-year bonds, short the SPY & long the US Dollar.

This is a very risky trade 'cause only 21% of the market participants, as shown by the Fed funds rate & Eurodollar action, expect a raise in interest rates next week. However big money is made by discounting the known & betting on the unexpected.

The inflation figures continue to trouble Fed policymakers, who have said core prices are rising faster than they'd like. The central bank has raised interest rates 17 times in the past two years, but much of the impact of those rate hikes has yet to be felt, Fed officials have said.

However, data points towards a pause (the GDP & NFP #s) & some points towards a hike (PCE & ISM). At this juncture i think the real question is whether Bernanke will rely on a slowing economy to ease inflation or not? I think he will raise rates & there will be a drastic change in his statement, such as: Inflation fears have been persistent but with consumer spending & economic growth slowing drastically, from hereon further inflation shall be benign. Tuesday morning's productivity and unit labor cost figures could prove unusually important.

Lastly i'd like to quote a part of Geroge Soro's currency theory which is valid for the time being. One part of that theory had it; that if a huge decit arose at the same time as an expansionary fiscal policy and a tight monetary policy, a country’s currency would rise.

Goldman Sachs Economic Research: While we do not disagree with the notion that Fed officials would like to pause, data released since the last FOMC meeting show higher inflation, more general wage acceleration, and some indications that growth in Q2 may not have been as slow as first reported and that Q3 will probably firm up a bit. Thus, while the decision is clearly close and could go either way, we think the balance still tilts in the direction of one more rate hike for the road. -- courtesy WSJ

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