By keeping interest rates low, the Fed is raising the supply of dollars and other forms of liquidity in the financial system, thus weakening the value of the U.S. currency. But the lack of scrutiny of the central bank in the current oil debate is curious.

"We suspect that at least some of the liquidity being pumped into the system by the Fed is going into the oil market," says RGE Monitor analyst Rachel Ziemba. "There are global supply-and-demand forces driving oil prices on a long-term basis, but in the short-term, the Fed's actions must be lending momentum to the market."

A spokeswoman for the Fed declined to comment.

It's difficult to figure out exactly how the Fed's manipulation of the money supply is affecting the energy markets. The Fed reports that its broadest measure of the money supply, M2, increased by 6.3%, or $457 billion, over the last 12 months.

While the Fed is expanding the monetary base in an attempt to stimulate the sluggish economy and cushion the financial system against the ravages of the credit crunch, some observers say it's driving speculation in the red-hot energy markets.

Some lawmakers have pointed fingers at unnamed speculators for high prices, and big oil companies like Exxon Mobil(XOM - Cramer's Take - Stockpickr) and Chevron(CVX - Cramer's Take - Stockpickr) have pushed to loosen current restrictions on domestic oil drilling.

The central bank is designed to be independent from the federal government in its decision-making, but Congress created the central bank and it does have oversight responsibilities for it. The Fed's decisions on interest rate policy are particularly sensitive during an election year. This time around, rate hikes would be viewed as a boost for Democrats, while further rate cuts would favor the incumbent Republicans in the fight for the White House.

The Fed has slashed interest rates by 325 basis points since the credit storm made landfall on Wall Street last summer.

On Wednesday, the Fed elected to keep rates steady, with only Dallas Fed President Richard Fisher dissenting from the decision in favor of a rate hike.

While the Fed took no action, meeting expectations on Wall Street, it did talk tough about inflation in its policy statement.

"Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased," the central bank said.

The Fed also reiterated its longstanding -- but so-far woeful -- forecast that inflation pressures will soon abate as oil prices moderate.

"However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high," said the Fed.

Despite those statements, futures markets show that expectations for rate hikes from the Fed later this year are waning. Crude oil prices set a new record above $142 a barrel in trading on Friday, while the dollar weakened against other major currencies. The Dow Jones Industrial Average, meanwhile, made new lows for 2008, with shares of General MotorsGM hovering near a 53-year low.

Bank shares have also been crushed of late, with Merrill LynchMER dipping Friday after a Lehman Brothers analyst said it expected $5.4 billion in fresh writedowns in the second quarter, due to downgrades to bond insurers MBIAMBI and AmbacABK.

Anthony Crescenzi, chief bond market strategist with Miller Tabak and a contributor to RealMoney.com, said in a note Thursday that the dollar was declining in response to lowered expectations for rate hikes from the Fed.

"Weakness in equities is spurring a flight into investment strategies that are working, such as buying commodities," said Crescenzi.

Source : www.thestreet.com

The bottom line: "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased." Which is what recent Fed-speak had implied anyway.

But that doesn't mean any rate hikes anytime soon. Indeed, odds in the fed-funds futures market were little changed in the wake of the FOMC decision. The futures put a 38% chance of a 2.25% target rate at the Aug. 5 meeting and a 68% probability of a 2.50% funds rate (with at least 2.25% a sure thing) by the Oct. 28-29 meeting.

"The case for an early tightening is still weak, in our view," argues BCA. "The underlying inflation picture is better than the headline data suggest, many market interest rates are still higher than before the Fed started to ease, and the credit system is not yet functioning properly. Market expectations of a 50 basis point rise in rates over the next six months are too aggressive."

Lena Komileva, head of G7 Market Economics for Tullett Prebon in London, sees the uncertainty about future rate hikes -- which has pushed up term (that is, longer than overnight) money-market rates -- working in the Fed's favor. "The Fed is now making a better use of the yield curve to meet its conflicting growth and inflation objectives. Low overnight rates and liquidity-supporting measures in short-term financial markets will help counter downside risks to growth. At the same time, higher term funding rates will provide a hedge against rising inflation risks."

But there are risks to this tack. "A steeper money market curve on expectations of Fed rate hikes has the effect of reducing visibility into the liquidity outlook, which will ultimately slow down the banking sector's remedial balance sheet efforts causing further damage to private-sector credit conditions," she adds.

Since the April 30 FOMC meeting, when the panel signaled it was finished cutting rates, and indeed since the mid-March rescue of Bear Stearns, monetary conditions arguably have tightened. As High Frequency Economics' Shepherdson points out, the M2 measure of the money supply is shrinking. And since that time, the dollar has stopped making new lows and gold is more than $100 off its high of over $1,000 an ounce.

"The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability," the FOMC concluded. The risk is that those economic and financial developments will be negative, which will likely preclude any rate hikes in 2008 and well into next year.

Source: www.barrons.com

Peak Oil Implications
Demand

Demand for oil has consistently risen globally. Should demand continue to rise when total output has reached its peak, basic economics tells us that oil prices will steadily rise with demand. And when production falls - which will occur when oil becomes harder and harder to find - oil prices will rise at a much greater rate. Oil exploration will become much more aggressive, and alternative oil sources - such as Canada's oil sands - will be increasingly exploited to squeeze out every last drop of oil.

Alternative Energy

Alternative energy sources will become much more popular as countries are forced to move to a sustainable energy supply, and as fossil fuels simply become too expensive. The way we live our lives would dramatically change if oil-based energy becomes economically out of reach. For example, people will probably live closer to where they work, leaving municipalities strained in their attempts to provide adequate transit as well maintain social services and infrastructure at a much higher cost.

When and if peak oil does arrive, it needn't be all doom and gloom. It can be a major investment opportunity as there are areas in the market that will benefit. Some of these investment opportunities include:

* Oilfield Services
As the amount of reserves oil companies hold starts to diminish, oil companies will need to increase oil exploration and drilling to replenish reserves - after all, they are in the business of selling oil. As oil producers increase spending on exploration, it is the oilfield services sector that will win by receiving more orders and seeing higher revenue. Oilfield services companies provide the tools and equipment required in the exploration of oil including drilling rigs, offshore rigs and transport equipment. Therefore, with a dramatic increase in drilling, oil field service companies are likely to be in demand, making them a hot investment.

* The Oil Giants
Investing in the top guns of the oil industry is a good bet, peak oil or not. If peak oil is reality, the steady decline in supply will drive the price of oil up causing each company's oil inventory to steadily increase in value. This will result in higher valued stocks for these companies. Basically, the higher oil prices are, the more oil and derivative products will be sold, which should increase profits.

* Alternative Sources of Oil
As conventional oil is depleted and becomes harder to find, oil companies will increasingly look to unconventional sources to boost production. Additionally, higher oil prices brought on by higher demand and lower production make these alternative oil sources financially feasible. The oil sands in Canada and Venezuela are examples of such an unconventional source, where bitumen - a heavy crude oil - is mixed together with sand and clay. This substance is extracted and refined to produce oil.

Oil shale is another alternative. Extracting oil from oil shale - rock containing kerogyn that can be converted to synthetic crude oil - is an even more intensive process than that of the oil sands. Oil shale production is only a viable alternative when oil prices are over $70 per barrel.

Some processes exist that convert coal to synthetic oil. However such methods will likely only be interim alternatives because coal is also a finite resource.

* Alternative Energy
The most obvious option in the peak oil dilemma is to move to something other than oil for our energy needs. This option isn't yet as feasible. Alternative energy only accounts for a small percentage of energy sources, but the onset of peak oil will force society to look elsewhere to meet its energy needs. If the optimists are right and peak oil is decades away, we have time to develop new technologies to harness alternative energies. But with the hype generated by high oil prices and peak oil speculation, this industry is getting a boost.

Because such a very small percentage of our energy sources include alternatives to oil, it could be said that the market for these products has nowhere to go but up. Energy sources such as geothermal, solar and wind energy will be sought after as solutions. Additionally, because many of the technologies that harness these energies are built using oil dependent machinery, there will be an additional push to develop technology for this purpose as well.

Hybrid and electric cars have become increasingly popular in recent years due to high gasoline prices. Expect a greater degree of growth in this area with the arrival of peak oil and higher prices at the pump.

All of the technology required to produce alternative forms of energy will need further research and development to ensure greater efficiency and economic viability. Investments in the companies leading these R&D initiatives will likely bear much fruit. As oil production falls and oil prices rise, research will become more intensive as industry puts both feet forward to develop the next generation of energy technology.

Investments to Avoid

In general, the investments to avoid in a peak oil situation include companies that rely on oil and other petroleum products as a major input cost. For example, transportation companies and airlines are susceptible to price fluctuations in oil and would be hurt by the extremely high prices that would be the result of a peak oil situation.

Conclusion

Peak oil brings with it several opportunities for investors. Whether it's oil, oil field services, or alternative energy, investors can cash in on this phenomenon. But be careful. If we reach peak oil, it will mean dramatic changes to society in the way we live and do business. Watch your investments closely and be sure to adjust to a changing marketplace.

John Hanley has a Bachelor of Arts degree in political science from the University of Alberta. He is a freelance writer and has lived in Edmonton, Alberta with his wife Mikaela for the past eight years. John grew up in Saskatchewan and previously worked as a radio broadcaster.


Source: http://www.investopedia.com/articles/07/peak-oil.asp?viewall=1

For example, taking one of the favored pairs in the market right now, let's take a look at the New Zealand dollar/Japanese yen currency pair. Here, a carry trader would borrow Japanese yen and then convert it into New Zealand dollars. After the conversion, the speculator would then buy a Kiwi bond for the corresponding amount, earning 8%. Therefore, the investor makes a 7.5% return on the interest alone after taking into account the 0.5% that is paid on the yen funds.



Now on the earning side of the trade, the investor is also hoping that the price will appreciate in order to make further gains on the transaction. In this case, anyone that has invested in the NZD/JPY trade has been able to reap plenty of benefits. For 2007, not only were traders able to benefit from a 7.5% return, they also benefit from a currency that has appreciated by 20.6% since the beginning of the year - a far cry from your ordinary U.S.

Flags and Pennants: Easy and Simple

With the currency rising the way it has, how can a trader really capture market profits in the bull market? One such formation that has proved to be a great setup may be the all too familiar: flag and/pennant formations. This has been especially useful in carry currency crosses such as British pound/Japanese yen and New Zealand dollar/Japanese yen. Both formations are used in similar capacities; they are great short-term tools that can be applied to capture nothing but continuations in the foreign exchange market. They are both even more applicable when the market, especially in the case of carry trade currencies, has been trading higher and higher in every session.

To get a better sense of how this works, let's quickly review the differences between a flag and a pennant:

* A flag formation is a charting pattern that is indicative of consolidation following an upward surge in price. The name is attributed to the fact that it resembles an actual flag with a downward-sloping body (due to price consolidation) and a visually evident post. Targets are also very reliable in flag formations. Traders who use this technical pattern will reference the distance from the bottom of the post (significant support level) to the top. Subsequently, when the price breaks the upper trendline of the flag, the distance of the post will more often than not be equivalent to the next level of resistance.

* A pennant formation is similar to the flag formation - it differs only in the form of consolidation. Instead of a body of consolidation that moves in the opposite direction of the post (as in the case of a flag), the pennant's body is simply a symmetrical triangle. Although pennants have been known to slope downward as well, the textbook formation has also been noted as a symmetrical triangle, hence the name.

Trade Setup
Let's take a look at a real-life example using the British pound/U.S. dollar in July 2007. Here, a 60-minute short-term chart offers a great opportunity in the GBP/USD in Figure 1. After convincingly breaking through resistance at the pivotal 2.0200 trendline, the underlying currency proceeds to top out at 2.0361 and consolidates. Forming a flag technical pattern, we note that the post is 160 pips in length and apply it when the currency breaks through the top trendline at 2.0330. As you can see, the estimate rings true as the pound sterling gains against the U.S. dollar far above market targets and tops out at 2.0544 before consolidating again.



Flag and Pennants in Carry Candidates
Similar setups are seen in the cross currency pairs, giving the trader plenty of opportunities in the currency market, with or without dollar exposure. Taking another market favorite, the British pound/Japanese yen, let's take a look at how this method can be applied to the chart.

In the short-term 60-minute chart in Figure 2, a typically long flag formation is coming around in the GBP/JPY currency pair. In order to establish the formation initially, it is recommended that the chartist draw the topside trendline first. This rule is a must as an initial drawing of the bottom trendline may lead to varying interpretations. Once the initial downward-sloping trendline is drawn, the bottom is a simple duplicate. Here, the trader will make sure to note a touch by the session bodies rather than the wicks in verifying the formation as true. This is to isolate only true price action and not volatility or common "noise" that may occur in the short term.

In Figure 2, the bottom trendline has been pushed slightly higher to incorporate the bodies rather than the wicks. Next, we measure the post. In this case, referencing a major support level at 245.69, we calculate the differential with the top of the move at 248.93. As a result, the distance between the two prices is 324 pips. Theoretically, this will place our ultimate target at 251.74 on a break of the trendline at 248.50.



Trading Rules
When placing the entry, always make sure of two things:

1. The trade is on the side of carry. This means that the speculator is always buying the higher interest rate currency. In this case, the trade is going long pound sterling and gaining 5.25%.

2. Always place the buy entry after the candle close. Applying a buy order after the break of the top trendline ensures that the trendline has been broken. Placing the entry before the close above the trendline may subject the order to being hit on possible market noise above the resistance barrier. This may leave the trader in an unfavorable position as consolidation continues.


Taking into account both rules, we place the entry on the close or slightly below, at 248.77. Risk takers will likely hold the carry trade until the full move has been completed. However, a more conservative strategy, and one that works more often than not, involves placing an initial target at the halfway mark. Taking into consideration the break at 248.50 and half of the full forecast of 324 pips, initial targets should be set at 250.12 with the corresponding stop five pips below the session low.

Step by Step
Now let's take a look at a step by step process that will allow traders to enter on the carry trade momentum in the market. Figure 3 shows a great opportunity in the New Zealand dollar/Japanese yen cross pair. Following the complete downturn that occurred July 9 - July11, 2007, a visual burst can be seen by chartists as bidders take the currency higher over the next 48 hours, establishing a temporary top at Point A.



Now we set the stage (Figure 4):

1. After consolidation, draw the topside trendline first, completing the formation with the duplicate bottom trendline giving the chartist the flag boundaries.
2. On a sign of a trendline break, measure the distance from the bottom of the post to the top. In this instance, the bottom support of the post is 93.81 with the top at 95.74. This gives the trader a potential for 193 pips on the trade after a break of the top trendline.
3. Once there is a confirmed break of the trendline, place the entry that is at the session close or lower of the finished candle. In this case, the break occurs approximately at 95.40 with the entry being placed at that session's close of 95.46 (Point C). Subsequently, a corresponding stop is placed five pips below the session low of 95.37. Ultimately, the position is well within normal risk parameters as it is risking 14 pips to make 193 pips.
4. Set initial and full targets. With the full move estimated at 193 pips, we get a partial distance of 96 pips (193 pips / 2). As a result, the initial target is set for 96.42 (Point B).
5. Set contingent trailing stops. Once the initial target is achieved, the overall position should be reduced by half with the rest being protected by a trailing stop set at the entry price (or break-even). This will allow for further gains while protecting against adverse moves against whatever is left. Longer term strategies will hold to the entry price as the ultimate stop, promoting a worst-case scenario of break-even.

Incidentally, the initial target is achieved right before a slight retracement in the NZD/JPY currency in the example. Subsequently, the position remains on target for further gains as it continues to trade above the entry price.



Conclusion
Flags and pennants can accurately support profitable trading in the currency markets by assisting in the capture of overwhelming market momentum. In addition, applying strict money management rules and using a trained and disciplined eye, a trader can boost returns while helping the overall portfolio in capitalizing on the yield offered through the interest rate differential. Ultimately, sticking to those two tenets of market price and yield, FX investors can't go wrong being long on carry.

Richard Lee is a currency strategist at Forex Capital Markets LLC. Employing both fundamental models and technical analysis applications, Richard contributes regularly to DailyFX and Bloomberg. He has extensive experience in trading the spot currency markets, options and futures. Before joining the research group, Richard traded FX, equity and equity derivatives for a private equity consortium. Richard graduated from Pennsylvania State University with a Bachelor of Arts in economics and a Bachelor of Science in French with an emphasis in international business.

Source : http://www.investopedia.com/articles/forex/07/carry_currency.asp?viewall=1

On Monday, however, it was clear the Treasury and the Fed were actually were on the same page as Secretary Henry Paulson uttered the "I" word --intervention. "I would never take intervention off the table or any policy tool off the table," he said in an interview with CNBC.

The U.S. hasn't intervened in the currency markets since the Bush Administration took over in 2001. That's what makes the mention significant. Markets that figured selling the dollar was a one-way bet now have to be on their guard, even if odds of actual intervention remain very long.

Intervention alone can't affect exchange rates except over the short term. It has to be backed up with complementary changes in monetary policy, with weak-currency nations tightening and strong-currency nations easing.

The outlook for central-bank policies has shifted radically, to increases from cuts, because of concerns about worsening inflation -- even in the teeth of weakening growth, rising unemployment and the unwinding of arguably the greatest bubble ever.

In the U.S., the November federal-funds futures contract now fully prices in a quarter-point increase in the key policy rate at the Oct. 28-29 meeting of the Federal Open Market Committee. A further quarter-point hike in the funds rate at the Dec. 16 FOMC meeting is nearly discounted by the January 2009 futures contract. Moreover, the futures market even priced in two additional quarter-point hikes by next May -- just in Monday's trading.

That marks a huge reversal in expectations for Fed policy, which had been thought to be on hold after the April 29-30 FOMC meeting, when it cut the fed-funds target to the current 2%. Minutes of the confab showed the decision was a "close call," with two dissents in favor of no reduction out of concern about inflation. But the notion of rate hikes was not evident.

Meanwhile, rate-hike expectations are becoming ingrained in Europe. As noted, the ECB is expected to move next month. And in the U.K., investors started to brace for the Bank of England to boost rates over the coming year, also a massive reversal in expectations, given the financial fallout from that nation's housing bust.

The short end of bond markets on both sides of the Atlantic sold off sharply, with the two-year Treasury note yield ratcheting up 33 basis points (about a third of a percentage point), a huge battering. There also were massive hits at the short end of U.K. gilts and German bunds, the benchmark of the European bond market.

The dollar firmed Monday following Treasury Secretary Paulson's comments but remains under pressure, in part because of expectations of ECB rate hikes. But such moves could backfire.

"The Trichet way to fight inflation is dumb because it is counterproductive," writes Ed Yardeni, the veteran Wall Street economist who heads an investment advisory bearing his name. "The ECB has the same inflation problem all other central banks are facing: Oil and food prices are soaring, partly because of the weak dollar. Bernanke's comments helped to strengthen the dollar and weaken commodity prices. Trichet's comments had the opposite effect, causing the dollar to sink and oil prices to soar."

The effects of skyrocketing oil, a weak dollar and contradictory interest-rate policies were apparent in Friday's market rout. The likelihood of the Fed raising interest rates when the unemployment rate is rising sharply -- even if it's only a statistical quirk -- historically have been slim and none.

In 1987, the Bundesbank insisted on raising interest rates despite the precariousness of currency markets. Back then, Washington was looking to crack down on corporate takeovers, which were deemed to be excessively speculative -- just as long-only commodity funds are being viewed with increasing suspicion by regulators. And, then as now, there was the explosion of derivatives -- stock-index futures and portfolio insurance in the 1980s, credit derivatives in this decade -- that have the potential to destabilize the financial system.

Those are perhaps superficial similarities. There are two distinct differences now. In 1987, the global economy was strong and oil was cheap. It really may be different this time, but not better.

Source : www.barrons.com

The answer depends largely on how governments and central banks worldwide respond to the oil shock. The challenge most discussed in recent weeks is the one facing central banks. If the surge in oil prices causes accelerating pay growth and then a second round of price rises in goods and services not directly exposed to oil, central banks will face stark alternatives: either deliberately to create recessions and mass unemployment by raising interest rates even amid the present property slump, or to accept 1970s-style wage-price spirals, which will have to be cured eventually with even deeper recessions, higher unemployment and greater financial grief.

The other, even bigger, challenge of the oil shock is the one presented to governments. This is the question of what can be done to reverse the rise in oil prices. This question is even more important than the central banks' inflation-deflation dilemma and yet is hardly discussed. Most politicians, economists and financiers simply assume that the trebling of oil prices in the past few years has been a natural phenomenon that must be accepted as an act of God - or at least an inexorable judgment by the markets. However, are there really no policy changes that could restore the more benign conditions in which oil prices of $40 or $50 were seen as normal?

The standard answer is “no” - oil at $100-plus must be accepted as inevitable and natural because growth in global oil production cannot keep up with growing demand, especially from China and the developing world. However, even if this were so - and statistical facts about the “peak-oil” limit to global production capacity are ambiguous, to put it mildly - it begs the question of whether oil consumers could soon take steps that would drastically reduce demand.

Specifically, there are four big steps that governments in oil-consuming regions could take once they recognise the existential economic threat of a $100 oil price.

The first and most urgent step is for developing countries, now responsible for all the growth in world oil demand, to reduce and ultimately eliminate energy subsidies. Once Asian consumers face global oil prices, they will change their behaviour - for example, buying smaller, more fuel-efficient cars - far more quickly than European and American consumers, since $100 oil is much more of a burden relative to total income for poorer consumers. Indonesia and several smaller Asian countries have begun this process and last week the Indian Prime Minister announced plans to reduce energy subsidies over time. China will surely follow. Once China and India made clear their aim to move towards global oil prices, the impact on oil prices would probably be very big and immediate, even if abolition of subsidies were spread over several years.

Today's high oil prices are largely sustained by expectations of huge Chinese demand growth. Mere announcement of a plan to align Chinese and global market prices could have a huge effect on long-term futures market prices, which have been driving up physical oil's price.

The second big step would be for financial regulators in the United States, Britain and Europe to reduce the artificial demand for long-term oil-hoarding created by pension funds, insurance companies, endowments and other long-term investors. These investment institutions have been piling into commodities recently in the same way they did into technology shares in the late 1990s and into mortgage-based credit derivatives from 2003 to 2006. Last week there were signs that US commodity market regulators may close loopholes whereby these long-term investors can accumulate immense positions far larger than those permitted to ordinary commodity speculators. Just like banking authorities in the sub-prime mortgage boom, US commodity regulators initially have been reluctant to interfere with market forces, but under political pressure from Congress a tightening of both regulations and tax rules seems to be on the cards.

Such a touch on the regulatory tiller might well, on its own, reverse the most recent spike in the oil price.

The third step to cut long-term oil demand is up to the US Government. A political consensus seems to be forming to end America's costly reliance on oil imports. This consensus could lead America towards European-style energy taxes, offset by lower taxes on income and employment. Any such shift would have a huge effect on global oil demand. If US oil usage could be reduced gradually to today's European level - perfectly plausible, given the similar populations and levels of development of these two continental economies - the cut in global oil demand would be almost equivalent to China's oil consumption.

The fourth big step in reducing global oil dependence would be for Europe and Britain, as well as the US, to create far greater financial incentives for renewable and nuclear electricity generation.

The ultimate aim should be a shift from oil-based to electricity-based technologies in all industries and throughout the global economy.

If such measures are adopted, there can be no doubt that the price mechanism will cut long-term oil demand drastically. So much so that the peak oil thesis about the inevitable dwindling of global oil production will almost certainly stay untested and unproven; for, in the end, a large part of the world's oil supplies will be abandoned for ever, virtually worthless, in the ground. The effect of price on demand was summarised during the last energy shock by Sheikh Yamani, then Saudi Arabia's Oil Minister, when he told greedier Opec colleagues that they would encourage replacement of oil by other energy sources. “Remember,” he said, “the Stone Age didn't end because the cavemen ran out of stone.”

If oil stays anywhere near $100 a barrel, the price mechanism and the political economy of national survival will ensure that the oil age ends long before the world runs out of oil.