A futures industry without trading in foreign currencies and other financial futures is difficult to imagine today. But in 1971, futures markets were largely seen as unfit for anything but trading in agricultural commodities.

This was the ideological wall Leo Melamed ran into before he requested the opinion of Milton Friedman, who soon agreed to write a commissioned paper validating the idea for a futures market in foreign currencies.  The timing was impeccable. A month after the men met to discuss the idea, President Richard Nixon ended the gold standard, triggering the fall of Bretton Woods, and the necessity for a futures market.

On May 16, 1972, under Melamed’s leadership, the Chicago Mercantile Exchange established the International Monetary Market, a futures market in seven foreign currencies.

Opening day for the International Monetary Market – May 16, 1972

Today, thanks to the vision of Melamed and the continued leadership of CME Group, the global FX market has advanced dramatically, to the point where it seems impossible to envision foreign exchange trading any other way. While we are the largest regulated marketplace in the world for FX trading, other exchanges across the globe have followed our lead by offering foreign exchange futures based on the model established here 40 years ago.  Over this time, FX products have grown increasingly sophisticated as we have continued to invest in market-leading technology to suit the evolving needs of global market participants.

National flags representing the seven foreign currencies on opening day of the IMM

At CME, we now transact over $120 billion a day in FX products, offering 56 futures and 31 options products in our FX product suite across 20 underlying G10 and emerging market currencies. Our product portfolio includes standard sized Futures contracts as well as smaller-sized e-mini and e-micro versions of contracts, FX volatility products and a robust FX Options product suite.

And with the approaching mandates for clearing over-the-counter FX trades, we continue to lead through innovation by being the first clearing house to go live and clear client trades in OTC FX products. We now offer OTC FX clearing services in 12 emerging market non-deliverable forward currencies.

First day of trading at the IMM

In 1972, many large corporations were conducting business globally, and CME’s groundbreaking new FX futures market allowed them to efficiently and effectively hedge the financial risk they incurred as currency prices fluctuated in response to financial, political and economic events.

Today, we live in a global economy where even the smallest businesses make purchases or earn revenues with some foreign currency risk associated with it. We continue to provide the key hedging and risk management tools these customers need.  As the FX market continues to grow in response to these needs, and as transactions get conducted at ever greater speeds and in increasing volumes, there has never been a greater need for a deep and liquid foreign exchange futures market.

The uncertainty in Europe following the French and Greek elections in early May and the threat of an extended crisis has placed the European Central Bank back in the spotlight.

As the Wall Street Journal reported:

If Greece’s fractured politics cannot forge a coalition government in the coming days, then markets may look to the ECB as the last body standing to keep the currency union intact.

But with all the attention on the ECB lately, it’s easy to forget that Europe and the surrounding region is made up of several central banks with many issues that have little or nothing to do with Greece or protecting the euro.

For example, in late April, we hosted senior central bankers from 12 countries across Europe, the Middle East and Southeast Asia at our European headquarters in London to discuss how those central banks and the derivatives industry interact.

The topic most on the minds of everyone at the event was not potential bailouts, but financial regulation. In particular, questions were raised around over-the-counter (OTC) clearing for derivative products and the current proposals in both the United States and Europe.

In addition, the group discussed key tools for interest rate management, including Eurodollar and Treasury futures and options, Gold as a reserve currency, foreign exchange as an asset class, and the role of the Renminbi in the global economy — all issues where futures and options markets play a pivotal role.

Not that the fiscal crisis in the Eurozone isn’t something that these banks consider. They must construct strategies around the potential fallout of the situation here. But that’s where markets can help.

Markets like ours are host to trading and clearing in asset classes that are intimately tied to the heartbeat of any country’s economy: interest rates and foreign exchange. Banks frequently use interest rate futures and options to hedge and these instruments also provide a useful bellwether of market sentiment.

This is the first time we have held our Central Bank Forum in London, following the model that we established in Chicago in 2011 followed by Asia in March.  These forums provide a platform for sharing ideas between key participants in policy-setting and reserve management , and discussing current developments in the market.

Often, those developments involve the uncertain fiscal environment in Europe, but they might also deal with regulation, emerging markets, or inflation. In all of these cases and many others, futures and options play a significant role in managing the associated risks.

We’ve frequently seen the role of commodity speculators questioned this spring while gasoline and crude oil prices rose. But now that crude prices have dropped  9 percent in May, where does the argument against speculation stand? Mark Perry makes this point on his Carpe Diem blog:

 Since oil speculators got the blame for rising prices in February, do they now get the credit for falling oil prices in May?  How exactly does the “speculators cause high oil prices” crowd now explain the falling oil prices?  Do speculators somehow contribute to only rising prices, but not to falling prices?

That got me thinking about the consensus around this issue among those who’ve studied it closely.  Following is a collection – but by no means all –  of the recent pieces that highlight the important part speculators play in the marketplace, with some thoughts from each:

James Hamilton in The New York Times: “Even if there are no dramatic geopolitical events, continuing to increase production to meet the world’s growing demand is a daunting challenge. It is time we stop blaming the speculators and start to acknowledge the reality that we are highly dependent on a critical resource whose ready supply is not something on which we can count.”

Robert Samuelson in the Washington Post:  “We should exorcise the politically convenient notion that high oil prices result from the market maneuvers of greedy “speculators.” It’s convenient because it suggests that a solution to high pump prices — or a partial solution — is to banish the offending speculators from the marketplace. That’s fantasy.”

Tim Worstall in Forbes: “There’s just as much futures speculation in the natural gas market as there is in the oil market. How can such speculation in one market drive up prices while in the other it drives them down?”

Bloomberg Editorial:  “Yet speculators aren’t inherently bad. Quite to the contrary: They serve a vital purpose, helping create a market of buyers and sellers. Many academic researchers have found that speculators, by anticipating future price moves, can reduce volatility.”

Blake Clayton in Foreign Affairs: “What critics derisively refer to as “oil market speculation” is all too often a nebulous, epithetical catchall meant to bring to mind clandestine profiteering by financial tycoons at the expense of the rest of the nation. But casting the blame for high gas prices on speculators is sloganizing populism, not serious oil policy.”

Scott Irwin in The Washington Times: “There is no “smoking gun” connecting speculation to the rise in gas prices. In fact, just the opposite is likely to be true: Expanding market participation by different kinds of speculators likely reduces the cost of hedging, dampens price volatility and better integrates commodity markets with financial markets.”

Commodity Online: “The oil futures market cannot function without speculative traders providing liquidity and assisting in the price discovery.”

Donald Boudreaux in Newsday: “Speculation makes resources ore abundant when there is great scarcity by encouraging people to use those resources more sparingly when there is relative abundance.”

Howard Becker in American Thinker: “The fact that consumers benefit from the activity of speculators is not obvious, but it is true.”

Matthew Philips in Businessweek: “Do we really want to go back to 1973, when one morning we wake up and the price of oil has quadrupled overnight?”

The list goes on…

The trifecta of problems

In the pre-crisis years, both Ireland and Spain allowed their public finances to become reliant on property bubbles that had also seen the countries’ banks over-extend themselves and their construction sectors grow unsustainably large. When the property bubbles burst, this house of cards fell in on itself.

Banks in the two countries faced massive losses and in some cases were pushed to insolvency, while in the real economy unemployment spiked and construction activity ground to a halt. The Irish and Spanish governments were left to pick up the tab, just as government revenues started to slump.

With debt and deficit levels soaring, the Spanish and Irish governments were forced to retrench, adding yet more pressure to their economies. What started out as a property bubble underpinned by cheap cross-border credit quickly turned into a trifecta of problems in both Ireland and Spain: banks needing government recapitalization, ever-greater demands for austerity to bring the public finances back under control, and the drag of austerity on economic growth.

This trifecta brought Ireland to its knees in late November 2010 when it was forced into an EU/IMF bailout program. Eye-watering losses on banks’ commercial property loans were crystallized over the course of 2010 as they were transferred to NAMA, the bad bank for Ireland’s worst non-performing loans. To prevent these losses collapsing Ireland’s banking sector and undermining the wider eurozone financial system, the Irish government was forced into a series of recapitalizations.

Spain’s residential property market has only collapsed around 22 percent from its peak in 2007 to the end of 2011 – compared with over 50 percent in Ireland – and will probably fall an additional 15-20 percent. The more gradual fall in Spanish property prices means Spain’s bank recapitalization costs have been smaller as a percentage of GDP than those in Ireland. Spain’s bank recapitalization has also been smaller because Spain’s bank resolution institution, FROB, does not force banks to crystallize bank losses up front.

This unfortunately does not mean Spanish banks are any healthier today than Irish banks were back in late 2010. As Spanish property prices fall further and unemployment continues to soar, mortgage defaults will rise. Spanish banks will almost certainly require further recapitalization from the government.

As was the case in Ireland, it is extremely difficult to estimate the size of the hole in the Spanish banking sector, and this uncertainty is deeply corrosive of investor confidence. As long as the health of Spain’s banks remains a huge source of doubt, investors will shun Spanish sovereign debt and borrowing costs for Spain will remain elevated.

Austerity vs. growth

In order to rein in its budget deficit – a key requirement of the EU/IMF bailout agreement – the Irish government introduced a steady stream of draconian austerity measures in successive budgets. With the government retrenching just as banks, companies and households were forced to rebuild their balance sheets, Ireland was pushed into a depression.

Spain’s budget deficit ballooned to 8.5 percent of GDP in 2011, and the Spanish government has agreed with the European Commission to reduce its budget deficit to 5.3 percent of GDP this year and 3 percent of GDP in 2013. We have already witnessed in Ireland what happens to GDP when the government is forced to retrench alongside every other level of society. There is no reason to expect a different result in Spain, which slipped back into recession in the second half of 2011.

The government can’t win

In late 2010, Ireland had reached a point at which it could no longer shift market sentiment in its favor. A small fiscal adjustment by the Irish government would have been perceived as a lack of seriousness about the need for fiscal sustainability. A big fiscal adjustment, on the other hand, would raise concerns about the impact of retrenchment on growth.

The government opted for the latter strategy, bond yields rose further and within weeks Ireland was forced to enter its bailout program.

Spain’s current trajectory looks eerily similar. In early April, Spanish bond yields started to creep upwards to unsustainable levels once again. In an effort to reassure investors, the Spanish government announced an additional €10 billion in savings. But the news of a bigger Spanish fiscal adjustment only served to unnerve investors, who fretted about the implications for economic growth. Consequently Spanish government bond yields edged upwards even further.

Sneak Preview?

If the Spanish government cannot regain market confidence, it will be forced to request access to official funding. This may initially come in the form of support for Spanish banks, but recapitalizing the banks only addresses one piece of the puzzle. In the absence of economic growth, the Spanish sovereign will need a bailout too.

Given the similarities between the Irish and Spanish cases so far, is the success of the Irish bailout program a sneak preview of things to come in Spain?

Let’s hope not.

Ireland has been hailed as a success story by the European Commission, the ECB and the IMF. This is true in a relative sense – Ireland’s bailout program has gone better than those in Greece and Portugal. But Ireland dipped back into recession in the second half of 2011, and with domestic demand set to contract further and foreign demand weakening, it is unlikely the country will find sustainable growth in the next few years. Consequently, Ireland will almost certainly require a second bailout when its first program expires.

This highlights a crucial difference between the Irish and Spanish cases: size.

Ireland is small enough for a second round of EU/IMF funding to be affordable if it is needed. Spain is not.

There is only enough money in the EU/IMF arsenal to bailout Spain once. If Spain were to fail to find sustainable growth during the course of a first bailout, it would get no second roll of the dice. Instead, we would face a debt restructuring in one of the eurozone’s largest economies, with detrimental effects on global growth.

“China is a well-oiled machine when it comes to projecting its interests globally”

OPEC pushes up oil production to the highest level since 2008

Why has the recovery in employment in the US been so slow?

Why some entrepreneurs are planning to leave France following last weekend’s elections.

“The economy is on track for 3 percent growth.”

Life lessons for the office from a Harvard Business professor

Facebook launches app store as it prepares to go public next week… and of course you can Like us on Facebook too.

Next week, the Seaway pipeline between Cushing, Oklahoma and the Gulf of Mexico will reverse, directing 150,000 barrels of oil per day (400,000 by 2013) from the bottleneck at Cushing to the Gulf.  As my colleague Dan Brusstar wrote last November after the initial announcement, this is major change to the North American oil complex that will enhance the value and global availability of West Texas Intermediate crude.

Jim Teague, COO of Enterprise Product Partners who owns the pipeline, was on the floor of the NYMEX yesterday talking with traders about the reversal and the affect it will have on crude prices. He also talked with Sandra Smith of Fox Business in the above video, who asked him what will happen when pipelines begin running to the gulf where refineries are using foreign oil:

“There’s a lot of domestic crude being produced making its way to the gulf coast. You’ve got crude coming out of the Eagleford going to the gulf coast. And you’ve got shale plays all over the country that will produce more domestic crude oil. The effect of the total is going to be to back out imports. We import about 5 million barrels a day from places other than Canada and Mexico… What if we produced 4 million barrels a day of (domestic) crude oil?”

Backing out oil means foreign crudes from the north sea and western Africa will need a new home because North American crudes will be used at these refineries instead. At that point, we may see prices/spreads to move back to their historical levels.

This infographic from the Wall Street Journal shows how the pipeline will be reversed.

CORN

The report today projected higher yields for corn, raising the projection to 166 bushels per acre, up from 147 bushels last year.

“I’ve been a little reluctant to jump into this idea of 166 bushel yield, primarily because of the huge expansion expected of nearly 5 million acres of corn in the U.S.,” said Gidel. “You have a situation where you’re adding more marginal acres into the total.”

Overall, the report projected a record 14.8 billion bushels of corn this year from U.S. farmers, 2.4 billion higher than the 2011/2012 marketing year.

Gidel noted the increased corn production comes as increased demand is expected, especially from China.

“The Chinese corn buying for the coming year could have a huge impact on this corn price. If they had a drought issue or a problem there, which can happen in la nina year, they could be a huge wild card yet in the corn situation, and we could see exports increase.”

SOYBEANS

“There’s certainly nothing negative about the soybean numbers here today in contrast to corn,” said Scoville.

Expected ending stocks for the year were cut on an uptick in demand, especially from South America, which is suffering the effects of a drought. Reserves in the United States are expected to drop to 145 million bushels, from 210 million, according to the USDA.

Scoville:

“The USDA is signaling that the soybean situation is going to be bullish as we move through the summer and into the harvest period and beyond, until we see next year’s South American crop. That implies we’re going to continue to see some very strong prices in the soy complex relative to corn and wheat.”

He adds that South American demand won’t have much additional impact going forward: “The overall effects from drought (in South America) are pretty much factored in.”

WHEAT

The corn/wheat relationship was highlighted by the panelists. The higher demand and lower price for corn means there’s less expected use for animal feed, which impacts the use and price of wheat.

“With the start of the winter wheat harvest in the southern plains the last few days, the price relationship is definitely encouraging people in the southern plains, particularly in the feed yard area, to be a big buyer of wheat. I’ve heard that some of the big buyers there are looking at that hard,” said Gidel.

Today’s report projected a 13 percent increase in winter wheat production.

According to Kitt:

“Truth be told, we do need that. Over the next June, July, August period we’re probably going to be feeding record amounts of wheat in the U.S. And of course the old corn crop situation has been well documented, and we’re going to need a lot of that wheat…

Wheat is corn, corn is wheat. Wheat is going to be held to what corn does in term of price response, and that’s probably not very positive,” he said. “On top of that you have very negative seasonality. We think corn’s probably going to be about 15-20 cents lower. Wheat will be lower as well. Production is going to be going from burdensome to just more than adequate.”

Read the full WASDE report, and watch more on the CME Group crop report page.

The lead in this New York Times story says a lot:

“Europe is in danger of giving itself a nervous breakdown with all the talk of economic failure and irreversible decline.”

This seems to capture the mood of the news reports, analysis and most critically, market activity following the elections Sunday in France and Greece, where political power was splintered among several parties and a governing coalition may be difficult to find.

In response to the situation, several asset classes have traded lower. NYMEX gold hit its lowest point since the first day of trading this year; Copper hit its lowest point in a month,; WTI crude has dropped on expected weak demand; and global stock index futures have declined, including every major U.S. index.

Much of the reaction is due to the shakiness of the euro, which has already fallen against the dollar for seven consecutive sessions, and dipped below the critical $1.30 mark earlier this week.  Oil, gold and copper are all denominated in dollars.

Foreign exchange traders have begun seeing volatility as well at the prospect of a falling euro, particularly in emerging market currencies.

In other words, all kinds of market participants are suddenly finding increased risks in the eurozone. As  the situation here progresses, CME Group’s 56 futures and 31 options products in foreign exchange  will increasingly serve as an important place to manage those risks.

In a paper yesterday on the situation, our chief economist Blu Putnam, summed up the stability concerns in Europe:

A splintered Europe is not a crisis, but it does have the potential to destabilize markets, and this will put even more pressure on the European Central Bank to provide several more rounds of long-term lending to European banks to make sure financial markets stay liquid.

Until some stabilisation is found, currency markets will be among the most sensitive to this process.  The search for a coalition in Greece, political rhetoric from newly elected leaders, and future votes will place pressure on the Euro. This makes liquid FX markets particularly valuable in the months ahead, as the uncertain situation in Europe invites the need to manage all the risks associated with it.

Editor’s Note: This is our first post in a new feature we’re calling Today’s Number. CME Group subject matter experts  will be highlighting critical numbers they see trending in the marketplace, and offer their perspective on the impact the number has on financial markets and the global economy.   

There are numerous political and economic risk events coming up in the next few weeks following the results of the French and Greek elections. The world may become more “risk-off” in the coming weeks as we work through potential volatility in various asset classes. As the Eurozone debt crisis continues to rattle markets and investors, EUR/USD  options Open Interest (OI) will likely remain high as market participants continue to take refuge in hedging their exposures with buying and holding lower positions on the euro.

We want to highlight a key trend in our EUR/USD May expiry 1.25 strike puts with high OI at nearly 10,000 lots. The trend has continued for the 1.25 put, breaking our previous OI record, and for the year setting new record highs of almost 50 percent greater than January. We see continued strong demand and trading in EUR/USD options, particularly around the May 4 expiry 1.25.

The chart below shows the growth in our July contact Open Interest where the strike is most prevalent.

As we hover around the key EUR/USD resistance level of 1.3000, we expect to see increasing open interest build in the June expiry EUR 1.2500 strike puts (most popular strike currently).  On May 4, CME had open interest around 6,500 lots. On Monday, even with the UK Bank holiday, CME OI climbed to over 8,300 lots. A “Risk-off” environment is back in play.

To stay on top of this trend be sure to bookmark our CFTC Commitment of Traders in FX Futures Report and our new FX options open interest tool.

CME Group chief economist Blu Putnam today discussed the market reaction to news in Europe, including what he expects from the oil market, with Sandra Smith of Fox Business Network. Putnam also shared his view of the chances of economic recovery in the United States:

“This is absolutely a real recovery. We’ve got a 3 percent (GDP growth) plus economy on our hands. Sure we had a little slowdown in jobs, but we had that the last couple of years. This slowdown’s not as much as before. Things are going fine.”

Read Putnam’s full paper, The Political Splintering of Europe, on the market reaction to Sunday’s French and Greek elections.

CME Group chief economist and OpenMarkets contributor Blu Putnam expects the Federal Reserve’s continued low interest rate policy to drive economic activity in the near future. He spoke with Sara Eisen and Michael McKee of Bloomberg’s“On the Economy” podcast Friday, and shared his views on the latest jobs numbers, where  he expects economic growth to come from, and his outlook for Fed policy:

“The zero interest rate policy will be the driver for this year and next year helping the economy do well, so you don’t need a QE3 or anything like that.”

Putnam also released a paper last week “FOMC Members Become Slightly More Optimistic” about the views of Federal Open Market Committee voting members stated at their April 24-25 meeting. The 2014 consensus among members for raising interest rates remained the same, but four members moved their projections earlier, and six members say they expect rates to rise in 2012 or 2013.

“One must remember, however, that the Fed provides guidance and does not make commitments. If the facts change, then the Fed’s guidance may change. The improved performance of the US economy over the past six months has impressed a few FOMC members to become a little more optimistic in their economic projections.”

Access Putnam’s analysis at CME Group’s Market Insights page, and listen to the full Bloomberg interview here.

As this story from CBS News suggests, it was a week for examining the news and policies impacting economic growth across the globe. Several of the world’s biggest economic and financial decision makers presented their views at the annual Milken Institute Global Conference in California, which wrapped up Wednesday.  With today’s U.S. jobs data, and elections in Greece and France on Sunday, there will be a lot to watch next week in financial markets as well.

Some more stories worth reading from the past week:

Are rapid technological change and globalization responsible for lower than expected job growth?

Dismissing the criticism: Speculators provide vital liquidity to markets.

San Francisco Fed chief says the U.S. must continue a “highly accommodative monetary policy.”

Former President Clinton:  ”No American should want Brazil or China or India to fail. We have a common future.”

Where will economic growth come from?

FOMC members are slightly more optimistic, according to our chief economist.

A more flexible renminbi still matters.

Why copper is intriguing right now.