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Monday January 28, 2008 - 01:06:00 GMT
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Sound and Fury -- Market Directions Sunday January 27, 2008


Considering the size and scope of the week’s events, calamitous equity falls worldwide on Monday, what appeared to be an imminent American plummet on Tuesday, a massive Federal Reserve rate cut and continued intransigence from the European Central Bank (ECB), perhaps the most remarkable development was the relatively small effect all this sound and fury had on the dollar. On Tuesday the euro closed at 1.4627 and on Friday it finished at 1.4670. The Tuesday close did disguise the volatility of a more than three figure move trough to peak on the day. But the most telling fact for the future direction of the euro (and the dollar) was the united currency’s close for the week more than a figure below its peak against the dollar.

Another 50 basis point cut in the US Fed Funds rate is coming at Thursday’s FOMC meeting and it is fully priced into the market. The ECB has made it abundantly clear that it will not be cutting rates in response to equity market turmoil. Jean Claude Trichet, the President, Alex Weber, governing board member and head of the German Bundesbank, and Jurgen Stark another board member took turns diminishing market expectations for an ECB rate reduction. As Mr. Weber said in the most succinct comment such expectations were “wishful thinking”.

Tuesday’s surprise did not deviate from the projected overall US rate scenario, it only altered the timing. 125 basis points in total reductions and a 3.00% Fed Funds rate by the end of the first quarter has been priced into the dollar for several weeks, at least since the December Retail Sales results were released. An ECB rate ease, or even a move to a neutral bias has not been priced. The beginning of such an adjustment to an ECB policy change which had resulted in the euro move down to below 1.4400 was short circuited by Mr. Bernanke on Tuesday.

Equity markets, led by the New York exchanges have been falling since the turn of the year and as the decline became more panicky the dollar benefited. That economic logic has not changed measurably and in that logic is the hope for the Usd. The European central bankers have done their rhetorical best to deny what many traders believe—that the next ECB rate move will be a cut. If the markets truly expected a widening of the US-EMU rate divide beyond what is already priced in, then 1.5000 should be in the rearview mirror; it is not. In the background is the belief, already expressed so dramatically by the equity markets world wide, that a US slowdown will affect the entire globe, and the ECB will sooner or later have to reduce rates.

European and Asian investors seem to be just waking up to the perils of the worldwide financial market. If US bond insurers fail portfolios globally will have to be rewritten. If European banks have been less than aggressive in writing down sub prime debt that does not obviate the final accounting and the ECB’s stalwart inflation stance will not then prevent recession.

Central Banks

European Central Bank

It was the same old story from the ECB this week, inflation, inflation, inflation; or was it? On Tuesday, amid historic equity volatility, Jurgen Stark, governing board member said the crisis in the financial markets should not be overemphasized, “We should not dramatize the situation”. Is the Fed just histrionic? After all, European and Asian bourses have been as hard hit as America’s. The equities markets are speaking with one voice, decoupling is a mirage and the ripples from a US slowdown will effect economies worldwide. A US recession, assuming it gets that far, will seriously damaging economic growth around the globe. That is the inescapable message from the world’s stock traders. All bourses have suffered severe losses in the past several weeks, not one has been spared.

Jean Claude Trichet the ECB president, speaking before the EU parliament, acknowledged the risks to European economic growth. But still, he said, the bank was not ready to change its anti-inflation policy. There is no sign, no hint from the public spokesmen for the ECB that a rate cut is being prepared or even considered. “In demanding times of significant market correction and turbulence, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets”. “We have a baseline scenario and at this stage I’m not going to modify this…”. “I would say that the risks [to economic growth] are on the downside”, stated Mr. Trichet.

There is however another more benign scenario. ECB spokesman have made it patent that their corporate concern is the ‘secondary effects of inflationary expectations’ meaning a wage price spiral where rising prices, and more importantly the anticipation of future price increases, push workers and unions to demand ever higher wages. Since union contracts tend to be multi year, when such expectations are written into a contract they imbed inflationary expectations into the economy. That is precisely what the ECB is seeking to avoid.

By both stressing the need to solidly anchor inflation expectation, that is to prevent European workers from developing inflationary expectations and by emphasizing the transitory nature of the current inflationary pressures, the ECB is speaking directly to Europe’s unionized labor force. “I am not happy with current inflation of more than 3.0% but it is probably temporary”, said Mr. Stark. Translation -- we are determined to prevent inflation, the present spike above 3.0% will pass, there is no need to seek large multi year wage increases. Is there an unspoken addendum that when the ‘temporary inflation’ subsides, the ECB will attend to economic growth?

Federal Reserve

A whiff of panic clung to Tuesday’s surprise 75 basis point cut in the Fed Funds and in the Discount Rate. But by the end of trading on Wednesday the Fed governors had the result they desired, the relentless selling that had gripped the equity markets was over. On Tuesday the Dow managed to erase most of an early 400 point decline finishing off only a little more than 100 points. Wednesday evinced an even more powerful reaction, with the NYSE ending the day up 298 points, almost doubling the opening 300 point decline. Yet the economic outlook had not changed from one day to the next, nor had the Fed added to the total anticipated rate reductions.

The Fed statement explaining the surprise move stressed “ weakening economic outlook and increasing downside risks to growth”, that “broader financial market conditions have continued to deteriorate and credit has tightened for some businesses and households”, and that a “deepening of the housing contraction” exists, and “appreciable downside risks to growth remain”. But the overriding motivation of the Fed governors was to break the panicky psychology of the equities markets and in that they were successful

Bank of England

The Monetary Policy Committee of the Bank of England (BOE) voted 8 to 1 to leave rates unchanged at 5.5% at the January meeting. The chance for another cut at the February 7th meeting of the Monetary Policy Committee is now rated even.


The Bank of Canada cut the overnight rate 25 basis point to 4.0% on Tuesday in step with the US Federal Reserve. It is likely that there will be two more cuts of 25 points each in February and March. “Financial market conditions have deteriorated since October. The outlook for the US economy is now significantly weaker”. “For Canada the effects of the weaker US economic outlook will lead to additional downward pressure on export growth” said the accompanying statement.


The slow revaluation of the yuan is proceeding, it has gained 2 % against the dollar since early December and is worth 6.93% more than it was a year ago. But for Chinese economic planners striving to rein inflation and curb excessive economic growth a stronger yuan is a two edged sword. A rapid appreciation of the yuan could inflict much damage on Chinese exports and industry. A dearer yuan makes foreign goods more expensive, which helps combat inflation but it also draws capital into the country, fueling both economic growth, and inflation. CPI was at 6.9% in November an eleven year high. If the American economic slowdown spreads and if the US enters recession the Chinese economy will not be unscathed. “If the US consumption weakens our country’s exports will be very much affected”, said Zhang Tao, head of the People’s Bank of China (PBOC) International Department quoted by Market New International. The Fed rate cuts have already made it much harder for the PBOC to raise interest rates as investors seek the higher returns in China coupled with the potential for yuan revaluation.


The Bank of Japan left rates unchanged at 0.5%, to universal expectation and universal disinterest. There is no expectation for a rate increase in the near future and little chance that a rate cut would have any economic effect should the Japanese economy start to recede. The vote of the policy committee was unanimous.

The Week in Review January 21 – January 25

United States

The week was dominated by the equity markets and the policy responses of the world’s central bankers. The ECB declined to join the Fed and its governors and president went out of their way to squash speculation that they would soon shift policy to accommodation. The US economy was largely undocumented for five days, with no important statistics released. Only weekly jobless claims, which at 301,000, were well below levels associated with an actual or pending recession, seemed to belie the economic catastrophe predicted by the stock market. But as the equity panic subsided, the economic logic that had boosted the dollar revived somewhat. If the US is further along the curve to recession, but also to recovery having started first and responded first—with Fed rate cuts, then the dollar should in the long run benefit. Such was the logic behind the market reluctance to push the euro higher despite the week’s unusual events. The six month prospect for the dollar has not changed very much regardless of the fireworks.


The ECB and has made it quite clear that it will not be reducing rates in response to current market or economic conditions. It would likely take a drop in GDP growth to below 1% annually to shake the govenors from their anti-inflation stance. But it is also evident, despite rhetoric to the contrary, that the bank will not be raising rates. If the US slowdown materializes and then travels to Europe, the ECB governors will look like unimaginative ideologues. If the US does not does not slow or its effects do not cross the Atlantic then they will be steadfast protectors of the public good. But either way they have taken their stance.


Only in Japan might a 0.8% monthly rise in CPI be a cause for quiet relief. This underscores the difference between Japan and the rest of the industrialized world. Japan has flirted with price deflation, a phenomenon not seen in the west since the depression, for much of the last 15 years. Plagued by an aging and falling population, the government’s attempt to re-inflate the economy and boost domestic spending have been only marginally successful.

Economic Releases January 21 - January 25

United States

Thursday: weekly unemployment claims fell 1,000 in the January 19th week to 301,000 the lowest total since September 22nd of last year. Median prediction had been for a rise of 20,000 to 321,000. Initial claims often drop in January following layoffs at the end of the Christmas season in late December. But 400,000 or more, is usually associated with the beginning of a recession. Existing Home Sales slipped 2.2% in December to 4.89 million a bit below the median prediction of 4.95 million. In the first nine months of 2007 existing home sales, homes that are normally occupied by their owners, fell an average of 3.76% per month. During October, November and December the pace of decline slowed to an average of 0.97% per month. The median home price in December was $208,400, six percent lower than December 2006.


Wednesday: industrial new orders were almost twice as active in November as predicted gaining 2.7% on a +1.4% forecast. October’s figure was unrevised at +2.5%. The flash (1st issue) composite Purchasing Managers Index (PMI) for January registered the lowest since June 2005 at 52.7, December had been 53.3. Services PMI fell to 52.0 from 53.1, a 53 month low; manufacturing PMI was unchanged at 52.6.


Thursday: the IFO Index of businesses posted a surprising rise in January with the headline ‘business sentiment’ moving up to 103.4 on expectations of 102.2 and a December reading of 103.0. ‘Business expectations’ gained also to 99.00 on predictions for a fall to 97.3 from December’s 98.2. Only the ‘current assessment’ component was lower in December at 107.9, as opposed to December’s 108.1, though it was ahead of the 107.1 prediction. “On the whole the condition of firms in German industry and trade continues to be robust”, said IFO president Hans-Werner Sinn in a prepared statement.

Friday: GfK consumer confidence was stable in February at 4.5, the same as in January and 0.1 higher than December.

United Kingdom

Monday: Rightmove House Prices complied by the British real estate web site sank 0.8% in January, leaving them 3.4% higher on the elapsed year.

Wednesday: preliminary fourth quarter GDP rose 0.6%, 2.9% year to year. This was 0.1% less than the growth in the third quarter, stronger than the 0.5% expected but below the most recent BOE estimate of 3.2%.


Friday: national core CPI in December rose 0.8% year to year in December, led by gasoline and heating oil prices. A gain of 0.6% had been predicted. In November the index rose 0.4%. Central Tokyo CPI, often take a proxy for the national tendency, moved 0.4% higher in January after a 0.3% rise in December. In all of 2007 this index rose 0.1%, the same as in 2006.


Q4 core inflation rose to a 16 year high at 3.6%, well over the Reserve Bank target band of 2-3%, and keeping anticipation rife that the Reserve Bank of Australia will hike rates in February despite the 20% fall in the All Ordinaries Stock Index.

The Week Ahead January 28 - February 1

United States

Monday: New Home Sales for December at 10:00 ET; expected 648,000, November 647,000

Tuesday: Durable Goods Orders for December at 8:30 ET; expected +1.5%, November +0.1%. Case/Shiller House Price index for November at 9:00 ET; October -6.1%. Conference Board Consumer Confidence for January at 10:00 ET; expected 87.0, December 88.6.

Wednesday: ADP National Employment Report for January at 8:15 ET; December +40,000. 4th quarter 2007 GDP (advance, 1st issue) at 8:30 ET; expected +1.2%, 3rd quarter +4.9%. FOMC policy announcement at 2:15 ET; expected 50 basis point reduction in Fed Funds rate.

Thursday: Personal Income for December at 8:30 ET; expected +0.3%, November +0.4%. Personal Expenditures for December at 8:30 ET; expected +0.2%, November +1.1%. PCE Core Price Index for December at 8:30 ET; expected +0.2%, November +0.2%.

Friday: Non-Farm Payrolls for January at 8:30 ET; expected 50,000, December 18,000. Unemployment Rate for January at 8:30 ET; expected 4.9%, December 5.0%. ISM Index for January at 10:00 Et; expected 47.2, December 47.7. University of Michigan Consumer Sentiment for January at 10:00 ET; expected 79.0.


Monday: Money Supply (M3) for December at 9:00 GMT; expected 12.1% y/y,

November 12.3%. Money Supply (M3) 3 month moving average at 9:00 GMT; expected 12.2%, November 11.9%. Loans to private sector for December at 9:00 GMT; November 11.0% y/y.

Thursday: flash HICP for January at 10:00 GMT; expected 3.1%, November 3.1%. EMU Economic Sentiment Index for January at 10:00 GMT; expected 104.0, December 104.7. EMU Industry Confidence for January at 1000 GMT; expected +1, December +2. EMU Consumer Confidence for January at 10:00 GMT; expected -10, December -9. Unemployment rate for December at 10:00 GMT; expected 7.1%, November 7.2%.

Friday: Manufacturing PMI for January at 9:00 GMT; expected 52.6, December 52.6.


Thursday: Total Retails Sales for December (release time undetermined); November -1.5% m/m, -5.6% y/y. Unemployment rate for January at 8:55 GMT; expected 8.3%, December 8.4%. Preliminary CPI for January (release time undetermined) expected -0.4% m/m, +2.6% y/y, December +0.5% m/m, +2.8% y/y. Preliminary HICP for January (release time undetermined) ; expected -0.5% m/m, +2.8% y/y, December +0.7% m/m, +3.1% y/y.

United Kingdom

Monday: Hometrack House Price Survey for January at 00:01 GMT; December -0.3% m/m, +3.0% y/y.

Tuesday: Land Registry House Prices for January at 11:00 GMT; December +0.6% m/m, +8.1% y/y. CBI Distributed Trades Survey(reported volume of sales) for January at 11:00 GMT; expected 4, December 8.

Thursday: Nationwide House Prices for January at 7:00 GMT; expected -0.3% m/m, +4.1% y/y, December -0.5% m/m, +4.8% y/y. GfK Consumer Confidence for January at 10:30 GMT; expected -14, December -14.

Friday: CIPS Manufacturing CPI for January at 9:30 GMT; expected 52.5, December 52.9.


Tuesday: Unemployment Rate for December at 23:50 GMT (prior day); November 3.8%. Household Spending for December at 23:50 GMT (prior day); November -0.6%. Retail Sales for December at 23:50 GMT (prior day); November +1.6% y/y.

Thursday : Housing Starts for December at 5:00 GMT; November -27% y/y. Construction Orders for December at 5:00 GMT; November -3.8%. y/y.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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