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Wednesday February 6, 2008 - 20:41:18 GMT -

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US NFP disappoints and the USD rebounds

Come again? The seemingly incongruent reaction is best explained, I think, through the lens of risk aversion. The unexpected loss of jobs reinforced fears that the US economy was tipping further towards recession, and this alarmed risk-seeking investors, who had been emboldened in recent days by stock market gains and a stabilization in the outlook following an additional 125 bps of Fed easing in January. Risk aversion had dropped off significantly over the week up to the NFP release, leading gold and stocks to reach their best levels in a while. For a moment, it seemed as though the market’s worst fears were not going to be realized, and carry trades (long JPY-crosses) and stock prices were near their highs. Then came the NFP which jolted traders nerves and led to a widespread liquidation of risky assets. Gold, oil, and JPY-crosses all plunged in the aftermath, and as we have seen repeatedly in recent weeks and months, when risky assets are unloaded, the USD benefits. So rather than a USD-specific causation, a sharp deterioration in the risk environment was the ultimate take-away from the weaker NFP report.

There was also a unique Forex element to today’s price action. The all-time high in EUR/USD at 1.4965/70 was in sight in the run-up to the January employment report. Longer-term players who think the USD has bottomed were primed to sell into any tests of that high and the key 1.5000 level just beyond, setting up a major obstacle to further EUR/USD gains. It looks as though the selling interest was even larger than thought and once the pre-NFP price level was breached after the spike higher, shorter-term EUR/USD longs were forced to bail out, triggering a wave of stop-loss selling all the way back down to below 1.4800. In Cable (GBP/USD), the psychological and technically significant level of 2.0000 was also within reach, but with the BOE set to cut rates next week, Cable buyers were going against the grain. The spike higher in GBP was the briefest of all the majors and you had to be fast if you wanted to just get out at the pre-NFP level. Subsequent liquidations led to a similar collapse in Sterling.

Possible bailout for bond insurers

Risk aversion has undoubtedly risen in the short-run, but I am also seeing some indications that a larger improvement may be developing. Regular readers of this report will know that I have been cautioning for some time about the potential for ratings downgrades to the major bond insurers, known as monolines, which would likely precipitate additional multi-billion dollar write downs by the financial industry. News at the moment indicates a consortium of major US and international banks is working with the NY State Insurance Dept. on a plan to raise capital for the monolines, with one specific firm as the primary rescue target. If a plan is worked out, and there is no guarantee a deal will be reached, a major disaster will have been avoided, or at least postponed for a while. Mind you, the monolines’ woes are just one piece of the financial sector mess that is currently being sorted through, but rather than an inexorable deterioration, the sector may in fact be stabilizing.

Stocks in particular have proved highly sensitive to the plight of the monolines. Recall that US stocks continued to fall even after the surprise inter-meeting 75 bp rate cut by the Fed on Jan. 22. Only when news surfaced that the NY State Insurance Dept. was convening meetings to shore up bond insurers did stocks find a bottom and begin to rally. Looked at from that angle, the modest gains in US stocks on Friday suggest that the news of a monoline bailout (along with the Microsoft/Yahoo merger) has been able to offset the negatives of a weak NFP. In technical terms, Friday closes above 12,600 in DJIA and above 1284 in the S&P 500, both derived from Ichimoku charts, suggest significant upside potential is coming into play. I would also note that, Friday’s sell-off notwithstanding, the JPY-crosses are still toward the upper-end of recent ranges, with GBP/JPY the notable exception. Relative JPY-cross strength is another indication of receding risk aversion overall.

By no means is the environment for risk stable and I have no way of knowing what surprises are coming next, but all things considered the negatives seem to have diminished in my reckoning. Riskier assets, especially stocks and carry trades (JPY-crosses EUR/JPY, AUD/JPY, and NZD/JPY) look set to perform better in the weeks ahead. Other risky assets which are tied more closely to the global growth outlook, such as oil and gold, are less likely to follow along, which would mark a significant decoupling of recent highly correlated moves among asset groupings. In this sense, the weaker US NFP and the risks of a sharper US slowdown point to a slower global growth outlook, which is perfectly consistent with lower commodity prices. Gold, in particular, posted a very bearish pattern on the weekly candlesticks, a shooting star, suggesting a failure above $900. A daily close below $893 will serve as confirmation of a larger reversal in the yellow metal.

In currencies, the combination of improving risk appetites and commodity weakness suggest USD/JPY is likely to outperform to the upside, allowing JPY-crosses to advance, while lower commodity prices will restrain EUR/USD strength.

ECB, BOE and RBA to decide on rates next week

Next week is relatively light on major data, but there are plenty of central bank rate decisions and Fed speakers scheduled next week. The Reserve Bank of Australia (RBA) leads off on Tuesday afternoon local Sydney time (2230NY time) and is expected to raise rates by ¼% to 7.00%. The RBA certainly has the economic data to justify a rate increase, but the risk is that they postpone due to still uncertain financial market conditions and a softening global growth outlook. The Bank of England (BOE) and the ECB are both set to announce on Thursday afternoon European time (early morning NY). The BOE is expected to cut rates by ¼% to 5.25%. Recent data (manufacturing and retail sales especially) has confirmed a slowing in the UK economy and a rate cut is justified. The risk, however, is that the BOE declines to cut, citing inflation concerns. The ECB is expected to hold rates steady, but I also expect ECB Pres. Trichet to remain vocally hawkish, citing second-round effects from wage settlements and energy prices as the primary concerns, even as the growth outlook softens.

Key data reports and event for next week

Next weekend, G7 finance ministers and central bank chiefs will meet in Tokyo for a quarterly gathering. There will be various briefings on the G7 agenda next week (US Treasury will brief on Tuesday morning), but at the moment, currencies do not appear to be a major topic for discussion. To the extent they are a topic, the need for additional Asian currency appreciation will be the primary theme. I look for the G7 communiqué’s language on currencies to remain unchanged, citing the desire to avoid excessive volatility and for countries with large trade surpluses to allow their currencies to appreciate faster. They will not mention the JPY, but that’s one of the currencies they’re talking about, the Chinese Yuan being the other.

US data is mostly second-tier, starting with Dec. factory orders on Monday. Tuesday will see the ISM non-manufacturing or service sector sentiment index. Wednesday sees weekly mortgage application data and 4Q non-farm productivity and unit labor costs. Thursday sees weekly jobless claims, Dec. pending home sales, and ICSC chain store sales for January. Friday has only Dec. wholesale inventories. Fed speakers are numerous. Of those speaking on the economic outlook, Richmond’s Lacker speaks on Tuesday and Wednesday; Philadelphia’s Plosser on Wednesday; Atlanta’s Lockhart on credit markets on Thursday, and San Francisco’s Yellen on Thursday night from Honolulu. US Treasury Sec. Paulson will also testify to the Senate Finance Committee on Tuesday morning.

Eurozone data begins on Monday with the Sentix investor confidence index and Dec. Eurozone PPI. Tuesday sees Eurozone and country service sector PMI’s and Dec. Eurozone retail sales. Thursday sees Dec. German factory orders and the ECB rate announcement. Friday sees Dec. German trade balance and both French and German Dec. industrial production.

Data from Japan come late in the week, with Dec. leading economic index due on Wednesday afternoon in Tokyo. Thursday sees only January preliminary machine tool orders. Fridays sees Dec. machine orders, money supply and bank lending, and the Economy Watchers survey in the afternoon.

UK data has HBOS house prices slated for the week, but no firm time has been set. Monday sees January construction PMI, followed by service sector PMI’s on Tuesday. Nationwide consumer confidence will be released on midnight Tuesday/Wed., followed by the BRC shop price index and leading indicators on Wednesday morning. Thursday will see industrial/manufacturing production in the morning followed by the BOE rate decision in the afternoon. NIESR will release its Jan. GDP estimate on midnight Thursday/Friday.

Go Gints.


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