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Friday September 22, 2006 - 22:46:37 GMT
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Market Directions September 18-22, 2006

The Philadelphia Business Activity Index is not normally an event in the FX markets. This week it initiated the biggest fall in the Dollar in over a month. Coming in at a contracting -0.4 against an expected reading of 14.0 and a prior reading of 18.5 (August) the index had capped a week of moderate to weak American data. PPI, Housing Starts, Jobless Claims and Leading Indicators all reinforced the Fed scenario, a weakening US economy damping inflation and obviating the need for an increase in the Fed Funds rate. Several additional factors contributed to surprising reaction to the Philadelphia Index: the market had tried but had been unable to penetrate support at the 1.2640-60 level six of the previous nine sessions, the index is released at noon Eastern Time, the London close, always a period of heightened volatility as the London desks close their intra-day positions, the very limited range of the prior two weeks (1.2650-1.2750 from September 7th) left the market vulnerable to stops positioned above the high of 1.2750. These stops were quickly activated and the sellers of the past two weeks were left scrambling higher with the buyers.

A few points to remember. Though the market has largely discounted the possibility of a Fed hike this year, no doubt dollar bears were disappointed by the mild FOMC statement on Wednesday. As a thought experiment imagine where the Usd would be today if the Fed had specifically mentioned the rise in Unit Labor Costs in its statement. More interesting was the response of the Treasury market which broke support at 4.70% in yield on the 10 year to trade down to 4.63%. The two year yield fell 13 basis points to a six month low of 4.685%. Given the Dollar yield component versus funding currencies such a shift is clearly a disincentive. Though the recent Euro zone economic figures are moderately strong (except the German ZEW) they do not break the economic assumptions under girding the current ranges. The same is true for the most immediate American statistics, they point to the soft landing the Fed has been indicating for several months.

The basic market scenario has not changed dramatically, though perhaps a tilt in favor of the Euro has begun. We have been driven back to the center of the 1.2550-1.2950 range that has bordered the Euro since the beginning of May. The Philadelphia Index has delivered figures very wide of the mark in the past. Speculation on ECB rate hikes continuing into 2007 has barely begun and they are not priced into the market. The market close Friday at 1.2790, only 20 points above Thursday’s propelling stops and 40 points below the top is cautious. Traders will require more reinforcement before abandoning the current balance of forces. To paraphrase Lord Keynes, ‘If the facts change I change my mind, what sir, do you do?”

The recent fall in the price of oil should not have a substantial impact on ECB or Fed calculations. ECB figures assume an oil price of $71.00 in 2006 and $77.6 in 2007. Oil would have to sustain its current or an even lower price for some time to decrease the ECB average assumption. The Fed tends to view the oil price as a factor more important to growth and consumer expectations than as a mitigating force on inflation.


The Chinese Yuan reached an all time low of 7.9230 on Thursday with much speculation that some type of agreement had been reached at the G-7 meeting. That is very unlikely. China has heard this appeal before. Let your currency appreciate to help redress international trade imbalances. China, as always listens, but then does what is best for the Chinese economy. Treasury Secretary Paulson has taken this tact on his visit to the mainland. He has stressed the benefits to China of a progressive Yuan revaluation, most importantly in helping to drain inflationary and expansionary pressures in the Chinese economy. Considering the pragmatism of the Chinese economic planners, their long view of development and the intensive integration of China with the world economy this approach, because it jibes with Chinese needs, seems better tailored for success than the protectionist tariff bill pending in Congress.

Japanese Cabinet Secretary Shinzo Abe was elected President to the ruling Liberal Democratic Party, insuring that he will replace Prime Minister Koizumi at a full session of the Diet next week. His economic policies are assumed to be the same as the outgoing prime minister; his foreign policy is likely to favor a more aggressive diplomatic and even military response to external threats. A more outgoing foreign policy will support the yen, and the market already suspects that the Yen will lead the Yuan higher in the coming weeks.

 

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