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Tuesday October 31, 2006 - 17:38:37 GMT
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Market Directions October 23-27

The Week in Review

On last Monday the market seem poised to capitalize on strong pro dollar sentiment. The Euro rally late in the previous week had fallen short and the dollar was again probing to the upper limit of its range against the Euro and Yen. With a series of telling statistics scheduled for the week dollar bulls only needed confirmation of their view that the American economy concealed hidden strength to break the Usd out of its volatility defile of the past three months. But by the end of the week the pro Dollar view had been sorely tried. Durable Goods Orders and Existing Home Sales were slower than expectations but the big blows against the dollar were the FOMC statement on Wednesday afternoon and Friday’s GDP number. While GDP prospects had been tempered, the 1.6% growth in the third quarter was both below expectation and below the long term trend for the US economy. It was perhaps unreasonable of the market to hope that the Fed would sharpen its inflation rhetoric in its post FOMC statement since there was no concurrent anticipation that the Fed would alter its rate policy. If there is one trait of the Bernanke Fed that stands out it is caution. A notable honing of the anti inflation wording would have given the currency market the excuse it needed to take the Usd higher; it also would have injected volatility and uncertainly into the inflation outlook, and damaged the bond and stock markets. In the event the text of the Fed statement on inflation was almost identical to the last meeting. It did not sharpen the inflation rhetoric nor did it weaken it. But hope denied, even unreasonable hope, is still disappointing. Traders had wanted a concrete reason to push the dollar into new territory. Either mediocre statistics and a sharp Fed inflation warning, or good statistics and an unchanged Fed, would probably have been enough to force the Dollar higher, but the market did not get either. Mediocre statistics and the existing Fed inflation rhetoric did not inspire traders to new pro Usd positions but only to take profit on their current long Usd placements; by the end of trading Wednesday the Dollar was well on its way back toward the middle of its ranges against the Euro and the Yen.

The old saw about ‘never bucking the Fed’ still resonates with currency traders. Little could be more important to a currency portfolio than a change of view at the Fed. With that in mind there I will illustrate the two differences between Wednesday’s statement and the prior statement on September 20th. A phrase referring to ‘energy and commodity price’ contribution to inflation was removed from the Wednesday statement and a comment on the future economy was added, “going forward the economy seems likely to expand at moderate pace”.

The reference to energy and commodity prices is missing for the simple reason that prices have declined and they are unlikely to contribute to inflation from their current lower levels. Bernanke has stated in the past that lower energy prices concern him more as a spur to consumer spending and growth than as a curb on inflation. In that context the inclusion of a reference to returning growth seems more important than the exclusion of the energy inflation phrase. The potential for growth is a more important clue to future fed policy than the removal of one or two inflationary factors. In other words, if growth returns to the 3% trend the Fed will retain its tightening bias.

Does the Fed sees signs of higher growth returning next year and perhaps in the fourth quarter as well? Fed governors likely knew of the 1.6% third quarter when composing their statement. Is 1.6% a “moderate pace” of growth, a rate of growth that will dampen inflation as the Fed anticipates and is it the rate we might expect to carry forward into next year? I suspect not. The long term US GDP growth rate is over 3% and a US economy growing at less than 2% would be underperforming and would quickly excite calls from business and government for a rate stimulus. Probably the Fed expects a return to 2.5-3.5% growth in the fourth quarter and the term “moderate growth” contrasts to the torrid 5.6% pace in the first quarter of this year. Although at this point the Fed doesn’t have much information beyond the third quarter I imagine there are gathering signs that the growth reducing effect of 17 rate increases is wearing off and the Fed is acknowledging this fact by including the reference to expansion. With the pro-growth history of the Fed and the expansionary bias in the American economy and political system it would a development of the first order for the top US banker to characterize 1.6% GDP growth as moderate. The Fed’s tightening bias remains but in the context of market expectations the mere retention of the bias was not enough to stave off dollar declines in a market that was hoping for more.

In the early part of the week several European statistics helped build a positive background for the Euro as the market waited for the American results. In addition Jean Claude Trichet President of the ECB and Alex Weber and Guy Quaden ECB Governing Council members, all repeated their previous statements on monetary policy. They warned that rate increases will continue if circumstance warrant. While none specifically mentioned increases in 2007, it was hard not to take these comments as a response to recent market commentary outlining the case for an ECB halt in 2007.

Position squaring of recent dollar longs was the motive propelling the Usd lower in the latter part of the week. By Wednesday afternoon those who had looked for a break higher in the Usd knew that their reward was not coming this week. And by Friday the Euro had regained almost the exact center of its recent range. In no sense is this new trend, it is a recapitulation at the failure of the dollar breakout.

Economic Releases October 23-27

United States:
The major American statistics of the week depicted a slowing economy and the still potent decline in the housing market. Existing home sales dropped 1.9% to 6.18 million, below the expected level of 6.2 million and off Augusts’ 6.3 million rate. Durable Goods Orders posted a stellar headline number at +7.8%, well over predictions of +2.2%. But the Durable Good ex-transportation number told a more accurate story of the economy as a whole. It came in at +0.1%, much less than the 1.0% hoped for, the difference between the headline number and the ex transport number was accounted for by 175 new jet orders booked by the Boeing Company. The third quarter GDP statistic covered above showed a steady decline in US activity this year, first quarter at 5.6%, second at 2.6% and third at 1.6%. The two Fed areas that reported on economic activity also showed declines from their previous readings. The Richmond Fed Manufacturing Index fell to -2 from the prior of 9 and the Kansas City Fed Production slumped as well, reaching -9 after posting a prior at 6. One positive note in a generally dismal week was the University of Michigan Consumer Sentiment report which at 93.6 was substantially improved over the 92.4 expectation.

In contract to the US releases European numbers gave the Euro a much needed fillip in economic confidence and helped to douse overt speculation that the ECB might move to restraint in 2007. Industrial New Orders at +3.7% (m/m) was more than 4 times the prediction of +0.9% and the year over year number at +14.3% was almost 5% more than consensus. Taken together with the October IFO survey in Germany, 105.3 over the consensus of 104.4 and the prior at 104.9, the European expansion looks a good deal more robust than it did at the beginning of the week. Even the dour German consumers perked up with a confidence reading at 9.2 bettering both the prediction and prior of 8.9. Finally, the three month M3 money supply moving average entered the list with a gain of 8.5%. ECB officials have stated in the past that a reading above +8.0% would keep the central bank on a tightening bias. As the September reading was above the month earlier average of +8.2%, and noticeably higher than the +8.0% warning limit the ECB may be constrained by its own anti-inflation rhetoric until the rate of M3 expansion recedes.

The Week Ahead:

United States:
A busy week for American statistics awaits traders. On Tuesday we receive the readings on Consumer Confidence and the Chicago Purchases Index. With the decline in gasoline prices consumers spending is widely expected to rebound and the October number with it to 108.0 from the earlier 104.5. With consumers once again touted as the motive force in the US economy this number, though historically volatile, will be closely observed for indications of their emotional well being. A slight fall is anticipated in the Chicago Index which is generally a background number, noted with other business indicators, (predicted 58.0, previous 62.1). The ISM index on Wednesday, expected at 52.5 slightly lower than the September number of 52.9, will be carefully monitored for any sign of slowing orders. The weak Durable Goods number last week throws a spotlight on the business activity side of the economy and the ISM is the most direct signal we will see this week. Fed Chairman Bernanke’s oft cited Non Farm Productivity and Unit Labor Costs arrive on Thursday. Non Farm Productivity for the third quarter is thought to be +1.0%, a fall from the second quarter’s +1.6%. Unit Labor Costs, also for Q3, is expected to rise at 3.4%, less than the rapid second quarter pace of 4.9%. Expect any low reading in Non Farm Productivity alone or combined with a higher than anticipated ULC number to excite a return of rate increase fears. If productivity is falling and labor costs are rising that means inflationary pressures are reaching the wage scale. This is a development the Fed is sure to notice. Friday brings the fun, Non Farm Payrolls, no doubt the current volatility inducing champion. Last months number, with its low headline figure and massive benchmark revisions, incited a vicious whipsaw move as the market first sold the Usd on the headline number then reversed on the huge benchmark restatement. The revision indicated that the economy had actually produced 810,000 more jobs over a one year period than initially recorded. Similar thinking affects the current payroll number. Payroll expectations have returned to the long term average of +130,000, rather than last months’ example of +51,000. Any result that comes in less than 100,000 will not bode well for the Dollar. With the housing market deep into contraction, consumers are buoyed by the availability of employment. If the economy creates fewer job that could shortly translate into reduced consumer spending. If consumer wages begin to contract then the last prop could fall from beneath the economy. We are nowhere near that point yet, but the market will be watching for the earliest signs of faltering.

The chief statistic this week is not a statistic at all but the ECB rate decision on Thursday and Trichet’s news conference afterwards. While no hike is expected this week the market views a 0.25% increase in December as a near certainty. Flash HICP on Tuesday will be noted as well. The previous release at +1.8% was the first reading below the ECB’s stated limit of 2.0%. With median expectations of +1.7% and one ECB council member on record as saying that he considered the 1.8% figure an aberration and he expects inflation to return to above 2.0% in coming months, traders will be keenly interested in this pan European release.

The market has by no means written off the Usd. But the burden of proof is now directly on the American economy. For the past two weeks traders had been willing to cut the Usd some slack, that consideration has evaporated. If the Usd is to avoid a move into the lower reaches of its Euro and Yen ranges it will have to find real support in this week’s economic statistics.


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