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Monday December 4, 2006 - 17:31:47 GMT
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Market Directions November 27- December 1

The Week in Review

The Euro is looking anything but consolidative. Each trading day this week has produced a higher Euro and Euro/Yen close. This is a sign of long thwarted speculative interests reasserting themselves as much as it is an indication of the Euro’s inherent strength. The 1.3330 Euro close in New York on Friday was the highest since March of last year. Whenever long term ranges are broken the market tends to overshoot in the direction of the break as trader are freed at last to trade, speculate and turn a profit.

American statistics continue to be the prime catalyst for movement. Thursday’s Chicago Purchasing Managers Index (PMI) and Friday’s Institute for Supply Management (ISM), both registered below the 50 expansion contraction divide and prompted substantial Usd slippage, as did a lower than anticipated Durable Good Orders number on Tuesday. Strong European statistics earlier in the week had garnered little or no response from traders. Clearly it is the rise or fall of the American economy that is the driving factor in the view of the currency markets. The Dollar is by no means without statistical or rhetorical support, but the market is not listening. Explicit inflation warnings by Bernanke, Plosser and other Federal Reserve officials fell unheard. Bernanke said that inflation “remains uncomfortably high” and Plosser repeated his assertion that “growth will gradually pick up and return to trend”. The Core PCE inflation held steady at 2.4%, but in the context of Fed’s “high inflation” view that is not necessarily comforting as the decline in economic activity is expected to reduce not just check inflation.

The weak ISM and PMI reports have restarted consideration of the Fed’s next rate decision, when will the cuts begin? New home sales revived fears that the housing slump will be a contagion for the general economy. A Fed rate cut sometimes in the second quarter is now given the highest likelihood, despite the Fed’s aggressive anti-inflation comments. Historically the central bank has cut rates after an ISM reading below 50 but the timing of the rate cut has varied from one month to over four after the below 50 number. Market assumptions have turned against the Usd, or to put it more accurately, traders have chosen for the time being, and quite unselfconsciously, to see only the Euro’s charms and the Dollar’s faults. A little over a month ago it was quite the opposite.

In some ways the Euro has been an unwitting beneficiary from the Dollar’s troubles. The European economies are performing well, but a comparative analysis with their American counter part, on GDP growth, job creation, inflation or most other economic gauges could leave the fair minded spectator wondering what the fuss is about. The American economy leads in almost every category. What has changed is the relative position of the two economic areas. Take GDP for example. In the second quarter of 2006 the OECD’s estimate of US GDP was 3.6% for 2006 and 3.1% for 2007. Those predictions are now 3.3% and 2.4%. European estimates had been 2.2% in 2006 and 2.1% for 2007; they are now 2.6% and 2.2%. European statistics released this week were good but not spectacular; pan European unemployment dropped a tenth of a percent, with strong 3rd quarter GDP growth and improving consumer sentiment, especially in Germany. Lower money supply numbers were balanced by an up tick in inflation. Whatever the shifting economic comparison between the continent and the United States one conclusion seems inescapable: the Fed will not be raising rates any time soon. And that too is a relative change. As recently as mid October, the Euro closed at 1.2500 and Fed rate increase speculation was heating up again before the third quarter GDP release. Speculation was doused by the 1.6% GDP number and this week’s revision to 2.2% did not reignite it.

Internal ECB discussions on rates received attention in the press last week. One story reported that an unnamed bank source claimed that several ECB members were unworried about the Euros rise above 1.3000 and that, though the ECB’s discomfort threshold was not clear, it could be much higher perhaps 1.3500 or greater. Another story highlighted the lack of policy consensus on the ECB Governing Council, with a split between those who wish to prolong the rate increases into 2007 and those for whom a pause for the first quarter seems prudent. The next ECB meeting is December 7th and the source said “there will be plenty of debate on that” topic and that “many [national] central banks want to wait and see”, and some want to “stop” the monetary tightening policy altogether. Though a good deal of the recent European growth is thought to come from increased domestic demand, the threat of excessive or at least inhibitory rate increase to the Eurozone economies is quite real. Due to several factors, not the least of which is Europe’s barely growing population, Europe as a whole has less leeway in GDP growth. The statement from the December meeting will give a good indication of the compromise reached on the governing council. On this topic the American Federal Reserve is an example and a threat; an example because it seems to have correctly judged its rate pause and a threat because if the ECB does not soon discontinue its rate campaign the Euro will climb beyond the level of sustainable exports.

Sterling was the clear leader against the dollar this week rising almost 2.5% with the 2.00 level now in clean sight. A strong and unexpected increase in UK housing prices, the fastest rise since February 2005, will keep inflations concerns active at the Bank of England and the sterling bid. Historically Sterling has spent very little time north of 2.00. Stg/Yen was not quite as active as the parent currency lifting 1.75% on the week, with the yen only slowly strengthening despite the overall dollar weakness. Renewed volatility and rate concerns put a crimp in the profitability of carry trade.

The Japanese economy kept rate increase worries in the forefront. Industrial Production turned in a surprisingly good result in October rising 1.6%. The CPI data, though muted will not, in the opinion of most economists, keep the BOJ from raising rates in the new year. Indeed the war of words between the Bank of Japan officials and government and LDP party chiefs continued. But as a fomenter of future Yen strength, the 0.25% hike, whenever it comes, is largely moot. The disparity between Japanese, European and American rates is so large that only a concerted rate increase campaign could return real strength to the yen.

When contrasting the economies of Japan and Europe with the United States we should keep in mind the differences in population growth. Europe is static, its population is not growing; Japan’s population is falling, slowly now, with acceleration soon to come. Among the major industrial countries only the United States continues to increase in population. Economies grow in large part because the population they serve grows. With a static or receding population the natural expansionary potential of an economy is less, and the long term economic growth rate will track the population. Regulatory impediments and government bureaucracy are not the only reasons for the disparity between the long term European GDP growth rate and that of the United States. The United States has enjoyed this population advantage for many years. It is one of the prime factors underpinning the resilience of the dollar.

Economic Releases November 27- December 1

United States
American data began and ended with disappointments this week. Durable goods orders issued on Tuesday came in below predictions at -8.3% (expected -5.0%) as did the Conference Board Consumer Confidence reading at 102.9 (expected 106.4). Durable good orders, large ticket items, have a larger discretionary component than other consumer goods. This reading elicited fears that the housing slowdown may be beginning to affect discretionary consumer spending. New Home Sales was reported at 6.24 million units (expected 6.20) but the number of unsold homes was up a 1.9%. This monthly rate would increase the stock of unsold new homes 34% on an annual basis. The actual year on year increase is 24% over this same month last year. The housing market continues to worry with every decline in consumer related statistics laid at its feet. Wednesdays 3rd quarter GDP revision, up to 2.2% from the preliminary 1.6% was a silver cloud with a black lining. The majority of the added growth was from accumulated inventories not additional consumption. Those inventories will have to be sold in future months and may impose a drag on 4th quarter GDP. The release prompted a small positive correction in the Usd but it returned almost immediately to pre release levels. The disparity in Personal Income +0.4% and Personal Expenditure +0.2% was due to ‘balance sheet repair’, households recouping some of their previous expenses, higher energy prices, and rebuilding savings rather than purchasing new goods. The Chicago PMI and the ISM Index, covered above, were both below the 50 expansion limit. This is the first economic reading that has given a result generally associated with a recession. The ISM number had been reported to the Fed on Tuesday, according to Norbert Ore, head of the Institute for Supply Management the organization which conducts the survey. That was before Chairman Bernanke made his “uncomfortably high” inflation reference in a speech that afternoon.

European Money Supply figures, +8.5% (expected +8.8%), were reported on Tuesday, and though below predictions and the same as last month, they will not allay ECB inflation concerns. ECB officials have long cited +8.0% money supply growths (M3) as the upper limit for inflation control. Euro zone GDP figures arrived as expected for the 3rd quarter, +0.5% (expected +0.5%), but were slightly better in the year on year numbers, 2.7% (expected 2.6%). The quarter two numbers were +0.9% and +2.7% respectively. The Eurozone economies continue to perform slightly better than predictions. But what is perhaps more comforting for the ECB planners is that the expansion seems to be sustainable. European economic managers would no doubt prefer a long lasting +2.0-2.5% growth rate than a higher rate shorter lived scenario. Flash HICP at +1.8% years on year (expected +1.9%) was below the ECB’s 2% limit. But Trichet, among other ECB officials, have said that they expect inflation to regain the limit in the coming months, which justifies continued rate increases. European numbers give the ECB several options. The inflation number has maintained below the 2.0 limit for the second month; it was 1.6% in October. The ECB might take a leaf from the Fed’s book and rely on slow growth and vigilant rhetoric to control inflation. A cooling American economy will no doubt help keep European growth from accelerating. European politicians, particularly the French whose presidential election in 2007, will remind the ECB of the political effects of its strict policies. Unlike their central bank counterparts at the Fed, the members of the ECB governing council see 2.7% GDP growth as little bit dangerous. They have already said that they expect the return to +2.0% inflation. In this view there is no reason for the ECB to relax its rhetoric or its ‘strong vigilance’ policy. However, good economic growth and an improving employment picture give the ECB time to monitor and assess the situation. A +0.25% hike this week is a done deal. Another rate hike decision is not due until February. The ECB will retain its hawkish anti inflation tone right up to the decision to suspend its rate campaign in the spring.

The Week Ahead

United States
Non Farm Productivity and Unit labor cost on Tuesday begin the US statistical week. Non Farm productivity for the 3rd quarter is expected to return to the positive at +0.5%; it was flat in the 2nd quarter. The expansion in Unit Labor Costs is predicted to moderate from its +3.8% pace in the 2nd quarter to 3.2% in the 3rd. Both are key figures for the Fed. By making each worker more productive and responsible for a greater share of output productivity growth helps to restrain inflation. Companies can expand their output without always hiring new workers, or paying existing workers higher wages. Unit Labor Costs is a measure of wage inflation, separate from the standard CPI measure of price inflation. With a tight labor market and unemployment at 4.4% any increase will concern Fed policy makers. Friday brings the market favorite, Non Farm Payrolls. This has been a particularly volatile number lately, with revisions to prior releases giving more suspense than the main number. An increase of 100,000 is predicted for November against the October figure of +92,000. The most recent results for these measures have been the only support for an active Fed rate policy. Dire results for these numbers will not upstage the Euro, nor will they return a Federal Reserve rate hike to the market agenda. But combined with the Fed’s repeated inflations warnings this past week they could add a cautionary note to the Euro’s ascent.

The main even this week is the December 7th ECB meeting and its attendant rate increase. More important than the +0.25% increase will be the prepared statement and Trichet’s news conference after the meeting. Any indications that the ECB may join the Fed in a pause will warrant an immediate recalibration for those Euro bulls with their eye on the 1.3600 horizon. If the ECB cites a possible slowdown in growth in the New Year or the effect of restrained GDP on inflation look to the Euro downside. Due to be released on Monday are Industrial PPI figures for October. Forecasts are for +0.2% month to month (m/m) and +4.1% year on year (y/y). September’s figures were -0.5% m/m and +4.6% y/y.


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