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Monday May 14, 2007 - 14:16:10 GMT
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Market Directions Sunday May 13, 2007

The Week in Review May 7 – May 11

With their economy mired in low growth and high unemployment the French elected the conservative Nicholas Sarkozy to the presidency of the Fifth Republic this past Sunday. It was a convincing victory for the Gaullist former Interior Minister, 53% to 47% over his rival the Socialist newcomer Segolene Royal, and the largest winning margin in over 40 years in a direct confrontation between the left and the right. Electoral participation was exceptional at 84%; in comparison the most recent nationwide American and British elections gathered only 64% and 61% electoral interest respectively. Mr. Sarkozy can rightly claim a mandate for change or “rupture”, to use his most descriptive term for the break he plans with the economic policies of the past. In every sense the choice between the candidates was stark; Ms Royal spoke in nebulous terms of keeping the welfare state intact, Mr. Sarkozy harped on work, responsibility and authority, Ms Royal is ambivalent to America and to an Atlanticist outlook in foreign policy, Mr. Sarkozy is supporter of friendship with the United States and went so far as to have his picture taken with President George Bush, surely the bravest photo opportunity for a European politician in memory. And finally, Mr. Sarkozy promised change, irrevocable and swift, and there can be no one in France who doubts his word or the potential for political turmoil that lies ahead.

Neither the election campaign nor Mr. Sarkozy’s victory stirred any reaction in the currency markets. Though the polls had shifted somewhat in the two weeks between the first and second rounds of the French election, Mr. Sarkozy never trailed and the consistency of the polling obviated most speculative interest in the election. In the long run Mr. Sarkozy’s election bodes well for the French economy and that will have a direct impact on the overall economic health of the Eurozone and the Euro. But before that result is reached Mr. Sarkozy will have to enact his reforms, and whatever his electoral margin there is bound to be resistance and vociferous if not violent protests against his program. Awaiting repetition are the Parisian street riots of last spring when university and lycee students demonstrated, often violently, against Prime Minister Dominique de Villepin's attempt at mild reform in the labor laws governing newly hired workers (i.e. students and the young). As Ms Royal won the vote in 11 of the 20 arrondissements of Paris and among under 24 year old voters, perhaps the election was a case of the wisdom of suburban parents triumphing over the petulance of their urban children. In 2006 Jacques Chirac withdrew the proposed labor law reforms under the pressure of the demonstrations; before the Euro can benefit the markets will wait for confirmation that Mr. Sarkozy is made of sterner stuff.

Wednesday’s FOMC meeting and statement provided no surprises. There was no expectation of a change in rates and only minor hope that the Q1 1.3% GDP reading and the retreating inflation numbers would prompt the Fed to modify its avowed anti-inflation stand. In the event the statement was virtually unaltered from March; Dollar bears were disappointed and the Usd gained as a result.

American inflation has moderated lately. Q1 productivity was better than expected and the preliminary unit labor costs figure surprised by dropping to 0.6%, just 1/10 of the 6.2% rise in the fourth quarter of 2006. These are numbers that fit perfectly in the Fed’s scenario, rises in productivity absorbing the declining inflationary pressures, themselves mitigated by slowing economic growth. Balanced against these positive inflation developments are the strong gains in gasoline prices which are likely to continue through the summer. Inflation appears to be headed lower in a manner congenial to the Fed Chairman, Ben Bernanke. But the preliminary 1.3% GDP figure was anemic and while there are two scheduled revisions yet to come, prolonged growth at this rate would set off all sorts of alarm bells at the Fed.

The two predictive sections in the Fed statement “likely to expand at a moderate pace over coming quarters’, describing economic growth, and ‘recent reading on core inflation have been somewhat elevated” and” likely to moderate over time” for inflation, were unchanged from the March 21 statement. In the speculative hullabaloo over what the Fed may or may not do and when and what Mr. Bernanke may or may not have meant in any one utterance it is sometimes hard to remember that the past 10 months have evolved almost exactly along the general lines laid out by him last July. It was perhaps unreasonable to expect that one quarter of preliminary growth at 1.3% would panic the Fed into a ceding that the inflation fight was won and that their concern was now the fading economic growth. Returning growth in the later part of 2007 has been a predicted constant for the Fed since the beginning of the year. All this being said it is still useful to remember that Q1 2007 is now the fourth quarter in a row with sub 3 % growth. In the past every instance of five quarters of sub 3 percent growth quarters in a row has produced a rate cut as the next Fed rate move. Despite the disappointment of the rate doves in Wednesday’s statement their case remains ascendant until the economy produces consistently stronger growth statistics. The week’s US numbers have shifted the balance for the next Fed rate move closer to a cut for the simple reason that both GDP growth and inflation are still falling. However, as the Fed rate hold has been the operating market assumption, nothing of essence has changed. For the time being no one expects the Fed to rejoin the rate dance until well into the third quarter.

American Retail Sales came in well under forecasts at -0.2% for April; prediction had been for an expansion of 0.4%. The negative impact of this was mitigated somewhat by upward revisions of a total of 0.4% to the March and February figures. Consumer Credit for March almost tripled the forecast for an expansion of $4.0 billion with a reading of $13.5 billion; February was adjusted $2.5 billion higher as well from $3.0 billion to $5.5 billion. Whatever else in happening in the American economy the consumers have not deserted their posts.

Jean Claude Trichet used the magic words on Thursday, “strong vigilance” and traders duly noted that the European Central Bank (ECB) will raise rates 0.25% at the June meeting. The current rate remained at 3.75%. It is curious to note that though Trichet will never preempt future rate moves with a flat statement, the ECB uses code words that are universally taken to promise a rate hike. The logic may seem a bit artificial but it gives the policy makers cover if unexpected developments force a change in plans. Like the Fed action, the ECB move was long anticipated by the market and long incorporated into trading levels. In fact the Euro finished the week 100 points lower than Monday’s high despite the virtual guarantee of a 0.25% hike. With the June increase all but assured speculative attention will soon turn to the post 4.0% future, baring, of course, unforeseen circumstances.

The Bank of England (BOE) raised the base rate 0.25% to 5.5% on Wednesday as expected. Given the recent first ever letter from the Governor of the Bank of England Mervin King to the Chancellor of the Exchequer Gordon Brown explaining why inflation was more than 1% over bank predictions and the BOE’s surprise 0.5% hike earlier in the year it was natural that the market give credence to the possibility for a 0.5% hike. This opinion was muted but the Pound nevertheless fell on the rate hike announcement. With a 0.25% hike long factored traders had little choice but to express mild disappointment and sell the Sterling.

Tony Blair the British Prime Minister announced on Friday that he would resign on June 27 turning the leaderships of the ruling Labor party and the government over the Gordon Brown the Chancellor of the Exchequer. As with much of the news this week, the anticlimactic nature was hard to dismiss, and the market reaction was negligible.

Traders suffered from Euro fatigue more than anything else this week. The prolonged inability of the Euro to gain upward traction despite good if not excellent European statistics and moderate or weak American results gave Euro longs no choice but to take profits, regroup and perhaps keep their fingers crossed for the post 4.0% ECB future.


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