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Tuesday May 22, 2007 - 17:24:40 GMT
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Market Directions Sunday May 20

The Week in Review May 14 – 18

While the carry trade has never been far from the headlines, it moved back into large print on Friday as the result of a series of surprise announcements by the Peoples Bank of China (PBOC). Three policy changes by the Chinese Central Bank had a dramatic and immediate impact on the currency markets. The PBOC widened the daily trading band of the Yuan against the Dollar from 0.3% to 0.5% effective May 20, hiked interest rates for a second time this year and raised the reserve requirement for the fifth time. Though all of these moves had been expected it is the first time that the PBOC has ever made all three adjustments at once. The Euro/Yen promptly slipped more than a figure lower (100 points), with the bulk of the constituent adjustment felt in the Usd/Jpy, down 75 points, rather than the Euro/Usd which dropped only 25 points.

The immediate worry for the Chinese Government is the rampant rise of the Shanghai stock market. With real interest rates in China near zero Chinese investors have been pouring money into domestic equities. In an effort to draw funds back to the banks deposit rates were raised 27 basis points but lending rates were pushed up only 18 points. Clearly the Chinese Government intended a dramatic move to dampen the speculative frenzy in the stock exchange. But there is a second reason for such a provocative announcement.

Next week members of the Beijing Government including Vice Premier Wu Yi will be meeting with Bush Administration officials and members of Congress as part of what is called the ‘Strategic Economic Dialogue’. The chief topic of this dialogue will be the terms of trade between the US and China. Various protectionist measures are being contemplated in the Congress including steps to officially declare the Yuan a ‘manipulated currency’. Under the new Chinese guidelines the Yuan trading band will widen to 2.5% a week from the current 1.5%. A wider trading band is not a pre-determined appreciation. In fact the existing 0.3% daily band was not being fully used. The market had not been pushing the Yuan higher to the limits of its band and there is no guarantee it will do so now. Despite steady appreciation the Yuan has only risen 7.34% against the Usd since it was officially removed from its dollar peg on the 21st of July 2005, and that includes a 2.15% appreciation that day.

By permitting the market greater sway in determining the value of the Yuan against the Dollar the Chinese government hopes to impress government officials in Washington with public action on the Yuan. It also neatly hoists Western critics and free market advocates on their own rhetoric particularly if the Yuan does not greatly increase its rate of appreciation. It is a clever political play and it is surely aimed at the US Congress. On May 23rd the Senate Banking Subcommittee is to investigate “US economic relations with China and options on FX and market access”. The Chinese are letting Washington know that they will act but on their own terms. Now they can say and with greater emphasis than before, that the market needs to be given time to work.

The long term implications of the PBOC moves for the Yen and the carry trade will be limited. By mid afternoon on Friday the Euro/Yen and the Dollar/Yen had recovered almost all of their initial losses. A stronger Yuan only pressures the Yen in the sense that the Yen is viewed as a proxy for the Yuan; and that a weak link at best. Clearly the two currencies have been moving in opposite directions for the past two years. The Yuan has been driven by internal economic conditions in China and the Yen by the overwhelming interest rate differentials between Japan and her trading partners. Neither of these conditions will be greatly affected by these Chinese adjustments. In fact the PBOC corrections may perversely work to attract capital to China. If Yuan deposits are receiving higher compensation than before and the Yuan is set to appreciate faster both make capital investment in China potentially more profitable. Time will tell if the PBOC has complicated its own tasks of preventing the economy from overheating and securing local investors from the dangers of stock market collapse. The potential political damage from an equity swoon to a government that offers little to its people except economic benefits must be frightening. As always with the Beijing Government, domestic economic and political concerns set foreign exchange policy.

The Euro has been slowly falling from its late April high of 1.3680. It has been a tactical withdrawal; it is not yet a strategic retreat. The Euro is caught in a stale scenario that has run its course in upside momentum. European economic growth is strong but not likely to strengthen, in fact there are preliminary signs that economic growth may have peaked. Trichet has made clear his intention to raise rates 0.25% in June but beyond the 4.0% horizon nothing is clear. Traders have not yet priced in increases to 4.25% or beyond and are not likely to do so until the June increase is complete. With the America economy showing some early signs of life highlighted by the Dow’s record run it will probably take concerted rhetoric by the ECB to convince traders that more hikes are in the cards and nothing short of that will return the Euro to its peak.

American inflation numbers continue to decline, a direction that has found great favor with equity investors. The Industrial Production figure for April, especially the manufacturing component which was higher for the second month in a row, supported the notion of a recovering US economy. Equity investors backed up their view with money as the NYSE broke several new records during the week. To the equity investor the six to twelve month outlook looks bright, inflation is down, corporate profits are strong and job growth is steady. Doubters looked once again to the housing sector where a reasonable Housing Starts number was more than balanced by a precipitous fall in Building Permits and by the National Association of Home Builders Housing Market Index (NAHB) which sank to a low for the current housing cycle. But the housing sector is already an old story, first bruited as a cause for the pending recession last fall, and not likely to generate new gloom.

The Bank of Japan left its benchmark interest rate unchanged at 0.5% on Thursday at the end of its two day policy meeting. There had been no expectation otherwise but comments by the Economics Minister Ota and Bank of Japan (BOJ) Chief Fukui left market participants uncertain about future rate increases; the carry trade was the immediate beneficiary. Ms Ota said the economy was continuing to recover but that it was not out of deflation yet. Mr. Fukui said the economy was “expanding moderately” and that the bank will adjust rates moderately. He also stated that rates could be raised even if the Consumer Price Index was negative. These brave words were shortly greeted by new all time high in the Euro/Yen at 163.88. It is tough to give much credit to the idea of the BOJ raising rates in the concerted fashion necessary to convince traders that the carry trade is coming to an end. There is no inflation to quell and without that spur the political resistance to raising rates would probably thwart any BOJ increase. Even another 0.25% hike sometime in the third quarter would only assure the market that it was the last hike for the year. Inflation has been non existent in Japan for almost a decade. Though first quarter GDP at 2.2% is down from the 2.4% rate of a year ago and is above what is considered to be Japan’s potential growth rate of 1.5 to 2.0% it has still not produced an end to deflation let alone given Japan even the mildest inflation. In addition to market’s logical skepticism of public BOJ rate policy, Ms Ota said on Friday that she expects the bank to support the government in achieving the end of deflation; and that is definitely not a prescription for an independent BOJ rate policy.

The Bank of England quarterly inflation report predicted that CPI would be at or below its 2.0% target in two years, that is, in the first quarter of 2009. However, the stated assumption that went with that statement was that rates would be at market level, 5.7%. The current Bank of England rate is 5.5%. At that rate the report expects inflation to be slightly over 2.0% in two years. As with the previous inflation report this issue presages further rate hikes.

Economic Releases May 14 – 18 2007

United States
The core Consumer Price Index (CPI) in April rose 0.177% (reported as 0.2%) dropping the yearly increase to 2.3%. That is the slowest climb in inflation since mid last year. For the first third of this year the annualized number is even lower. Using the un-rounded monthly figures, January 0.256%, February 0.241%, March 0.06%, and April 0.177%, it is 2.202%. The headline CPI number rose 0.4% in April accompanied by a 2.6% increase in the year on year reading. Both results were in line with market predictions of 0.2% for the core number and 0.5% for the overall CPI. The core CPI rate has substantially moderated. Last September it was 2.9%. April’s 2.3% is a 20% decrease in less than nine months, a notable achievement, though is unlikely that this is enough to convince the Federal Reserve that inflationary risk are truly on the wane. Industrial Production came in at 0.7% for April much stronger than the 0.2% forecast. The manufacturing component rose 0.5% its second straight monthly increase. It was the best two month Industrial Production Manufacturing performance since last June and July. The March IP number was revised slightly down to -0.3% from -0.2%. Utility production rose 3.5% completing the weather related up down cycle that began with a 7.0% rise in February, a 7.5% fall in March as the weather warmed and a moderate recovery in April with its uneventful weather. Capacity Utilization remained steady at 81.6% in April, a minor advance over the March 81.4% reading. Housing Starts recovered slightly in April with March results rising 2.5%, 1.528 million units against 1.518 and were substantially better than the 1.475 million units expected. The increase was concentrated in multi-family dwellings and suggests that builders are still clearing inventory of unsold single family homes. Building Permits are a better gauge to future trends in the housing market and they plunged 8.9% to1.429 million in April a new low for this cycle. The NAHB Housing Market Index sank to 30 in April from 33 in March, equaling the lowest this cycle, also reached last September.

The Treasury International Currency System (TICS) report on foreign investment in the United States for March saw a net purchase of $67.6 billion of Usd long term securities at all levels of purchase government and private more that enough to cover the current account deficit of $63.9 billion in March. The February net purchase was 58.1 billion.

In the tumult of the PBOC announcement Friday positive revisions to March factory orders up to 3.5% from 3.1% and Durable Good order up to 4.1% from 3.7% were largely overlooked. The preliminary University of Michigan consumer sentiment number for May at 88.7 was stronger than expected, 87.0 and an improvement on April’s result of 87.1.

The EU commission raised their estimate of GDP growth in the first second and third quarters of 2007 to 0.4- 0.9% from 0.4 - 0.8% across all three quarters. Interestingly the estimate for the fourth quarter was dropped slightly form 0.35 - -0.9% to 0.2% 0.8%. . Industrial production cam out better than expected at 0.4% for March slightly over the 0.3 median predictions. The year to year number was 3.7% as expected. The February result was downgraded from 0.6% to 0.5 and the yearly number to 3.9 from 4.1%
April final HICP was 1.9% slightly over the 1.8% preliminary number. This marks the sixth month in a row that the harmonized index has been below the ECB 2.0% ceiling.

April ICON consumer confidence set a new high at 107.0 well above the March reading of 104.00. The first release of the 1st 1 GDP, the flash estimate, was more robust than forecasts it arrived at +0.5% against +0.3% and +3.3% against +2.8% in the year to year figure. Final CPI for April was +0.4% monthly and +1.9% yearly, as anticipated, and the HICP number was +0.4% and +2.0% also as predicted.

United Kingdom
April CPI was +0.3% month to month and +2.8% yearly below the Bank o f England 3.0% ceiling. Mervyn King the Governor of the Bank of England anticipated this drop in his letter to the Chancellor of the Exchequer last month. Reductions in electricity and gas bill brought about the drop, without the gas reduction the figure would have been slightly over +3.0%. Retail Sales for April were much weaker than expected -0.1% monthly and +4.2% yearly on predictions of +0.6% and +4.8%. Cable dropped 50 points 1.9772 to 1.9722 in reaction.

First quarter GDP rose +0.6% quarter to quarter, slightly less than the +0.7% forecast. Yearly growth in the first quarter was +2.2%, less than the +2.4% of a year ago and the yearly fourth quarter 2007 GDP was revised down to +1.2% from +1.3%. The first quarter GDP deflator rose to -0.2% from -0.5%, the best performance since the second quarter of 1998, -0.4% had been predicted. Prices in Japan are still falling.

April CPI came in at +3.0% year to year, March had been +3.3% and predictions had been for a figure of +3.1%. Though this is an improvement and it matches the PBOC stated +3.0% inflation ceiling it will not supply the PBOC much comfort. Most of the increase came from boosts in food prices. Money supply for April raised +17.1% and while down from March it is the third month in a row that it has exceeded the PBOC target. Real saving rates are negative in China and that has helped fuel the booming stock markets. These numbers will do little to ease the pressure on the PBOC for further rate tightening measures and perhaps a faster Yuan appreciation in the coming months. Industrial production in April was +17.4% year to year down from 17.6% in March

The Week Ahead

Economic Releases May 21 – May 25

It is a week of limited statistics with notable releases only Thursday and Friday in the United States and Wednesday, Thursday and Friday in Europe.

United States
Durable Goods Orders on Thursday at 8:30 am are predicted to have increased 1.2% in May. With the upward adjustment to the March figure the market will look here for confirmation that US economic activity is picking up. New Home Sales on Thursday and Existing Home Sales on Friday will only obtain mild interest, 860,000 and 6.2 million respectively are forecast. The housing sector decline is well established, no possible result from these two statistics will change that.

Industrial New Orders for March are issued on Wednesday and are predicted to have increased 1.0% for the month and 6.9% for the year to date. The monthly statistic fell 0.7% in February; the yearly tally was +4.7%.

The May ZEW Economic Expectations report on Thursday and the IFO Business Expectations Survey on Friday will be closely monitored for signs of economic optimism in Europe’s largest economy. In April the ZEW Expectations Report was 16.5 and the Current Conditions section was 76.9, 24 and 79 are expected for May. The IFO Business Sentiment Survey is predicted to have hit 108.8 in May, a minor improvement over April’s 108.6. The Current Assessment section is forecast at 113.6 for May, also a slight rise over April’s 113.2.


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