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Friday May 25, 2007 - 21:26:29 GMT
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Market Directions - Sunday, May 27, 2007

--American and Chinese trade negotiators fail to make substantive progress at the Strategic Economic Dialogue (SED) talks in Washington

--The Shanghai Composite Index has a wild week, dropping 3.5% on Monday in reaction to PBOC rate adjustment on Friday, but ends the day 1% higher. Class B shares, for foreign investors, fall 7.9% then recover 8.7% on Allan Greenspan's waning of a possible "dramatic contraction" in Chinese equities.

--The Japanese Yen continues to depreciate, predicting little real adjustment in the Yuan. No end to the carry trade in sight.

--See details below on these three topics, economic releases from around the world, and information on The Week Ahead below

The Week in Review May 21 - 25

The Strategic Economic Dialogue (SED) between China and the United States concluded on Wednesday in Washington with a bland statement from Secretary Paulson and Vice Premier Wu Yi expressing mutual respect, an appreciation of the importance of the Sino American relationship to the world economy, a promise to consult, and little else. Before the SED American concerns centered on three areas: increasing US exports to China, addressing Yuan undervaluation, and assuring American intellectual property rights in the China. While the Chinese Central Bank moves last Friday are indicative of certain flexibility in the Yuan exchange rate, they do not address the remaining US issues. If the Chinese delegation hoped to convince US officials during the talks that more changes are coming they seem to have been unsuccessful.

There were no additional commitments by the Chinese for currency revaluation, or intellectual property rights, though the statement did mention "significant items in financial services, energy and ...the environment and civil aviation", without supplying particulars. There was small expectation that these talks, really just the public face of long term bilateral trade negations between the Peoples Republic of China and the US, would produce any substantive result but given the difficulties in the relationship some concrete results would have been welcome. However, the Chinese diplomatic positioning last Friday just before the talks via the People's Bank of China (PBOC) announcements cannot have pleased their American hosts. The rather transparent attempt to sway public and Congressional opinion has probably backfired.

In the American Congress the Chairman of the House Ways and Means Committee, Charles Rangel, Democrat of New York, promised that he would be "moving forward" with China tariff legislation. If the Chinese had hoped to mitigate Congressional protectionist sentiment and head off a move to declare the Yuan a manipulated currency with last Fridays currency and rate policy changes they have clearly failed. The bill was introduced into the House of Representatives Wednesday by Representatives Tim Ryan and Duncan Hunter which would allow the Commerce Department to impose duties on Chinese Goods to offset the "subsidy" effect of Beijing's currency rate policies. While it is not likely that the bill would be passed by the Congress or that President Bush would sign such a measure, it is one more sign of the increasing protectionist pressures in the Congress

The initial reaction of the Shanghai Stock Exchange on Monday morning to the PBOC currency and rate moves the previous Friday was dismay, the Shanghai Composite Index fell over 3.5% in the first hour of trading. But investors and punters soon regained their confidence that the economy would not be unduly affected by the PBOC adjustments and the Composite Index closed 1% higher on the day. By Friday the Index had fully recovered closing at 4179.78, up 56.2 % on the year, after posting a new intra day record of 4208.3. The Shanghai Exchange trades with different share classes for foreign and domestic investors, class A shares for domestic owners and B shares for foreigners. The Shanghai Composite Index includes both share classes. Though the large rise in Chinese equities this year has often be attributed to the excess of liquidity washing through the bank account of domestic investors, Class A shares, the domestic version, have only risen 53% year to date. Class B shares, the foreigner's preserve, have rocketed 125% higher. Though the increase in the deposit interest rate and the reserve requirements by the PBOC were aimed primarily at domestic investors, it seems those domestic investors are not yet concerned. It is the foreigners who are most avidly speculating and they were largely unaffected by the PBOC moves.

On Wednesday Alan Greenspan the former chief of the American Federal Reserve Bank warned of a possible "dramatic contraction" in Chinese equities. The market immediately recoiled but the two share classes reacted very differently. Class B shares, owned by non citizens, fell 7.9%, but A class shares, the citizen variety, were down only 1.3%. Though both classes recovered the following day, B shares rising 8.7% the disparate reaction was instructive; or perhaps not. While Mr. Greenspan is an iconic figure in western finance he is unknown to most domestic Chinese investors; certainly his pronouncements have no market weight in the Middle Kingdom.

To no one's surprise Nicholas Sarkozy, the new French President, has said that he is fully in favor of an independent European Central Bank (ECB). His criticism of ECB rate policy during the recent election when he suggested it should focus more on growth than inflation, was dismissed as a mere difference of opinion. "I have never called into question the independence of the ECB", stated Mr. Sarkozy. With the election over Mr. Sarkozy will have his hands full convincing French workers and students to help him in reforming the sclerotic French economy. Jean Claude Trichet, the current (and French) ECB President, who has long called for productivity reforms in Europe business, is an obvious ally in that struggle.

The minutes from the Bank of England Monetary Policy Committee meeting where the last 0.25% rate hike was debated revealed a 9-0 vote for the increase. Most bank observers had not expected the unanimous decision; also somewhat surprising was the discussion by several members of the validity of a 0.5% hike, though in the end all members went along with the smaller rise. In all estimation this secures the debate for another 0.25% boost this year with only the timing unsaid. Or to put it in the MPC's own words, "the committee agreed that should the economy continue to develop broadly in line with the central expectations the bank rate could be raised further as necessary".

The Japanese Yen has depreciated more than 1% in the past two weeks and there is no sign of traders deserting the carry trade for safer and less profitable pastures. Economic conditions in Japan, and government and Bank of Japan attitudes argue for an extremely slow pace to rate hikes. Worldwide low volatility and ample liquidity support the 'trade' an asset whose owners are not losing sleep over surprise central banks rate changes.

Economic Releases May 21 - 25
United States
Durable Goods orders continued the string of good US economic results and jibed with the recent ISM returns. In April the overall number rose 0.6%, below the forecast of 1.2%, and considerably less than the revised 4.3% rise in March. The ex-transport result was up 1.5%. This is the third month in a row with solid gains in manufacturing. The annualized rate of these past three months is a robust 27.5%. Boeing reported 126 new orders in the month.

April New Homes Sales rose 16.2% in April to 981,000, 860,000 had been expected. The March result was revised down to 844,000 from 858,000. The better than expected numbers were mostly the results of builders lowering prices to clear unsold inventory. The median sale pride fell 11.1% to $229,100. The unsold supply shrank to 6.5 months from 7.3 in March. These results are at odds with the NAHB number from last week which had reached a low of 30 for this cycle. Some level of adjustment is clearly ongoing but its effect on the overall economy has been and remains muted.

Existing Home Sales for April fell to 5.99 million units off from the 6.15 million unit statistic in March. This is the smallest number of sales since June 2003 when 5.94 million homes were purchased. The market supply of unsold units rose to 8.4 months a 15 year high. The Euro gained thirty points against the Usd after the release.

New Industrial orders for March outstripped forecasts coming in at +2.7% month to month and +8.0% years to year; +1.0% month to month and +6.9% had been expected. February's results were down 0.7% monthly and up 4.7% year to year. This volatile and often revised statistic was driven by orders from Asia and Russia and not the United States.

The ZEW Expectation Survey for the European Monetary Union (EMU), the official name for the countries using the united currency, for May came in at 22.3, well above the April issue of 10.7 and the Current Conditions section was 81.8, also a substantive advance over April's 69.9 reading. Both numbers are, not surprisingly, in line with the powerful reading for the same survey in Germany, the EMU's largest economy.

German Business confidence remained at high levels and reported consumer confidence gained proportionally this week. The widely observed Ifo Survey confirmed managerial confidence in the German economy. The Ifo Business Sentiment index for May at 108.6 was the same as the reading in April and a trifle less than the 108.8 forecast. The Business Expectation reading was 104.8, better than the 104.5 forecast and again the same as the April number. The Current Assessment number fell a bit to 112.5, 113.6 had been predicted, April was 113.2. First quarter GDP numbers confirmed with no change the preliminary statistics issued last month, GDP sa 0.5%, nsa 3.3%, wda 3.6%. The June GfK Consumer Confidence number at 7.3 was much higher than the forecast of 6, and well above the May figure of 5.7, and April's 4.4.

The ZEW Survey of May surpassed all expectation with the Current Conditions reading at an all time high. ZEW Economic Expectations registered 24 as expected and a marked improvement over April 16.5. But it was the Current Conditions call at 88, the record, much stronger than the forecast of 79 and April's 76.9, that focused the market on the sustained strength of the German economy. This is the sixth month in a row that the Economic Expectation quadrant has gained and it is the best reading since June 2006. According to Sandra Schmidt Senior Economist at ZEW, the firm conducting the survey, a strong rise in investment compensated for "lower domestic consumer demand and slightly lower exports".

United Kingdom
Housing prices in May gained only 0.5% monthly and 13% yearly, down from 3.6% and 15% in April. This is the slowest rise since December of last year and some evidence that recent Bank of England hikes are starting to bite. First Quarter GDP (second release) came in as expected in the monthly number, +0.7%, and slightly ahead of forecast in the year on year statistic at +2.9%,+ 2.8% had been predicted.

The Nationwide Core CPI statistic for April fell 0.1% in the year to year measure a decided improvement over March's -0.3%. Tokyo CPI for May 2007, released a month ahead of the nationwide number, was unchanged since May 2006. The improving deflationary outlook helped the Yen which gained almost forty points against the Usd, 121.50 -121.14, after the release.

The Week Ahead May 28 - June 1

United States
A telltale week for the American economy, with a long string of statistical releases scheduled, culminating with Friday's Non Farm Payroll (NFP) number, often as not the arbiter for Dollar gains or losses. Over 40 indicators of varying importance are on tap in four days; American markets are closed Monday May 28 for the Memorial Day holiday.

The minutes of the May FOMC meeting are issued Wednesday at 2:00 pm. Although it is rare for any important information to be contained in these edited transcripts the market will be sure to be alert for any possible nuances.

Tuesday brings the Conference Board Consumer Confidence number for May, 105 is forecast. The April reading of 104 was the lowest since last August. The University of Michigan Consumer Sentiment for May is out on Friday, 88 is forecast, and April was 88.7. Thursday the first revision to Q1 GDP is released. Predictions are for the 1.3% advanced number to be revised down to 0.8%. The Chicago Purchasers Index is also released on Thursday, May is expected to be at 54, 1.1 better that April.

Friday is the main event with the May NFP number and the unemployment rate issued at 8:30 am. Median expectation is for 135,000 jobs to have been created and for the unemployment rate to remain at 4.5%. Several major US indicators have been improving and the risk is for a better than expected release. The Usd could pick up considerable support from a good figure. Manufacturing ISM for May is out at 10:00 am. 54.0 is s predicted a small drop from the April result of 54.7.

Money supply (M3) figures for April are issued on Wednesday. This is one of the ECB's two most often cited statistics, the other being the HICP inflation rate. The target M3 expansion rate is 8%, April was 10.9% and May is expected to be little better at 10.7%, with the 3 month moving average at 10.5%. The first issue or 'Flash' HICP for May number is out one hour after the M3 number, 1.9% is forecast, April was 1.8%. If the prediction is correct European inflation will then have been below the 2.0% ECB target for more than six months. The EMU unemployment rate is expected to remain at 7.2% in April; this rate covers all the countries participating in the Euro.

The seasonally adjusted unemployment rate for May is released on Thursday, a slight improvement to 9.1% is predicted; the April rate was 9.2%. The Reuters Manufacturing PMI for May 1s issued June 1st, 57.2 is expected, April was 57.0

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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