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Friday June 1, 2007 - 21:48:37 GMT
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Market Directions - Sunday, June 3, 2007

The American Federal Reserve stays the course. No change in policy or outlook is anticipated from the FOMC minutes.

The Chinese authorities try to cool the booming Shanghai Stock Market, but this time the contagion does not spread around the world.

The US economy records surprisingly good manufacturing and job creation numbers, but traders recoil from wholesale Euro selling.
The Week in Review

United States
The Bernanke Fed is nothing if not constant. For almost a year the governers have kept their attention firmly on inflation. In their public statements, their policy decisions and market avisos, the rhetoric of the Chairman and governors has been calm, statistically focused and mildly encouraging. The minutes of the Federal Reserve Open Market Committee (FOMC) May 9th reinforced that constancy. There is no evidence in the edited transcripts of any scenario that could prompt a rate cut. The members reiterated their prediction that GDP growth will resume later in the year, and that leaves very limited time for resource utilization and productivity to further cool core inflation. "The risk that inflation would fail to moderate as desired remained the Committee's predominant concern" and "considerable uncertainty attend[s] the prospects for inflation" were the operational sentiments of the members. American labor markets are tight and the strong demands on US exports created by the weakening Usd were both cited as potential sources for inflation. The unstated assumption behind the Fed's economic policy is that with inflation controlled, in fact and in perception, the economy can be counted on to deliver growth on its own. Keep your eye on the inflation ball and the score will take care of itself. On the Fed's call of the game one has to say -- so far so good.

Further evidence for the prospect of returning American economic growth was delivered by the ISM Manufacturing Survey and the Non Farm Payrolls report. Both exceeded market forecasts and drove the Euro to seven week lows against the Dollar. Though Euro support at 1.3400 held firm in the aftermath of the release, the pressure is on the united currency.

American consumer confidence held up admirably in May with both major surveys scoring gains. The painful effect of high gasoline prices, $3.00 per gallon in many parts of the country, seems to have a diminishing negative effect the second time around. Consumers have factored the higher prices into their budgets, or at least the possibility of higher prices and are no longer surprised or discouraged by increases. Plentiful jobs, healthy income gains, a roaring stock market and low inflation have more than made up for the twin negatives of housing and fuel.

The China story this week is the event that didn't happen. Chinese regulators tripled the stamp tax on stocks to 0.3% from 0.1% and the Shanghai Exchange promptly fell 7.4%, closing the day down 6.5%. What did not happen was the cascading worldwide collapses that had occurred in a similar situation this past February 27th. That day an 8.8% drop in the Shanghai Composite fomented similar losses in bourses around the world. By the end of that week the Dow was off 4.21%, the S&P 4.36% and NASDAQ had lost 5.85%. Perhaps this time the contagion was prevented by the knowledge that within a month the Shanghai Composite had erased all losses and rocketed to new highs. In the past year and five months the Chinese Equities are up 190%, 130% in 2006 and 60% so far this year.

The problem for the Chinese authorities is that economic motivations of investors have not been affected by the Peoples Bank of China (PBOC) rate adjustments of two weeks ago or this week's tax increase. Several factors are supporting the flood of money into Chinese Equities. Real deposit rates in China are 1.0% or lower so potential savers have little incentive to park their excess funds in banks or time deposits. Money supply growth exceeds nominal GDP growth keeping constant pressure on inflation and the search for higher returns for invested capital. The Yuan is not a freely traded currency so it is difficult for Chinese punters to seek opportunities in foreign stock exchanges. And lastly the profits of Chinese companies are still growing strongly, a realistic support for equity prices. Until one or more of those factors change, local and external funds will continue to bolster prices on the Shanghai Exchange. There should, however be serious worries among Chinese equity owners. The PBOC has not been coy, Wu Xiaoping, the central bank's vice-governor has said that the stock market is growing too rapidly. It would be naive to think that the economic authorities in China will not persist until they obtain the results that they desire. Chinese investors should remember the American financial adage 'never buck the Fed'; it translates well into Chinese 'bu yao fan dui PBOC'.

European inflation was below the 2.0% ECB target for the 9th month in a row. The unemployment rate fell one tenth of a percent to 7.1%, the lowest level in the 14 year history of the harmonized index. It is perhaps indicative of the reform challenges facing the German and French governments that an unemployment rate that would be a source of national consternation on this side of the Atlantic is a positive achievement in the European Union. The German unemployment rate fell three tenths of a percentage point to 6.7%; in April of 2006 it had been 8.3%. The French rate slipped one tenth to 8.6%.

Economic Releases May 28 - June 1
United States
To no one's surprise the 'preliminary' 1st Quarter GDP figure was revised down to 0.6% from the 'advanced' 1.3% number. The market had anticipated a slightly smaller drop of 0.5% drop to 0.8%. As traders had long since discounted the revision and are far more interested in the pending 2nd quarter results, even though they are not due for five weeks, there was little market reaction. Corporate profits for Quarter 1, issued simultaneously, were 1.2%, appreciably higher than the flat forecast and the 4th Quarter result of -0.3%. April Construction Spending also caught the predictors flatfooted, rising a modest 0.1% on expectations of 0.0%. But it was the March result that really surprised. It was adjusted higher to 0.6% from 0.2%. This was the third positive month in row and marked the first sustained expansion in since last summer.

Consumer confidence improved despite continued high gasoline prices and the troubles of the housing market. The Conference Board reported May consumer confidence at 108.0, well above the forecast 105.0 and also better than revised April reading of 106.3, (up from 104.0). The University of Michigan Consumer Sentiment number for May was 88.3, a tad better than expectations though lower than April's 88.7.

Non Farm Payrolls easily bested expectations as 157,000 new jobs were created in May; economists had anticipated 135,000. The service sector supplied 176,000 jobs while manufacturing lost 19,000. March and April numbers were revised lower by a total of 10,000. The economy has started an average of 133,000 jobs per month this year, in the second half of 2006 it created an average of 170,000 monthly. The unemployment rate was unchanged at 4.5%.

The nationwide ISM Index improved in all aspects. Since this Index reached a low of 49.3 in January of this year it has had four months of improving statistics, with May's 55.0 reading the best pace in over a year. The change of direction has been striking. Median expectation for the May number had been 54.0; the April issue was 54.7. New Orders improved to 59.6 the sixth month of growth in a row and the highest level since November of 2006. April's figure was 58.5.

The PCE core Chain Weight Price Index, or as it is better known, the PCE Deflator increased 0.115% in May with the year on year number at 1.995%, 2.0% in the media reported rounded version. That is the smallest rise since February of 2006 when it gained 1.993%.

Pending Home Sales (PHS) fell 3.2% in May at 101.4. Last months drop of 4.9% to 104.3 correlated well with the unexpectedly weak 5.99 million units of New Home Sales in April. This PHS figure would estimate a 5.8 million level for May New Home Sales.

The annualized growth of the Money Supply (M3) moderated somewhat in May, slowing to 10.4% against an expectation of 10.7% and April's 24 year record of 10.9%. The three months moving average came in at 10.4% as well, below the forecast of 10.5%. Neither figure will give the ECB much comfort as their stated target of 8.0% has been long surpassed.

The pan European EMU Economic Sentiment Index for May was stable at 111.9 and a small improvement over the April reading of 111.0. But the Business Climate Indicator was unexpectedly weaker at 1.53, off both the forecast of 7.0 and the April issue of 1.61. Industry Confidence faltered as well dipping to 6.0 in May from 7.0 in April

The 'Flash' HICP (Harmonized Index of Consumer Prices) statistic for May was 1.9% the ninth month in a row that this Eurozone wide inflation number has been below the 2.0% ECB target. But, as with the US Federal Reserve, no one should expect any moderation in ECB anti-inflation rhetoric or, as yet, in their rate hike campaign. All is still go for a 0.25% hike in June.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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