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Friday June 8, 2007 - 21:32:47 GMT
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Market Directions - Sunday, June 10, 2007

--American interest rates rocket higher, crushing the US equities and driving the Dollar to a four week high against the Euro.

--The ECB hikes 0.25% but sows doubt about the need for continued increases.

--Risk returns to the Yen based carry trade as Euro/Yen drops to a four week low.

The Week in Review

United States
Where interest rates lead markets are sure to follow. The 10 year US Treasury yield touched 5.25% on Thursday, a level not seen since August of last year, and the equity and currency markets lined up to follow. The Dow Jones Industrial Average ended the week 1.8% lower with the bulk of the losses incurred on Thursday as bond prices sank and rates jumped dramatically. The Euro closed on Friday below 1.3400 against the Dollar for the first time since early April and the Euro/Yen, long the mainstay of the carry trade, finished below 163.00, a rate not seen since the second week of May. All this dramatic movement was the result of bond traders pricing in the potential for a Federal Reserve rate hike. The assumption that the US economy would weaken and that the next Fed move would be a rate cut has been a market mainstay to one degree or another since the housing contraction began late last year. It is no longer supported by the economic data. This week's economic information, the Institute for Supply Management Non-Manufacturing Index (ISM) and the International Trade Balance, only served to cap more than four weeks of good, and for the recession crowd, much better than expected, US statistics. Denial was no longer possible.

In the US, the rise in Unit Labor Costs for the 1st Quarter, now running at 2.2% a year and the fall in Non Farm Productivity to 1.0% from 1.1%, when combined with the resurgent manufacturing sector and tight labor markets, eliminated all possibility of a Federal Reserve rate cut. Nor will these statistics prompt the Fed to switch to a neutral rate bias. And, when they are joined with the Fed's own rhetoric, they make a rate hike, however far in the future, far more likely as the next Fed innovation. The markets have finally recognized this simple fact.

The declining US April Trade gap, particularly the level of net exports, +0.2% combined with the fall in exports, 1.9% lower in April could potentially add 1.25 to 1.5 percentage points to second quarter GDP. That is opposed to the second quarter result when net exports probably subtracted 1% from GDP. In any case, GDP in the second quarter is now expected to be considerably higher than the 0.6% expansion in the first quarter. Projections for the second quarter GDP range from +2.0% to +4.1%.

The European Central Bank (ECB) did the honest and raised the refinancing rate by 0.25% to 4.0% on Wednesday. There was little if any initial market reaction to the long telegraphed move. In the prepared statement and in his news conference President Jean Claude Trichet was careful to remain committed to the central anti inflation role but enough clues were scattered in the statements and comments to suggest that the bank sees the end of the increase cycle approaching. Perhaps the most emblematic clue was the addition of one word "still" to the statement on monetary policy. In the last ECB written statement policy had been characterized as "Monetary policy continues to be on the accommodative side", in the current statement that was changed to "Our monetary policy is still accommodative". "Still" implies future change, the implication is inescapable. Granted, it is a great deal of weight for a five letter word to bear. But we must remember that there are no unexamined or tossed off words in these central bank statements. The inclusion of that small adverb is a small step towards a neutral rate policy. The ECB statement also ended the description of current rates as "moderate". The ECB has proved to be a very deliberative institution, conscientiously informing the markets of its intentions and steadfast in carrying them out. It is impossible to believe that these changes were without meaning.

Trichet sees four possible threats to inflation control in the Eurozone and he spoke of each individually: Money Supply, "Short term interest rates ... have not as yet significantly dampened the overall strength of the underlying monetary and credit expansion; Wages, "There is a risk that wage developments will be stronger than expected which would pose significant risks to price stability; Oil, "Prices and oil price an upward slope, annual inflation rates are likely to fall...before rising significantly towards the end of the year; Economic growth, "Quarter on quarter growth of 0.6% real GDP growth in the first quarter of 2007 was again somewhat above previous expectations ".

The pace of ECB rate hikes has slowed. In the 2nd half of 2006 a 0.25% increase came every two months, in 2007 it has been every three, in March and June. Such a schedule implies the next hike no sooner than September. During the press conference after the announcement reporters tried to pin down Mr. Trichet on whether he would consider a bank meeting in August (the pan European vacation month) and he refused to comment on the possibility. The phrase 'strong vigilance' was also left out of the statement and when questioned about this Mr. Trichet said that if there is a need for strong vigilance he will say so. Clearly the present situation does not require letting the market know that another rate hike is imminent.

New Zealand
The Reserve Bank of New Zealand (RBNZ) hiked rates to 8.00%, a 0.25% rise. It was the third increase in less than four months. The New Zealand Dollar rose 50 points. At best the hike had been 50% priced into the trading rate of the New Zealand Dollar and its crosses. Alan Bollard the Governor of the Reserve Bank indicated that there is a good chance of another increase if domestic conditions, particularly housing and retail sales, do not soften. Business and consumer sentiment have been weakening so it is at best a 50% proposition for another hike this year. Bollard also said that the "Exchange rate [ of the NZ dollar] is both exceptionally and unjustifiably high on the basis of fundamentals", a bit of old fashioned jawboning which is logical only if you consider interest rates not fundamental to a currency's trading level - an eccentric view not held by most market participants. The NZ dollar hit a 25 year high against the Usd in the aftermath of the increase.

The Reserve Bank of Australia (RBA) left rates unchanged at 6.25%, as expected. However, the Australian Dollar rose to a 17 year high of its own against the US Dollar in the aftermath of the RBNZ increase. The three RBA hikes last year do not seem to have had the expected impact. Real GDP rose 1.6% quarter to quarter and 3.8% year to year, well over expectations of 1.2% and 3.1%. With GDP growth well ahead of trend in spite of the severe drought the odds are high for a July 0.25% hike by the RBA.

The potential interest rate paradigm shift, from a raising ECB and a cutting Federal Reserve to an ECB on hold and a Fed eying higher rates has, if true, profound implications for the current long established currency market trends.

Economic Releases June 4 - 8

United States
The April Factory Orders figure at +0.3% was less than half the forecast of +0.7% but as the March Orders number was adjusted considerably higher to +4.1% from +3.6%, the effect was market neutral.

The Institute for Supply Management Non Manufacturing Index (ISM) was the robust image of the Manufacturing ISM issued last week. The overall index was 59.7 for May, 3.7 points better than the forecast and the April measure, both of which were 56. This is the highest reading in 13 months. Employment was also higher at 54.9, April was 51.9. The New Orders component at 57.4 gave the best performance since September of last year; April had been 55.5. Prices Paid rose in May to 66.4, 2.9 points ahead of April's 63.5. These results provide solid support for expectations of a revival of GDP growth in the second quarter. The Prices Paid increase will no doubt garner the attention of the Fed.

Unit Labor Costs (ULC) for the first quarter was almost tripled on revision ending at +1.6%; the preliminary issue had been 0.6%. The result was not wholly unexpected as the market had been anticipating 1.5%. After the large downward revision to GDP such an adjustment to ULC was inevitable without a similar drop in hours worked. Productivity was lowered as well for the first quarter, from 1.7% to 1.0%, as expected and for similar reasons. The year on year increase in ULC is now running at 2.2%, the prior reading had been 1.3%. The yearly figure for productivity shrank to 1.0% from 1.1%.

The European economy continued to perform with some gathering signs from the forward looking indicators that the apogee may have passed. The Reuters Services PMI reading for May arrived as expected at 57.3 on a prediction of 57.2; April was 57.0 But the cyclical peak in this series, 60.7 was last June almost a year ago. Retail Sales was also more subdued than predicted, the April month to month statistic was +0.2%, forecasts were for a 0.4% rise; March had been +0.5%. The yearly number was 1.6% higher in April on an expectation of +1.9%; the previous month had been +2.6%.

April manufacturing orders were a bit below predictions shrinking 1.2%, traders had been expecting only a 1.0% fall. The March number was revised down as well dropping to +1.1% from +2.4%.

Australian unemployment fell to 4.2%, a 33 year low, 4.4% had bee forecast. GDP growth in the third and fourth quarters of 2006 reached an annualized rate of 5.5% well above the 3.5% trend line despite the severe drought.

The Week Ahead June 11 - 15

United States
The good American economic news is about one month old and this week will tell if the change in view of the US economy so dramatically priced into the market last Thursday will be sustained.

Retail Sales for May on Wednesday will give indication of whether the April number of -0.2% was a fluke in what had been a strengthening run of US numbers since January; +0.6% is predicted for the headline number and +0.7% for the ex food and auto version. Import and export prices for May are also issued Wednesday. In light of the substantial addition to second quarter GDP implied by the International Trade Balance these statistics will be watched for any sign of inflation.

Friday brings the busiest day of the week with the Consumer Price Index (CPI), Industrial Production, Capacity Utilization and University of Michigan Consumer Sentiment, market expectations are as follows: CPI for May, expected +0.6%, prior month +0.4%; CPI ex food and energy +0.2%, prior month +0.2%; Industrial Production for May expected +0.2%, prior month +0.7%; Capacity Utilization for May expected 81.6%, prior month 81.6%; and finally University of Michigan Consumer Sentiment for June, prior month 88.3.

The Industrial Production level released on Tuesday is expected to gain to 0.2% in April; in March the gain was 0.4%. The annualized rate is forecast to rise 4.3%; it was +3.7% in March. The final iteration of the Harmonized Index of Consumer Prices (HICP) for May issued on Thursday expected to confirm the preliminary figures already out, +0.3% for the month and +1.9% in the annualized reading. The April numbers were +0.6% and +1.9%.

ICON Consumer Confidence for May is issued on Monday, April was 107.0 and March was 104.0. Final HICP, the German portion of the Eurozone statistic for May is out on Thursday, no change is expected from the preliminary numbers, +0.2% for the monthly and +1.9% for the yearly. The April figures were +0.2 and +2.0% respectively.

The Chinese overseas trade surplus, the Yuan and the attempts by the People's Bank of Chinas and the Ministry of Finance to curb the Shanghai Composite Index, have all been topics of major interest to Western financial markets of late so we can expect serious attention for this week's mainland statistics.

The Consumer Price Index for May is released on Tuesday; April's numbers were +3.0% year to year and +2.8% year to date. Retail Sales for May are released the following day, +15.5% is expected year to year and +15.1% year to date. Industrial Output is released on Thursday, +17.4% is forecast year to year and +18.0% year to date. As always with the dynamic Chinese economy the concern is unsustainable and inflationary growth.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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