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Friday July 13, 2007 - 21:41:03 GMT
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Market Directions - Sunday, July 15 2007

American Equities soar as the Dollar flounders.

Federal Reserve Chairman Bernanke pitches the central bank against inflationary expectations in the US economy.

The ECB reaffirms its devotion to monetarist inflation policy.

The Week in Review July 9 - 13

United States
The disconnect between the state of the American economy and the state of the US dollar widened to a chasm this week. The Euro set multiple historical highs against the American currency as did the British Pound. At the same time US Equities soared to record levels in almost all the major American indices. The question might be asked, who is fooling whom? Both scenarios cannot be true. Either the US economy is headed for a strong rebound in the latter quarters of this year with the increasing upward pressure on US interest rates and the Dollar as implied by the equities, or the Euro level is a precursor to continued stronger continental growth and ECB rate hikes beyond 4.00%. A partial answer is that despite the equities record performance doubts remain about the health of the US economy. Many US statistics are predicting moderate but not stellar growth. Retail Sales on Friday was a major disappointment but was contradicted by large store sales and consumer sentiment figures, both unexpectedly strong.

The sub-prime housing loan market, by definition the far risk end of the home lending business, has obsessed market commentators but it has not, so far, had a great effect in the real world. Lax credit analysis by certain lenders combined with margin requirements against the holders of the questionable bonds as the default risk in the backing pool rises are the most plausible sources of the problem. It does not appear to be an interest rate or an employment issue. The default rate on these sub prime loans is rising, that is true. But the reason is not because of widespread unemployment or upward adjustments on adjustable rate mortgages are forcing the marginal borrower into default, but because the recipients of the loans were of dubious creditworthiness even by the standards of the sub prime market. The concern with the sub prime loan market is reminiscent of the universally grave misgivings over the housing market slide which began well over a year ago. Dire results were confidently predicted for the overall economy and especially consumer spending which was thought to be closely tied to the bubble in home prices. The bubble burst, home prices in many areas of the country have fallen - most sector indicators are at yearly lows - but last year's fear that the economy would be dragged into recession was clearly overwrought. The American consumer did not convert every bump in their housing equity into immediate consumption. Domestic consumer spending has continued to outpace gains in earnings but the confidence this exhibits has most likely been instilled by the 4.5% unemployment rate and low inflation. The Gross Domestic Product (GDP) has averaged 2.0% over the last four quarters, a full point below trend but very far from recession.

The doubts assailing the US economy are real enough, with the Fed on extended hold, oil prices and political tensions high, and a bloody and unresolved war In Iraq, it is easy to be pessimistic about chances for a return of sustained American economic growth. And besides, there seems to be an inherent dispensation for economists and pundits to look down rather than up just as there a predisposition for equity investors to gaze skyward. Neither view is inherently more correct, but the investor seeks returns in profits, pundits risk only their reputation.

In a speech before the Monetary Economics Workshop of the National Bureau of Economics Research in Cambridge Massachusetts, Federal Reserve Chairman Ben Bernanke said the following, the "output cost of disinflation may be lower...[and] the disinflationary effect will be felt not only though the usual output gap channel but also through a direct restraint on long term inflation expectations'. For an academic economist Mr. Bernanke is unusually clear spoken and stripped of economic terminology his aim is direct. The cost to an economy of high interest rates, or of not lowering rates, in output, i.e. GDP, is lower than previously thought, and the rates exert a direct reduction in inflation. Mr. Bernanke has in the past stressed the importance of expectations in the control of inflation; temper inflationary expectations and you gain a long march in the control of inflation. Interest rates target actual inflation in that they exert real economic costs on the economy. But the belief that the central bank is vigilant, to borrow the ECB term, against inflation and will always lean to the prevention side even at the cost of economic growth, will in the long run benefit growth more than a hyper reactive rate policy. Mr. Bernanke is saying quite plainly that a stable low inflation economic environment is the most pro-growth rate policy a central bank can have even if rates are deemed by many as higher than necessary. The Fed will be very reluctant to cut rates in the current economic and political environment. This reluctance has not been priced into the currency market.

The European economies showed some preliminary signs of cooling with Industrial Production for May substantially below predictions and the 1st quarter GDP confirmed as having slipped from the strong 4th quarter annualized growth of 3.3%. Jurgen Stark, ECB governing council member said that rate policy was 'still accommodative', the identical term of the last ECB policy statement. Mario Draghi, a council member from Italy reaffirmed that the Money Supply (M3) remains crucial to ECB judgment on inflation. While the Harmonized Index of Consume Prices (HICP) has been below the ECB's 2.0% target since last September, the M3 reading has been above its target of 8.0% for just as long.

The Economics Minister Michael Glos offered a view on the Euro similar to that long held by American officials about the Dollar. He said that the current level of the Euro was due to the strength of the European economies and that a strong Euro is good for the German economy because it make oil imports cheaper. Without that last addition about oil this is a very American viewpoint but it is not one that has been heard much from continental politicians. Most European government officials are more given to complaining about the damaging effect a strong Euro and strict rate policy have on exports and the economy.

In that tradition the new French President Nicholas Sarkozy admitted that he and ECB President Jean Claude Trichet, (also a Frenchman), "don't exactly see eye-to-eye' on the topic of ECB rate policy. Mr. Sarkozy had criticized the ECB during the recent election charging that it needed to be more sensitive to economic growth. Jurgen Stark ECB council member and former Bundesbank official replied pointedly that the "shortcomings' of policies at the national level are the cause of some states disappointing economic growth. This would be yet another minor tiff in the long running contest between the ECB and European national politicians but for the fact that a 0.25% rate hike is imminent. An ECB concerned about its independence might be tempted to increase sooner, in September, rather than later, in October.

The Bank of Japan (BOJ) left rates unchanged at 0.5% but the 8-1 vote was seen by some as a slight move towards the rate hike camp. In January the committee had voted 6-3 to maintain and in March they raised rates by 0.25%.

The Bank of Canada raised it main rate by 0.25% to 4.5% surprising no one and indicated that further raise hikes are likely.

Economic Releases July 9 -13

United States
Fed Chairman Ben Bernanke testifies before Congress this week, Wednesday in front of the Hose Financial Services Committee and Thursday to the Senate Banking Committee. The Representatives and Senators will no doubt focus their questions on the sub prime market and Mr. Bernanke will no doubt be patient and explanatory as the congressmen make their political statements. Nothing of substance should be expected though it will be interesting to watch Mr. Bernanke tiptoe around the question of additional liquidity if, as will no doubt be posed by someone, the sub prime problems grow. In a similar vein of thwarted expectations will be the Thursday release of the minutes of the Federal Reserve Open Market committee (FOMC) of the June 27th and 28th meeting. These minutes are edited and though they elicit much market interest they rarely if ever reveal any valuable information.

The US trade balance for May at -$60.0 billion dipped slightly from the April deficit of $58.5 but elicited no market reaction. More interestingly the April and May real trade balance was $2.5 billion lower than the first quarter average. This could add as much as 0.5% to the 2nd quarter GDP. The trade gap with China was $20.0 billion the highest since January when it was $21.0 billion, while that with Japan shrank to $5.9 billion, the least since May 2004.

Retail Sales for June fell 0.9%, well below the forecast of 0.0%, and far off the May 1.4% reading. The ex food and auto figure was down 0.4%, well south of the +0.2% prediction and the May result of +1.3%. These numbers were a bit of a puzzle as several major retailers, including Wal-Mart, JC Penny and Costco reported strong June sales, well in advance of expectations. A large drop in auto sales did account for almost 2/3 of the overall drop in sales but purchases fell across most retail categories. This follows the unexpectedly large gains registered in May. Retail Sales is a revised statistic and perhaps forthcoming adjustments will help to reconcile these results. But it is also true that sustained sales at this lower pace would mean a sharp drop in consumer spending with a commensurate slowdown in GDP. The trend in sales is still rising but the rate of increase is diminishing. It was +0.3% monthly for the first half of 2007, only slightly less that the +0.35% monthly average of the prior six months.

The University of Michigan Consumer Sentiment reading for July was 92.4, much stronger than the forecast of 86.0 and the May number of 85.3.

First quarter GDP was revised slightly higher to 0.7% monthly and 3.1% annually from the preliminary reading of 0.6% and 3.0%. These numbers were a piece with the May Industrial Production results, both the monthly figure, +0.8% and the yearly +2.0% were considerably below forecasts, +1.1% and 2.4%. The April results were revised a bit higher, to -0.7% monthly and +2.9% annually from -0.8% and +2.9%.

No significant economic statistics released.

United Kingdom
Retail Sales for June doubled the forecast rising 3.0% and well ahead of the May reading of 1.5%.

Economic growth in 2006 was adjusted up to 11.1% from 10.7%.

The Week Ahead Economic Releases July 16 - 20

United States
After the slow week just past reporting on the US economy picks up with important notices on Industrial Production, the housing market and the Consumer Price Index.

Tuesday: The Producer Price Index (PPI) for June, released by the Department of Commerce at 8:30 am, will give indications of the inflationary pressures faced by American business. The monthly figure is expected to have risen by 0.1%, the core figure, that is without food and energy items, +0.2%. The numbers for May were +0.9% and +0.2% respectively. Industrial Production and Capacity Utilization for June are issued at 9:15 am. An increase of 0.4% is anticipated for the production result; it was flat in May. The Capacity Utilization percentage is forecast to increase to 81.5% from the May level of 81.3%. The National Association of Home Builders issues its July Housing Market Index at 1:00 pm; the June figure of 28 was the lowest in over 12 months.

Wednesday: The Consumer Price Index out at 8:30 am from the Bureau of Labor Statistics will be the most closely watched statistic this week and the most likely to generate a market reaction. The headline number is predicted to have edged up 0.2% in June; the core to have gained 0.2% as well. In May the figures were +0.7% and 0.1%. Housing Starts and Building Permits for June are reported at the same time; the May numbers were 1.474 million units for Housing Starts, which was the lowest reading in over a year, with the exception of this past January (1.408 million); and 1.501 million granted permits, also the weakest number in over a year, excluding the April result, 1.457 million.

Monday: The final HICP figures for June at 9:00 GMT are not expected to deviate from the preliminary figures +0.1% monthly and +1.9% annualized. The May numbers were +0.2% and +1.9%.

Tuesday: The ZEW European Monetary Union (EMU) Business Sentiment Survey for July is reported at 9:00 GMT. In May the 'expectations' section was 19.0; the 'current conditions' was 86.0.

Wednesday: May Trade Balance at 9:00 GMT. The preliminary May results were, seasonally adjusted, +E3.5 billion, not seasonally adjusted +E1.8 billion. Construction Production for May at 9:00 GMT. April results were -0.9% monthly and +3.9% yearly.

Monday: Final HICP for June at 6:00 GMT, preliminary results +0.2% monthly, +2.0% annually. Final CPI for June at 6:00 GMT, preliminary results +0.2% monthly, +1.9% yearly.

Tuesday: ZEW Survey for July at 9:00 GMT, May results 'economic expectations' 20.3, 'current conditions' 88.7.

United Kingdom
Monday: DCLG House Prices for May at 23:00 GMT, April results +11.3% year on year.
Tuesday: Core CPI for June at 8:30 GMT, May result +1.9% annually.
Wednesday: ILO unemployment for May at 8:30 GMT, April result 5.5%. Minutes of the July 4th and 5th Monetary Policy Committee meeting.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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