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Friday August 10, 2007 - 21:45:21 GMT
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Market Directions - Sunday, August 12, 2007


  • American sub prime worries hit European credit markets and the ECB funds massive emergency liquidity.
  • The Fed reaffirms its inflation concern on Wednesday, has the Chairman changed his mind by Friday?
  • China takes the American Congress to task for its protectionist posturing.

The Week in Review August 6 - August 10


Over shadowing all events this week, the housing inspired credit crisis slammed into the equity and bond markets Thursday and Friday and the skyrocketing volatility sank the 'carry trade'. The Euro/Yen, the most widely traded of the Japanese crosses, had already fallen 2.2% from its July 22nd peak when the BNP Paribas announcement that it had halted redemptions from three of its investment funds struck the markets just before the Thursday opening of the Paris Bourse. The Euro/Yen cross promptly fell another 3.3% to the bottom early on Friday and took the Euro/Usd and the Usd/Yen with it. The other Yen crosses fell similar amounts as traders cut their losses or took profits before the opportunity evaporated. Though the Euro/Yen had recovered about one percent into the close on Friday the dramatic return of volatility over the past two weeks should inhibit any quick resumption in the 'carry trade', even as the rate differentials between Japan and West remain.

There has been widespread use in recent years of financial engineering to aggregate and securitize loans with different degrees of risk into one security or bond. Some of the risk is in the form of mortgages held on sub-prime loans in the United States. The complexity of these instruments, which package loans from several risk levels into one bond or security, intending to create an instrument with a lower overall risk profile than that of the individual loan components, has left many banks and bond holders uncertain about the actual degree of risk contained in the individual bonds and in their overall portfolio. When the markets cannot ascribe the amount of risk in a security it cannot price that security. With the greatly increased degree of uncertainty about the risk parameters of these securities, potential buyers are either waiting until clarity emerges about the extent of the damage to the sub prime market and its derivative instruments, or demanding a much higher interest to purchase the wounded securities. Hence the many recent quotes about liquidity 'drying up' in the credit markets; it was drying up at normal interest rate levels for these types of markets, rates which reference the official central bank rate--for the ECB 4.0% for the US Federal Reserve 5.25%. In normal conditions overnight money markets trade at rates slightly higher than the official rate. But when credit and default risk increases prospective lenders and buyers demand higher returns for proffering funds. The increase in rates that originated in the affected security markets quickly spread to other credit markets. What was initially heightened risk in a particular type of security market, that is in the markets for these engineered bonds, became a systemic risk, driven by the glaring fact that no one knew how widespread the problem actually was. In that sense the ECB financing, though undoubtedly necessary to quell market fears also exacerbated them, with the easily formulated question on everyone's mind, 'What does the ECB know that it is acting so aggressively?

The increase in money market rates in Europe, about 50 basis points, is what prompted the central bank to add E94.8 billion ($131 billion) to the market Thursday in the form of loans at the 4.0% refinance rate to any eligible bank that requested funds. It added a further E61 billon on Friday, stabilizing the overnight rate at 4.08%. Friday's funds were not unlimited because the ECB had reverted to the normal bid process, but on Thursday the ECB had provided any amount requested at 4.0% to any eligible bank that asked. The Thursday action was more than ten times the normal amount of daily money market operations by the ECB and was accompanied by the statement that it "stood ready to act" to "assure orderly market conditions". The American Federal Reserve added a much smaller amount to the US system $24 billion on Thursday, about twice the size of normal operations and released no statement. All central banks conduct these types of money market operations daily; it was the size of the interventions, particularly in Europe and the accompanying ECB assurance that were most noteworthy. The Bank of Japan, the Reserve Bank of Australia and the Monetary Authority of Singapore injected reserves to their local markets as well, though in much smaller amounts.

United States

The Federal Open Market Committee (FOMC), the policy body of the Federal Reserve Bank met on Tuesday and issued its customary prepared statement. The committee reiterated its long standing concerns about inflation though noting that "downside risks [to the economy] have increased somewhat". The exigent question is what effect the subsequent credit and equity turmoil will have on the Fed outlook. Prices in the futures markets indicate that at rate cut in September is a done deal but those are speculative positions as likely to be closed for profit in a few days as they are predictive of eventual Fed actions. Nonetheless, wherever the chance of a Fed rate cut in September stood on Tuesday afternoon, it is now considerably higher. If, in the coming weeks, the problems from sub prime loans and their securitization are found across a much wider swath of the credit markets and if, in response, market rates are driven high enough to threaten the Fed's GDP prediction then perhaps the Fed will be forced to act. But it will take a substantial and documented threat to economic growth before the Bernanke Fed relaxes its grip on inflation.

United Kingdom

The Bank of England (BOE) quarterly inflation report predicted that inflation would be above the 2.0% target in two years if rates remained at the current 5.75%, just above 2.0% in two years at current market rates (higher than the official 5.75% rate) and below 2.0% in three years at constant market rates. This would seem to presage the expected 0.25% increase in the fall. But this forecast is substantially below the previous quarterly report which had inflation above 2.0% under both the 5.75% and market rate assumptions. The market rate assumption predicts a rise to 5.9% by the fourth quarter of this year and to 6.0% in the first quarter of 2007. Since under the current rate of 5.75% the report forecasts CPI above the 2.0% target for the next two years the BOE should be expected to raise to 6.0% in September of October. The impact of the credit market upset at the end of the week will affect the BOE's calculations in a similar fashion as the Fed. As long as rate conditions do not damage economic growth the bank is likely to remain unchanged in its hounding of inflation. Though it may, perhaps, moderate its rhetoric somewhat.


'Two can play at this game' might have been the headline over the contretemps out of China on Wednesday. Did the protectionist American Congressman, who love to bash China for domestic political consumption, really think that they could threaten China with impunity, and whenever they needed a sound bite? Most likely the politicians in question do not care much about Chinese reaction to their posturing, knowing that any political damage will have to be borne by the Bush Administration in its ongoing trade negotiations with the People's Republic. In the event a Chinese official from a 'academic think tank' warned , in a interview with the British newspaper, The Daily Telegraph, that China could, if pushed, sell its vast hoard of US Dollars in retaliation for protectionist trade legislation from the American Congress. He noted that this would severely damage the US economy. That is, of course, true. The Chinese government could dump its holding of US treasuries and that would put a great strain on the American financial system particularly the debt structure of the Federal Government. But such an action would also do extensive damage to the Chinese economy, driving the Yuan sharply higher, diminish the value of China's remaining US denominated financial holdings and generate vast turmoil in the world's financial system. In an economy as dependent on foreign investment, export and rapid GDP growth as that of the mainland, the economic and political repercussions in China are unthinkable for the Beijing leadership. This threat, as crude as it was, is perhaps a warning to the Clinton campaign as well as to Congress. Ms Clinton has recently called for legislation to prevent America being "held hostage to economic decisions being made in Beijing, Shanghai or Tokyo". The Chinese government has limited patience for the essentially unserious attitude of some American politicians.


The Reserve Bank of Australia raised it cash rate 0.25% to 6.5%, an 11 year high. The Australian dollar peaked at 0.8660 and then fell relentlessly to 0.8400 on Friday in the wake of the credit market induced carry trade restructuring.

Economic Releases August 6 - August 10

With most of the industrial world on summer vacation it was a very sparse week for statistics.

United States

Tuesday: the preliminary Non Farm Productivity result for the second quarter rose less than expected at 1.8%; 2.1% had been predicted. In the first quarter productivity rose 1.0%. Unit Labor Costs (ULC), one of the Federal Reserve's bell weather statistics rose 2.1% in the second quarter besting expectations of 1.6%, and also the result from the first quarter, 1.8%. The year on year number is now at 4.5% in quarter 2, more than 20% higher than the 3.1% rise in quarter 1. It is the fastest sustained increase in ULC since the third quarter of 2000.


No important statistical releases.


Monday: Total Manufacturing Orders for June were much stronger than expected, 4.6% against the pre release estimate of -0.8%. The May result was revised down to 3.0% from 3.2%

Tuesday: June Industrial Output dropped unexpectedly 0.4%; an increase of 0.5% had been predicted. In May output was 1.9% higher.

United Kingdom

Monday: June Manufacturing Output rose 0.2% and registered a 0.9% increase in the year on year or elapsed measure, very similar to the May figures of +0.2 and +1.0%. Industrial Production gained 0.1% in June, adding 0.8% in the elapsed year, the same as the results for May. The British Retail Consortium (BRC) reported a 1.2% rise in Retail Sales (like for like) in July, year on year a substantial drop from the June reading of +2.2%. 


Wednesday: June Machinery Orders fell 10.4% much worse than the forecast drop of 1.1%. In May the orders rose 5.9%.


Friday: the trade surplus for July was the second highest on record $24.4 billion and slightly lower than the June record of $26.9 billion. Exports grew at a 34.2% pace over a year ago; imports increased at 26.9%.

The Week Ahead August 13 - August 17

United States

Monday: Retail Sales for July at 8:30 am ET. The forecast is +0.2%; the July issue was -0.9%. Retail Sales ex Motor Vehicle for July at 8:30 am ET. The forecast is +0.3%; the July result was -0.4%.

Tuesday: International Trade Balance for June at 8:30am ET. The June deault was -$60.0 billion.

Wednesday: Consumer Price Index for July at 8:30 am ET. The forecast is for a 0.1% rise; the prior month was +0.2%. The core Consumer Price Index (ex Food & Energy) for July at 8:30 am ET. The forecast is +0.2%. The July result was +0.2%. Treasury International Capital System Report for June at 9:00 am ET. The June figure was $126.1 billion in net purchases. Industrial Production for July at 9:15 am ET. The forecast is +0.3%. Prior release for June was +0.5%. Capacity Utilization for July at 9:15 am ET. The forecast is 81.8%. The July number was 81.7%. Housing Market Index (NAHB) for August at 1:00 pm ET. The July figure was 24, a cycle low.

Thursday: Housing Starts for July at 8:30 am ET. The July number was 1.467 million units. Building Permits for July at 8:30 am ET. The July number was 1.413 million units.

Friday: the preliminary University of Michigan Consumer Sentiment for August at 10:00 am ET. The August result was 90.4.


Tuesday: GDP (flash estimate q/q) for July at 9:00 am GMT. Median expectation is 0.5%; the July result was 0.6%. GDP (flash estimate y/y) for July at 9:00 am GMT. The July issue was 3.1% and the forecast is 2.8%. Industrial Production (m/m) for June at 9:00 am GMT. The June issue was 0.9%. The forecast is -0.1%. Industrial Production (y/y) for June at 9:00 am GMT. The June result was 2.5%. The median forecast is 2.4%.

Thursday: Final HICP (m/m) for July at 9:00 am GMT. The prior release for July was 0.1%. The forecast is -0.2%. Final HICP (y/y) for July at 9:00 am GMT. Prior month was 1.9% and median forecast is 1.8%.


Tuesday: Flash GDP (SA q/q) for July at 6:00 am GMT. The July result was 0.5% and the expectation is 0.4%.

Thursday: Final CPI (%mom/yoy) for July at 6:00 am GMT. The forecast is 0.4/1.9. The prior result was 0.1/1.8. Final HICP (%mom/yoy) for July at 6:00 am GMT. The July issue was 0.1/2.0. The median forecast is 0.5/2.0.

United Kingdom

Monday: DCLG House Price Index (%yoy) for June at 8:30 am GMT. The June issue was 10.9. RICS House Price Survey % (prices balance sa) for July at 23:01 GMT. The prior release was 10.6.

Tuesday: Core CPI (%yoy) for July at 8:30 am GMT. The July result was 2.0 and the expectation is 2.2. CPI (HICP %yoy/mom) for July at 8:30 am GMT. The July result was 0.2/2.4 and the forecast is -0.2/2.3.

Wednesday: BOE publishes the minutes of the August Monetary Policy Committee meeting at 8:30 am GMT. ILO Unemployment Rate for June at 8:30 am GMT. The prior release was 5.4%.

Thursday: Retail Sales (%mom/yoy) for July at 8:30 am GMT. The forecast is 0.0/3.3, prior 0.2/3.4.


Monday: CPI (% y/y, % ytd y/y) for July (no time indicated). The July issue was +4.4/+3.2. Actual Foreign Direct Investment (% ytd y/y. for July (release date undetermined). The prior result was +21.9/+12.17.

Tuesday: Retail Sales (% y/y, % ytd y/y) for July prior was +16.0/+15.4.

Wednesday: Industrial Output ((% y/y, % ytd y/y) for July. The result for July was +19.4/+18.5.

Thursday: Fixed-Asset Invest (y/y) for July. The prior number was +26.7%.


Monday: Preliminary GDP for April-June at 8:50 JST (23:50 GMT). Previous result was +0.8%.

Friday: Revised Leading Index for June 14:00 JST (5:00 GMT). June issue was 40.9.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]


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