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Market Directions - Sunday, August 19, 2007

Market Directions - Sunday, August 19, 2007

  • The American Federal Reserve addresses the psychology of the credit markets by cutting the little used 'discount rate' and US equities rise 233 points
  • Yen carry trade R.I.P.
  • Rate cut speculation returns to the Fed, the ECB and perhaps the BOE

The Week in Review August 13 - August 17

United States

Ben Bernanke and the Federal Reserve have illustrated the limitation of words in moving panicked markets and the effectiveness of surprise. By cutting the little used 'discount rate' a move wholly unexpected by the markets, the Fed demonstrated its concern far more emphatically than any number of reassuring phrases about standing ready to 'ensure liquidity' and 'smoothly functioning markets' could have. The 'discount window' is the Federal Reserve lending facility where banks can borrow funds from the Fed at 1 percentage point or 100 basis points above the primary US rate, the Fed Funds rate, now at 5.25%. It is so little used by the banks that its doings are barely reported. Nevertheless this is the rate that the Fed chose to cut in half; actually it cut the 'discount premium' over the Fed Funds rate in half from 100 to 50 basis points, dropping the rate at the 'window' to 5.75%. The Fed also extended the term of the borrowing; it is now renewable up to 30 days at the borrower's discretion.

This action is symbolic but not wholly so. The Fed has been supplying liquidity to the market since Friday last week in what are called open market operations. These operations function through a circle of 'primary dealers', large money center bank that are the intermediaries for the Fed actions. There are many mid level and smaller banks that do not have direct access to these liquidity operations, they must access the money markets themselves where banks charge the prevailing rate not necessarily the lower Federal Reserve rate. It is no doubt hoped by the Fed that many of these institutions will avail themselves of the 'discount window for their liquidity needs and thus the widening circle of stifled liquidity will ease.

The problems that have extended out from the initial sub prime mortgage situation are at base problems of trust, the trust of one bank for another. Banks that require funding for their balance sheets overnight normally borrow from other banks in the 'overnight market'. But because many banks have become unsure of the credit status of some of the securitized instruments on their own books, some of which may contain sub prime loans, or because there are unsure of the credit status of their own loan customers, hedge funds, private equity firms, corporations and others, and for the same reason, they have become reluctant to lend their excess cash to the market preferring to keep it as a hedge against an unknown future. Banks and other firms that need overnight cash have been hard put to find affordable funding. If the banks and firms that need funding cannot find it they may be forced to sell assets to obtain the cash. Nothing is more dangerous to an already weakened market than fire sale offerings to raise daily cash. It is one sure way for a correction to turn into a dangerous crash. This is the development the Fed and the world's other central banks are striving to avoid by supplying liquidity to the banking system.

The Fed has attempted to call the market to its senses by Friday's unusual actions. The discount rate cut is aimed directly at the panicky psychology that had gained so much momentum as the week progressed. The goal and the hope is to give the banks and other holders of questionable debt and securities time to figure out exactly what they hold and what it is worth. It is likely that given the time and space for analysis the banks will find that the threat to their balance sheets from sub prime mortgages and their packaging is far less than feared and that an orderly or at least semi orderly return to the lending markets will follow. The operational effect of the rate cut is almost purely psychological. For a non-trader, and now I am speaking as a former bank FX trader, Mr. Bernanke has an instinctive grasp of the psychology and the occasional herd mentality and sheer panic that can overtake any market. It is my guess that Mr. Bernanke would have made a very fine trader. If the markets resume normal operation shortly this 'discount intervention' will become the grist of market legend.

Friday's cut in the discount rate has, in the market view, also brought the chance of a decrease in the Fed Funds rate at the September 18th FOMC meeting much closer. The futures are currently pricing in three cuts before the end of the year. The risk for the Fed is that the anticipation of a reduction will be priced into market expectations and to disappoint those expectations will be risky. In the next four weeks Mr. Bernanke and his governors will have to manage those expectations very carefully.

The second issue of the 2nd quarter GDP number is due August 30th. The initial release is called the 'advance', for the 2nd quarter GDP that was on July 27th, and it was 3.4%. The first revision (and second release) is called the 'preliminary' and will be out as above on August 30th. The third revision is the 'final' and it will be issued on September 27th. The June International Trade Balance, at -$58.1 billion was almost 5% below the median consensus. Exports expanded, imports fell and the resulting underestimated economic activity could add 0.5% or more to the 2nd quarter GDP.


One of the longest running shows in FX history has come crashing to a close. The volatility shy Yen carry trade led by the Euro/Yen has collapsed. The Euro/Yen itself has fallen almost 12% since the July 22 peak at 169.10. Several factors have driven the Yen crosses, all off by similar or greater amounts, but profit taking was the most prominent. The interest rate differential between the Yen and its trading partners has shrunk as the credit markets have priced in the greater likelihood of a ECB rate pause but in these currencies which have risen 30% or more since June of 2005, it was the stop loss sellers compounded by eager short sellers that wrote the demise of the carry trade.

The pressure of cross trade selling, the fear of financial and macro contagion from the sub prime mess and growing concern that the ECB may delay or derail the September rate increase and forego subsequent hikes, all took their turn pummeling the Euro. The ECB and Jean Claude Trichet, the bank president, are caught in a bind and they have only three weeks to figure out their response. If the central bank does not hike the expected 0.25% on September 6th, or if it drops rates before the next meeting, European businessmen and politicians who have long been calling for an end to the ECB rate hike will be assuaged. But such an action risks reigniting credit market fears. What else does the ECB know? At the current juncture it is very unlikely that ECB will take any rate actions before the scheduled meeting, but if the equity and credit problems do not subside or if they worsen then fear will take second seat to market performance.

The preliminary (flash) GDP numbers for the second quarter exhibited less than half the growth in the first quarter, +0.3 vs. +0.7, less than the forecast of +0.5%, and one-third of the rate in the fourth quarter of 2006 when the European Monetary Union's (EMU) economy expanded 0.9%. The year to year number for the second quarter under performed as well coming in at +2.5% on expectations of +2.8%. In the first quarter the economy had expanded at +3.1%.

More worryingly these number give a picture of an expansion that peaked in the fourth quarter of 2006 at 3.3% and has declined each quarter thereafter, to +3.1% in the first quarter of 2007, now, to 2.5% in the second. Although it may not seem ominous this is almost a 24% drop in six months. The primary cause was the lack of growth in private consumption and that has occurred despite employment gains, the unemployment rate has fallen from 7.3% in January to 6.9% in June.


The domestic economy continued to accelerate in July, inflation, retail sales and industrial production all shot ahead of their June levels and foreign direct investment added further fuel to the Chinese hearth. Though much of the inflation was engineered by large increases in food costs there is no comfort in these statistics for China's economic planners. After a long string of rate increases, reserve requirement adjustments and a steady, albeit slow revaluation of the Yuan, the cumulative effects on the Chinese economy are largely negligible. One of the differences between the Chinese economy which in many ways and especially in the financial sector, is still a developing country, and the developed world is that in China there few alternative outlets for the domestic investor. If a corporation or individual has excess funds there are limited options for investment. One can buy goods or for corporations, invest in assets. The first produces inflation and the second boosts industrial output. In China, where the inflation rate is higher than the interest rate on saving accounts the real return on savings is negative. Your funds shrink in a bank account. The stock market is small, participation is not widespread and financial knowledge is limited. There are almost no investment firms for the domestic Chinese investor and few mutual funds or the like to aggregate small investors or place money in foreign investments. In short the Chinese economy is a structure without meaningful financial diversity.

The July monthly inflation reached its highest in over a decade at 5.6% but officially there was no loss of equanimity. In a comment that would do their more experienced western counterparts proud, a report in the China Securities Journal published by the State Information Center an organization known to have close ties to the Beijing Government, said that CPI will rise in coming months but will not "get out of control" and that it is still around the acceptable upper limit of 5% annually. While there is as yet no widespread demand driven pressure on prices further rate increases and Yuan appreciation by the Peoples Bank of China are near certainties.


The victorious AKP party of Prime Minister Recep Erdogan renominated Abdullah Gul to the Turkish presidency. It was the nomination of this same Mr. Gul several months ago that precipitated the election after the Turkish Military very publicly objected. The conflict between the military who see themselves as the guardians of the rigidly secular Turkish state created by Kemal Ataturk after the collapse of the Ottoman Empire in the First World War and the AKP is over what seems to an outside to be a small item. Mr. Gul's wife wears the headscarf of an observant Muslim women. But in Turkey that the wife of the president would wear the headscarf is highly symbolic. The Turkish presidency has considerable powers and is viewed by the military and many secularists as a guardian of Turkey's secular constitution. Popular enthusiasm for EU membership is at low ebb in Turkey and without the distraction of the recent financial events in Europe no doubt Mr. Gul's nomination would have marked much greater Western European notice. But be sure, if confirmed by the Turkish Parliament, it is another blow to EU membership.

Economic Releases August 13 - August 17

United States

Monday: Retail Sales for July were slightly better than expected, +0.3% on the monthly number against the 0.2% forecast; with car sales excluded (ex auto) the number was +0.4% versus the +0.3% prediction. The May and June numbers for both categories were revised higher as well, for the general result in May to +1.6% from +1.5% and to +1.7% from +1.6% for the ex auto figure. In June the new numbers were -0.7% from -0.9% general and -0.2% from -0.4% for the ex auto.

Tuesday: the June Trade balance shrank to -$58.1 billion well off the -$61.0 billion forecast and less than the May revised number which was lowered to -$59.2 billion from -$60.0 billion. Exports were $134.5 billion and imports $192.7. The Produce Price Index (PPI) grew 0.6% in June, only +0.1% had been forecast; the year to year rate was 4.0%. The core statistic was +0.1 on expectations of +0.2 with a year to year figure at 2.3%.

Wednesday: Consumer Price Index for July came in as expected at +0.1% with the core reading at +0.2%. Core excludes food and energy prices and energy price fell 1.0% in the month with gasoline falling 1.7%, depressing the overall numbers but not the core figure. The core rate held steady at 2.2% where it has been since May. Net long term purchases of US securities the so called TICS number (Treasury International Capital System) recorded an inflow of $120.9 billion in June. Foreign purchases were $148.6 billion, $53.8 billion from government sources and $94.8 from private origins. US residents bought $27.8 billion in overseas markets. Industrial Production expanded 0.3% in July as forecast; the June issue was revised up to 0.6% from 0.5%. Capacity Utilization for July was 81.9% slightly ahead of expectations, 81.8%. It remains above the average of the years 1972-2006 but below the rate of inflationary concern. The National Association of Home builders (NAHB) Index for August recorded at 22, the lowest since 1991. In the understated terms of the notice accompanying the release, "highly visible problems in the housing finance system are contributing to wait and see attitude among prospective buyers and reducing builder's confidence in the single family housing market".

Thursday: Housing starts sank 6.1% to their lowest level since 1991 at 1.381 million units in July. Building permits fell 2.8% to 1.373 million units, the smallest number in over a decade.

Friday: the University of Michigan Consumer Sentiment reading for August was 83.3, much less than expected and more than 7 point lower than July, no doubt dragged down by the turmoil in the mortgage and financial markets.


Tuesday: industrial Output for June was down 0.1% and up 2.3% on an annual basis as expected. The May level was revised up to 1.0% form +0.9% monthly and to +2.6% form +2.5% annually.

Thursday: the July final Harmonized Index of Consumer Prices (HICP) was unchanged at -0.2% monthly and +1.8% yearly leaving it for the eleventh month in a row below the ECB 2.0% target.


Monday: wholesale prices for July topped the increase in June +0.4% monthly and 2.6% annualized against +0.1% and +1.9% in the prior month.

Tuesday: the first or 'flash' release of GDP for the second quarter showed expansion of 0.3% for the period; +0.4% had been predicted. In the first quarter the economy grew 0.5%. As with the EMU growth rate, the German has shown a steady decline since the 4th quarter rate of 3.9%; in the 1st quarter it was 3.6% and in the 2nd 2.5%.

Thursday: the July HICP figure for July was unrevised as forecast at +0.5% monthly and +2.0% annualized. The CPI number was also unadjusted in its final release at +0.4% monthly and +1.9% yearly.

United Kingdom

Monday: the Department of Communities and Local Government (DCLG) June house price index gained 12.1% but the BOE concern at this increase over the May 10.9% rate will probably be subsumed by the money market, credit and equity problems of the past week.

Tuesday: CPI (HICP) fell in July 0.6%, and was up 1.9% for the year. This was considerably less than the forecasts of -0.2% and +2.3% respectively. Whatever

Wednesday: The International Labor Organization s (ILO) unemployment rate was unchanged in July at 5.4%.

Thursday: Retail Sales rose 0.7% in July and 4.4% on the year, much stronger than the consensus expectation of a flat monthly rate and +3.3% for the year. The June result was doubled to +0.4% from +0.2%.


Monday: preliminary GDP for the second quarter was +0.1%, not far from the consensus expectation of +0.2%. But the annualized rate was only +0.5%, barely half the median forecast of +0.9%. This is a large fall from the first three months of the year when quarterly growth was +0.8%, a 3.2% annual clip.


Monday: Consumer Price Index (CPI) for July rose 5.6% on an annual basis, far ahead of the predicted 4.6% and the June result of 4.4%. Once again the rise was driven by food costs up 15.4% on a year on year base in July. Supply shortages, particularly of pork (prices up 59.8% annualized), but the shortages should continue for several months and with them the pressure on food prices. Non food CPI was only 0.9% annualized in July and lower than June's 1.0%.

Tuesday: Retail Sales for July leaped ahead at 16.4% compared to a year ago, the fastest pace of increase in over three years; the June boost had been 16.0%.

The Week Ahead August 20 - August 24

United States

Friday: Durable Goods Orders for July at 8:30 am ET. Expected +1.0%, June +1.3%. New Home Sales for July at 10:00 am ET. Expected 820,000, June 843,000.


Wednesday: Industrial New Orders for June (m/m) at 9:00 GMT. Expected +2.0%, May +1.7%; Industrial New Orders (y/y) for June at 9:00 GMT. Expected +12.3%, May +9.1%.

Friday: the preliminary Reuters Manufacturing Survey (PMI) for August at 8:00 GMT. Expected 54.5, July 54.9. Reuters preliminary Services Index for August at 8:00 GMT. Expected 57.9, July 58.3.


Tuesday: ZEW economic expectations for August at 9:00 GMT. Expected -0.5, July +10.4. ZEW current conditions for August at 9:00 GMT. Expected 84.5, July 88.2.

Thursday: GDP seasonally adjusted (q/q) for the second quarter at 6:00 GMT. Expected +0.3%, quarter 1 +0.5%. GDP (WDA) for the second quarter at 6:00 GMT. Expected +2.5%, quarter 1 +3.6%.

United Kingdom

Sunday: 19-Aug 23:01 Rightmove House Prices (m/m, y/y) for August at 23:01 GMT. July +0.3 (m/m) +10.3 (y/y)

Friday: GDP (2nd release) for the second quarter at 8:30 GMT. Expected +0.8% (q/q), +3.0% (y/y), first quarter +0.8% (q/q), +3.0% (y/y).


No important statistical releases.


Wednesday: Trade Balance for July at 23:50 GMT. June +53.4%.

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