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Monday November 12, 2007 - 01:21:28 GMT
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Market Directions Sunday, November 11, 2007

After two successive rate cuts the currency markets will only anticipate more of the same from the Federal Reserve. Mr. Bernanke and the Fed Govenors can imply a neutral or tightening bias all they want. They can cite inflation and the potential for future inflation, they can quote the equal balancing of risk between inflation and growth; but in the end, traders will not now price anything but further rate cuts. Currency futures on Friday were, once again, almost unanimous in predicting a 25 basis point reduction in the Fed Funds rate at the December 11th FOMC meeting.

The European Central Bank rate policy is described equally well by their actions, not by their rhetoric. Jean Claude Trichet can recount the inflationary potential of rising oil prices and rehearse the paramount central bank task of ensuring price stability, but in the end the market will not price anything but an extended stay at 4.00%. No matter what the provocation from inflation, it is very difficult to see the ECB governing board raising rates in the near future. Gathering information is as good a public rationale as any.

Both Mervyn King, the head of the Bank of England (BOE), and Jean Claude Trichet, head of the European Central Bank (ECB) do not seem to believe that the economic storms brewing in the new world will reach the old. Or barring that, they have yet more time to contemplate the economic signs before acting. If the United States sinks to recession it is hard to think how the European Monetary Union (EMU) would be unaffected; that has been past history. Perhaps Mr. Trichet and Mr. King are implying their confidence in the US economy and its ability to avoid recession when they stand pat on rates.

Actual economic conditions are the Fed’s stated determinant for policy decisions. But the markets cannot see into the current economic picture anything but problems. Even if all the America news is not bad, and there are some positive influences. Jobs for one remain relatively plentiful and consumer spending has not fallen appreciably. The markets will not change their overall view of the Dollar without real positive developments. Without an end to the dismal news from housing, a stabilization in the equities and a completion of the asset-backed write-downs in the financial sector, the fear of recession will not abate nor will the Dollar recover. Sooner or later, the logic goes, foreclosures, the general drop in housing wealth, and now the dramatic retreat in the equities will force consumers to cut back on spending and then the down cycle leading to recession begins. So far, it should be remembered, this has not happened.

Markets may have short attention spans, but they also have exaggerated focus. Right now the focus is on the negative aspects of the US economy and the Dollar. The continual drumbeat reminds the markets only of the US economic woes and Dollar risk, adding market expectation for more Fed rate reductions to the actual pressure of economic events

The ECB is caught in a defile between inflation risks and sliding economic growth. Record oil prices exacerbate concerns on the inflation side which were already elevated due to the latest 2.6% HICP (Harmonized Index of Consumer Prices) figure. On the economic side the preliminary performance figures from the EMU itself and the now widely expected US economic slowdown and its contagion effects, offer abundant cause for worry. When combined with the as yet unresolved financial sector and credit market problems, the potential for economic damage approaches certainty

The policy predicament is essentially the same for the US Federal Reserve, the European EC and the British Bank of England, though the economic curve is more advanced in the US. The Fed sees more economic risk, or is more willing to do something abut the growth risk, which amount to the same thing, and the ECB sees more inflation risk, and is more willing to do something about that—refuse to cut rates, that is. The BOE is somewhere in the middle Mr. Bernanke’s “delicate balance” of growth and inflation is an apt descriptive for the uncomfortable position of all three central bank policies.

Oil prices, bank and mortgage industry asset write downs and the once and future housing crisis make a positive world economic view hazardous. But perhaps it is the prospect of a genuine Dollar crisis, where the world’s investors abandon the US currency and the tremendous strains that would impose on the world’s financial system that is the real fear lurking in the minds of traders as they contemplate their currency graphs and the slope of the Dollar’s decline. A genuine Dollar crisis would cause severe financial and economic dislocation, perhaps even more than could be handled by the world’s central bankers. Will such visions stop traders from selling the dollar? No. On the contrary such visions could provide great additional leverage, psychological leverage, against the dollar. A dollar contrarian is an extremely endangered species.

Central Banks

The Reserve Bank of Australia hikes  the cash rate 0.25% to 6.75% as expected, citing consumer demand, high capacity utilization and inflation challenges. The central bank view is that “the tightening in global credit conditions …has been less pronounced [in Australia] than elsewhere”.

The European Central Bank holds it main rate at 4.00%; the Bank of England does the same at 5.75%. Both decisions were expected.

The Week in Review November 5 – November 9

United States

Quarter two GDP was 3.8%; quarter three was 3.9% with a potential bump to 4.9% or higher when the preliminary (2nd issue) numbers are out November 29th. Even if, as Mr. Bernanke said in his testimony before Congress on Thursday, the economy slows ‘noticeably’ in the fourth quarter, what would that decline entail, growth at 2.5%, or 2.0%? Such quarter to quarter shifts are not uncommon. The last was on either side of the first quarter this year. If fourth quarter GDP is 2.0%, less than half the likely rate of the third quarter, the US economy would still have grown 2.6% for the year. A similar scenario in the EMU would leave GDP at 2.36%.

The ISM non manufacturing numbers do not point to a slowdown in the services sector at the beginning of the fourth quarter. The long term average of this series is 57.7 and the 55.8 reading in October, up from 54.8 a month earlier, remains moderately expansive. And, perhaps surprisingly, the services sector seems largely free of contagion from the housing collapse and the financial market credit crunch. “When you take away a few industries, most notably financial services and real estate, business is pretty good out there”, said Anthony Nieves, head of the Institute for Supply Management (ISM) non-manufacturing survey committee. Wholesale inventories could add a much as 1.0% to third quarter GDP, which would boost the preliminary number issued on November 29th (2nd release) to 4.9% from 3.9%, the strongest quarter since the beginning of 2006 recorded 4.8%. The estimates for additions to inventories in August and September which were included in the advanced GDP number issued on October 31st were much lower than the actual +0.7% and +0.8%. In addition, the increase in US exports represented by the much lower than forecast International Trade Balance, -$56.5 billion, will boost the ‘preliminary’ GDP statistic as well. Estimates currently range as high as 5.2% for the quarter.

Consumer sentiment collected by the University of Michigan plunged in November to 75.0 from 80.9 in October, five points below market estimates. It was the lowest level for this gauge since 1993 excepting the post Hurricane Katrina reading in fall of 2005. This level of sentiment is just above what is usually associated with a recession. But recessionary sentiment numbers are normally seconded by rising jobless claims which is not true currently.


“A hump” is how Jean Claude Trichet, head of the ECB, described near term EMU inflation prospects. He did not discuss the dimensions of the hill but all 'hills' have two sides and the far side is a down slope.

The Services Purchasing Managers Index (PMI) at 55.8 gave ECB officials some hope that the united economy may move fast enough to keep them from having to cut rates in the face of looming inflation. The services sector is not as dominate in Europe as it is in the States but the PMI was cited as a positive result by EU government representatives. However, September’s Industrial PPI, higher than predicted in both the monthly and yearly reading, and Retail Trade, less than half the expected increase, added to the string of economic figures pointing precisely at the ECB’s chief worries, inflation and slipping economic growth.

Economic Releases November 5 – November 9

United States

Monday: the Institute for Supply Management (ISM) non manufacturing Index was 55.8 in October higher than the median forecast of 54.0 and also better than September's 54.8 result. New orders was healthy as 55.7 over September's 53.4; employment dropped slightly to 51.8 from 52.7. According to Anthony Nieves, the head of the ISM non manufacturing survey, the service sector is not overly affected by the problems in the housing and credit areas. Firms in the mortgage banking and real estate sectors are recording difficulties but aside from that, “companies are doing good business at this time”, he said in an interview with Market News International. Export orders were a particular strong point rising to 56 in October from 50 in the prior month.

Wednesday: Wholesale inventories rose 0.8% in September; Augusts’ numbers was revised to +0.7 from +0.1, implying much more production than anticipated in the last two months of the third quarter.

Non farm productivity improved at a 4.9% annual rate in the third quarter far superior to the 3.2% expected and more than double the 2.2% rate in the second quarter. It was the strongest addition to productivity since the third quarter of 2003 when it was +10.4%. Output growth rose to 4.3% but hours worked fell 0.5%, hence the rise in productivity as labor costs are the largest component in most production. Unit labor costs (ULC) in the third quarter fell 0.2%, well off the anticipated 1.0% increase. In the second quarter ULC had gained 2.2%; productivity is now 4.3% higher than it was a year ago. There is little or no wage inflation in these numbers.

Friday: International Trade Balance for September came in at $56.5 billion $2 billion less than the general forecast. The August deficit was adjusted lower to $56.8 billion from $57.6 billion. The timing of oil prices, since September they have moved steadily higher, will add about $10 billion to the deficit over the next three months. Exports without oil rose 1.1% in the month led by food exports and are 13.6% higher on the year. Exports will supply further strength to the GDP revision now expected to be at 4.9% or higher in the third quarter.

The University of Michigan Consumer Sentiment Index fell to 75.0 in November, 80.0 was the median prediction. The October result was 80.9.


Tuesday: the October Purchasing Managers Index (PMI) services moved up 0.2 to 55.8 in the final report. It represented a weak recovery over September’s 54.2.

Retails Trade (sale) for September was a major disappointment coming in at +0.3% monthly and +1.6% year to year; +0.7% and +2.2% had been predicted. August had been lackluster as well at +0.1% and +1.0% respectively.

The industrial producer price index (PPI) for September gained 0.4% on a month or 2.7% over a year earlier. Vaulting energy prices were blamed for the increase; +0.3% and +2.6% had been predicted. Though not one of the headline ECB inflation statistics, the upward pressure energy products place on CPI is one of the reasons behind the ECB’s hesitation on rates.


Tuesday: October services PMI registered 55.1; September was 53.1.

Wednesday: Industrial output rose more than expected 0.3% in September, a 6.0% annual rate; -0.5% monthly and +5.2% annually had been predicted. The August figure was moved up to +1.9% from +1.7%.

United Kingdom

Monday: Monthly manufacturing output receded 0.6 in September, far below the predicted 0.1% growth. It was the largest manufacturing decline in seven months and along with the 0.4% fall in industrial production, these drops in economic activity could reduce third quarter GDP activity to +0.7% from +0.8% in  the second quarter. Industrial production had been expected to expand 0.2% in September.

The CIPS services index registered 53.1 in October, the lowest since May 2003, and much less than September’s 56.7.

Wednesday: Nationwide consumer confidence fell to 98 in October; 97 had been expected, the September reading was 99.


Tuesday: the Preliminary leading index dropped to 0 in September from 27.3 in August; but the coincident index at 66.7 remained indicative of moderate expansion, though down from 83.5 in August. These indices predict a slowing economy three to six months in the future when the result is below 50 and improving economic conditions when above 50. Opinion is divided whether the divergence of these two indicators presages recession in the second or third quarter of 2007. The last time the leading index was at zero in 1997 a recession did follow but at that time, tellingly, the coincident index was at zero as well.

Friday: September industrial production came in at -1.4%, after production had bounced +3.5% in August

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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