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Monday November 26, 2007 - 06:06:23 GMT
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Market Directions Sunday, November 25, 2007

Several major currencies have retreated from their early November peak against the US dollar. The British Pound topped out on November 9th, the Australian, New Zealand and Canadian Dollars on November 7th. All of the speculative Yen crosses are dramatically lower. Only the Euro and the Swiss Franc linger near their highest levels against the US Dollar. The Euro ascent to record on Friday took place in extremely thin Asian trading. Japan and the prior US market were both closed for holidays. And as is usual in such conditions, stops drove the market with little or no hindrance from normal liquidity. More telling than the upside run was the market’s reaction to a comment from the Governor of the Bank of Spain Miguel Ordonez. He said that the sees a stronger than expected slowdown in the Eurozone. Within 90 minutes the Euro had fallen more than a figure and a half against the Usd.

The currency markets are entering the least liquid trading month of the year. For many of the large players it is also the end of their accounting year. The Euro is at the end of a long and explosive rally; it is ripe for profit. The market reaction to Mr. Ordonez’s comment illustrates the vulnerability of the underlying assumptions that have bolstered the Euro since August: that the EMU will not be buffeted by the winds of economic slowdown and perhaps recession that are beginning to blow through the US economy, that European economies will remain insulated from any serious economic fallout from the continuing financial and credit market problems and finally that the EMU economies will only benefit from the strong Euro.

If the assumptions are all true then the ECB will not have to take out a rate insurance policy against its immediate economic future. Is that an overly optimistic view, does it jibe with the facts and with history? In the worldwide financial, commodity and consumer markets demand is driven by the sum of national markets. American and European consumers pay more for gasoline because demand is rising in new markets in India and China and consumer demand in the US fuels the manufacturing and service economies in both countries. The relationship is no less reciprocal between the States and Europe. If the US economy slows appreciably the ripple effects will cross both oceans. Rather than an isolated EMU economy unscathed by a US decline, a far more plausible scenario is that the more US growth slows, and the longer restricted credit and a strong Euro last, the less likely the Europeans will be able to escape their measure of economic pain. The world of the strong Euro is not as secure as it seems.

The Week in Review November 19 - 24

United States

The minutes of the Federal Reserve Open Market committee (FOMC) meeting of October 30-31 when the committee voted 9-1 to ease the Fed Funds target rate by 0.25% showed considerable discussion of the state of the economy. The balanced economic and inflation risk portrayed in the FOMC statement of the 31st was overshadowed by the emphasis in the meeting on the parlous state of the economy. If the Fed had hoped to remove some of the certainty the market attaches to a rate cut on December 11th by the release of the minutes it has failed. After the release the Euro shot up to what was then a new high against the Dollar. The new Fed central projections for 2008, updated since the last issuance in June, added to the Dollar’s needy state. Real GDP growth projections were lowered to 1.8% to 2.5% from 2.5% to 2.75%, inflation projections were reduced and “financial markets [were still viewed] as fragile and [susceptible] to an adverse shock such as a sharp deterioration in credit quality or the disclosure of an unusually large and unanticipated loss [that] could further dent investor confidence and significantly increase the downside risks to the economy”.

The key to market perception of future Fed policy is the actions they have already taken. Even though the FOMC minutes contained numerous statements as the following: “Participants viewed the downside risks to growth as somewhat smaller that at the time of the September meeting, but those risks were still seen as significant”; and that “Financial market functioning was judged to have improved somewhat…”, the impression left by the discussions amongst the committee members was that the Fed will reduce rates again if the economic conditions warrant. The committee will have to look no farther than their own detailing of the current economic risks to justify a 0.25% reduction in December. The market will credit action over rhetoric every time and the futures have priced the chance of at rate cut in December at 80%. The calculus is simple. The potential risks involved in not easing are considerably greater than the risks attendant upon another cut. A rate cut is easier to retract and is not likely to change the long term inflationary expectations in the economy, while delaying a rate cut could tip the economy into recession. With the housing and financial sectors already in severe contraction the potential for a reinforcing economic downturn as job losses curtail consumer spending which further inhibits production and jobs is not a risk the Fed may want to take. The FOMC has shown no affinity for monetary theory over economic practice. Clearly Mr. Bernanke and his colleagues would rather take a few inflationary notches out of an expanding economy than pumping up a collapsing one. If the Fed has made two rate withdrawals so far, the market cannot see why it will not go to the bank at least once more.

Eurozone

Jean Claude Trichet, the head of the ECB, is not happy with the currency markets but unless he changes his script his comments will have no more effect on the Euro level than they did this week. He repeated his view that the ECB does not welcome “brutal “ currency moves, that abrupt FX gyrations do not favor growth and that US officials say they support a strong dollar. There was nothing new here. European statistics in construction, industrial new orders and purchasing managers indices indicate an economy with substantially more to worry about than expected; these statistics will have more effect on the Euro than a month’s worth of central bank rhetoric.

Germany

Peer Steinbrueck the Finance minister said there was currently no need to worry about the Euro trading rate. His view is optimistic. He cited two main points about the German economy. First, he stated that more than 40% of German exports are to the Eurozone and unaffected by the external Euro exchange rate. While that is strictly true, the 60% of exports that are external to the EMU are the high value items that drive corporate profits and all exports will be affected if Germany loses ground in non EMU exports. Second is that a strong Euro forces German firms to become more efficient and that is a benefit for the entire economy. And though that is also true, the adjustment period brought on by a strong currency is long and often costly in jobs. The German economy is highly unionized and inflexible, the idea that an expensive Euro will spur productivity without social and political costs is naive. High value German goods have many competitors throughout the world.

United Kingdom

Bank of England (BOE) minutes for the November meeting revealed a 7-2 vote to keep rate unchanged, as opposed to the 8-1 vote that had been expected. The case for a rate reduction in the first quarter next year was strengthened slightly but only slightly. As with the FOMC meeting there seems to have been substantial discussion of the state of the economy. The November report projected inflation to remain above the 2.0% BOE target through the second quarter of 2009 under the current market assumptions of two 25 basis point rate cuts. This prediction helps to explain why the Monetary Policy Committee (MPC) did not ease rates earlier this month. The committee seems to have a bias towards cutting rates as most discussion was about when to cut rates not whether to cut rates at all. But members said they wanted more evidence of economic slowing before acting.

China

The People’s Bank of China (PBOC) is the latest official fan of the US dollar. At the G-20 meeting in Cape Town South Africa Central Bank President Zhou Xiaochuan joined previous bank representatives in distancing the central bank’s policy from remarks last month by a non bank Chinese official who had suggested that China should diversify its currency reserves out of US Dollars. That view does not necessarily reflect the view of the PBOC. “The People’s Bank has its own analysis”, he said, “We support a strong dollar”. It is hard to find a central banker who doesn’t back a strong Dollar. The G20 is a group of 19 of the world's largest economies, plus the European Union whose purpose is to serve as forum for consultation on the international financial system. Mr. Zhou also stated that because of the high liquidity in the Chinese economy the bank will continue to raise reserve requirements and would not rule out further rate increases. “So we don’t think we need to use too frequently the interest rate adjustment but we don’t exclude the possibility”, he said in the best tradition of central bank speak.

Economic Releases November 19 - 24

United States

Tuesday: Housing starts rose 3.0% to 1.229 million in October, something of a surprise in the general gloom in the home construction industry. When combined with the better than expected result and revision in the NAHB index last week is this a tentative sign of stability? But before optimism sets in building permits fell 6.6% to 1.178 in October and they are considered a better gauge of prospects in home construction. The gain in housing starts was due to a large jump in investment type multiple unit properties. Starts of single family homes dropped 7.3%.

Wednesday: the University of Michigan Consumer Sentiment poll gained 1.1 in the final release to 76.1; October was 80.9. This index is more than 21% lower than its January 2007 peak. The economic projections of the Fed govenors and presidents were changed as follows: real GDP growth for 2007 was raised to 2.4 to 2.5 from 2.25 to 2.5%; 2008 was lowered to 1.8% to 2.5% from 2.5% to 2.75%. The unemployment rate for 2007 was raised to 4.7 to 4.8% from 4.5% to 4.75%; 2008 was raised to 4.8 to 4.9% from 4.75%; core PCE inflation for 2007 was reduced to 1.8% to 1.9% from 2.0% to 2.25%; 2008 was lowered to 1.7% to 1.9% from 1.75% to 1.9%. With substantially reduced GDP, higher unemployment and lower inflation the FOMC has the economic specifics in hand should the members feel another rate cut is warranted.

Eurozone

Monday: Construction Production was flat in November and ahead only 1.5% on the year. Augusts’ numbers were revised down to +0.3% monthly and +2.6% yearly from +0.4% and +2.7%. Of the five months prior four were adjusted lower by small amounts, only July exhibited a minor rise. This indicator is composed of two parts, ‘building construction’ and ‘civil engineering’, and the building construction component information only goes back to last year.

Friday: Industrial New Orders fell 1.6% in September, leaving the yearly growth just 2.0% ahead of last year. When combined with the 2.6% drop in July this is the first quarter with two down months since the beginning of 2006. Augusts’ statistic was revised up to +0.8% monthly from +0.3% and to +5.3% from +5.1% yearly. Flash manufacturing PMI for November at 52.6 was slightly better than the 51.0 forecast and the October result of 51.5. However the services sector continued to falter dropping to 53.7 from 55.8 in October. It was the lowest reading for this year.

Germany

Tuesday: the Producer Price Index in October was a bit ahead of expectations at +0.4% for the month and +1.7% year on year; predictions had been +0.3% and +1.6%. August was unrevised at +1.0% yearly. Increases were led, as in the US and elsewhere, by food and oil products.

United Kingdom

Monday: Rightmove House Prices fell 0.7% in November, leaving the elapsed year 7.0% higher. The October results were +2.7% and +10.4%.

Tuesday: Confederation of British Industries (CBI) Industrial Trends Survey rose unexpectedly to +8% in November; October was -6.0%.

Friday: business investment was flat in the third quarter and is now ahead only +4.6% for the year. Growth of +0.5% and +6.0% had been predicted.

The Week Ahead November 26 – 30

United States

Tuesday: Case-Shiller Home Price Index for September at 9:00 ET; August 197.16

Wednesday: Durable Goods Orders for October at 8:30 ET; September -1.7%, ex transport +0.4%. Existing Home Sales for October at 10:00 ET; expected 5.00 million units, September 5.04 million. Federal Reserve Business Survey the ‘Beige Book’.

Thursday: preliminary (1st revision) GDP for the 3rd quarter at 8:30 ET; expected 4.9%, the advanced (initial release) was 3.9%. New Home Sales for October at 10:00 ET; expected 750,000, September 770,000.

Friday: Personal Income for October at 8:30 ET; September +0.4%. Personal Expenditures for October at 8:30 ET; September +0.3%. PCE Core Chain Weight Price Index for October at 8:30 ET; September +0.2%. Chicago Purchasers Index for November at 9:45 ET; October 49.7. Construction Spending for October at 10:00 ET; September +0.3%.

Eurozone

Wednesday: M3 Money Supply for October at 9:00 GMT; expected +11.5% m/m, +11.5% 3 month moving average; September +11.3% m/m, +11.5% moving average. The official ECB target of +8.0% was last satisfied in July 2006.

Friday: Flash (1st issue) HICP y/y for November at 10:00 GMT; expected +2.8%, October +2.6%. EMU economic sentiment index for November at 10:00 GMT; expected 105.0, October 105.9. Third quarter GDP (1st details) at 10:00 GMT; expected +0.7% q/q, +2.6% y/y.

Germany

Tuesday: IFO Survey for November at 9:00 GMT; business sentiment, expected 103.1, October 103.9; current assessment, expected 109.0, October 109.6; business expectations, expected 97.8, October 98.6. Preliminary CPI for November (time not determined); expected +0.1% m/m, +2.6% y/y, October +0.2% m/m, +2.4% y/y. HICP for November (time undetermined); expected +0.1% m/m, +2.9% y/y, October +0.2% m/m, +2.7% y/y.

Wednesday: GfK consumer confidence for December at 7:00 GMT; expected 4.3, November 4.9.

Thursday: ILO unemployment rate for November at 8:55 GMT; expected 8.6%, October 8.7%. Total retail sales for October (time undetermined); September +1.6% m/m, -0.3% y/y.

United Kingdom

Wednesday: Land Registry House Prices for October at 11:00 GMT; September +0.4% m/m, +8.7% y/y. Monday

Thursday: GfK Consumer Confidence for November at 10:30 GMT; October -8.

Japan

Wednesday: Retail Sales for October at 23:50 GMT (prior day); September +0.5%.

Friday: Notional Core CPI for October at 23:30 GMT (prior day); September -0.1% y/y. Central Tokyo core CPI for November at 23:30 GMT (prior day); October 0.0%. Unemployment Rate for October at 23:30 GMT (prior day); September 4.0%. Household Spending for October at 23:30 GMT (prior day); September +3.2%.

China

No statistical releases.

Joseph Trevisani
FX Solutions
Chief Market Analyst

Joe@fxsol.com

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