Pacing the global downturn

The USD should fare better

An aggressive BOE rate cut may support the pound

Key data and events to watch next week

The calendar may have changed, but the global economic environment remains the same--weak and getting weaker. The major data reports in hand so far (US manufacturing ISM and Eurozone manufacturing PMI's) point to further contraction in the US and European manufacturing sectors, typically leading economic indicators. The wave of economic weakness that began in the US is still washing ashore in Europe and rapidly spreading to key Asian economies. Even China, still growing to be sure, saw its Dec. exports fall into negative territory (-2.2% YoY) for the first time this decade, in a sign that the manufacturer to the world is beginning to feel the developed world's pain. We can expect further deterioration in incoming data reports at least through the 1Q 2009, led by poor US and European data.

Additional interest rate cuts are in store for all but the US, which has already cut rates to effectively zero. Next week will hopefully see another aggressive easing by the Bank of England (see below), and Sterling has under pressure in anticipation (many traders are still eyeing parity against the EUR as the next target). In the following week, the ECB looks set to disappoint as Trichet has reverted to his hawkish self. Should the data not convince the ECB to cut again, the market seems poised to punish the EUR on the basis that less aggressive central bank action will lead to a longer and deeper European recession, necessitating additional rate cuts later. The Bank of Canada is likely to cut rates sharply when it meets on January 20, while Australia and NZ will deliver additional rate cuts when they convene in early February and late January, respectively.

The USD should fare better

In FX, the prospects in this dismal environment generally favor the USD, if only because markets have already priced in the US recession, while there appears to be more room for EUR and GBP, in particular, to decline. In other words, it's not a USD-positive story by any stretch, but rather one of UK and Eurozone weakness. The US fiscal stimulus package is still being formulated, but reports suggest it will be massive, and this is inspiring optimism that the outlook may improve sooner in the US than elsewhere. Declines in US mortgage lending rates, which may enable strapped homeowners to refinance and limit the wave of defaults/foreclosures, have also improved the outlook for an eventual stabilization in the housing sector later in the year. US Fed plans to buy $500 bio of agency MBS is also helping to put pressure on mortgage lending rates.

In EUR/USD, the December rally has given way to a consolidation range between roughly 1.38-1.43 and I would note the fierce rejections of attempts to extend EUR gains. The result is a descending triangle pattern that has 1.3770/1.3820 as the key break-down level. A daily close below this level should see further declines to the 1.3450/1.3500 area initially. Sustained EUR/USD strength over 1.4160/70 would negate the triangle pattern and likely signal gains toward 1.44/45 in the near-term. USD/JPY has made a significant low and looks to be tracking US yields higher as the 10-year US Treasury yield has gained nearly 35 bps since its all time low around 2.04%. 92.50 in USD/JPY is the next key resistance level and opens potential back to 94/95 for starters.

I still favor selling commodity currencies (AUD, NZD, and CAD) on strength as the global outlook still points to ongoing weakness in commodity demand. The first trading day of 2009 has seen commodities rally, but I expect this to be short-lived as incoming data points to further weakness ahead. (See the Weekly Strategy for a USD/CAD trade plan.)

An aggressive BOE rate cut may support the pound

The Bank of England will meet next Thursday and announce its interest rate decision at 1300GMT. The market is looking for a -50 basis point reduction to 1.5%, but the forecast is clearly contentious. Indeed, there are several economists/strategists looking for a more aggressive -100 bps cut and even some expecting no change at all in rates. We believe that despite the modest improvement in UK economic data of late, the bank will be inclined to frontload rate reductions and likely cut by the steeper -100 bps. Besides, that relative improvement in economic data has been near negligible. PMI manufacturing rose to a still paltry 34.9 in December from 34.5 previously, retail sales rose 0.3% in November but the annual run-rate still fell to 1.5% from 1.7%, and December consumer confidence came in at -33 from a previous -35 print -- so nothing to write home about.

The implications for GBP are likely to be that the more aggressive the rate cut, the better supported the currency will be. The pound will probably need at least a -75 bps cut from the BOE if it is to catch any rally at all. An as expected -50 bps cut will probably see little in the way of price gains and is likely to come as a disappointment to many that expected the bank to be a bit more proactive. On the flipside, a much more aggressive -100 bps slash in rates will come as a welcome strategy at a time when economic activity in the UK needs major stimulus. This scenario should see GBP markedly higher on the follow. No rate cut is an extremely low probability event, though this would probably have dire consequences for the pound.

Key data and events to watch next week

It is a busy start to the first full week of 2009 and the US economic calendar is appropriately jam-packed. Monday kicks it off with construction spending and light motor vehicle sales. Tuesday sees the ISM services index, factory orders and the minutes of the December FOMC meeting. Wednesday follows with the ADP employment report and the usual weekly oil inventory numbers. Thursday has initial jobless claims and consumer credit lined up and Friday rounds out the week with the December employment report (NFP) and wholesale inventories. There are also multiple Fed speakers throughout the week, but their comments are less relevant now that the Fed has adopted ZIRP (zero interest rate policy) and QE (quantitative easing).

The Eurozone (EZ) has an equally busy week ahead. The action starts Monday with the EZ investor confidence indicator. Tuesday will see the EZ PMI composite, EZ consumer price estimate and French consumer confidence. Wednesday has EZ producer prices and German employment. Thursday is very busy with EZ employment, EZ GDP, German trade balance and German factory orders scheduled. Friday closes things out with EZ retail sales, French industrial production, French trade balance, German retail sales and German industrial production.

In the UK it is just modestly busy and PMI construction starts things off on Monday. Nationwide home prices and consumer confidence are on tap for Tuesday. The highlight comes Thursday with the Bank of England rate decision on deck (see above for analysis). Friday has producer prices and industrial production due up.

Japan sees a very light week for economic events. Light motor vehicle sales up on Monday and the leading economic index on Friday look like the only noteworthy events here.

Canada has a relatively light week ahead as well though nearly all of the data is top-tier. Tuesday has industrial production lined up while Thursday sees the all-important Ivey PMI index. The Canadian employment report and housing starts/permits close out the week on Friday.

It is characteristically light down under also. On Tuesday we get New Zealand trade balance, Australian retail sales and Australian new home sales. Australian trade balance and building approvals on Wednesday are the last things on the calendar down under for the week.