What to look for in the week ahead
â€¢ USD tries higher, but canâ€™t sustain gains just yet
â€¢ Risk aversion returns as outlook stabilizes, for now
â€¢ Fed rate cut (Tuesday) of Â¼% now expected
â€¢ Trichet is blowing smoke on ECB tightening
The USD is closing the week largely unchanged against most major currencies, but the dollar did manage to sustain the break-out from its downchannel in the US dollar index from last week. That breakout, led by gains in USD/JPY last week, was augmented by EUR/USD dropping out of its primary up-channel dating back to mid-August. Follow-through on the break lower, however, was cut short by exceptionally hawkish rhetoric from ECB Pres. Trichet, who went so far as to indicate that some ECB central council members favored a rate hike at this weekâ€™s meeting. The biggest loser against the USD was GBP, which plunged on weaker service sector and housing data ahead of the BOE Â¼% rate cut, which was correctly forecast in last weekâ€™s report. Even the Canadian dollar managed to recover a lot of lost ground following the ostensibly surprising Bank of Canada Â¼% rate cut, which was also correctly suggested in last weekâ€™s report.
The general lack of upside follow-through for the USD is disheartening for USD bulls to say the least, but not unexpected given that the Fed is expected to lower rates next week. Rather than an abrupt reversal to the upside for the USD, itâ€™s becoming increasingly apparent that the USD is transitioning into a consolidation phase with on-going potential to see further modest gains. The buckâ€™s fortunes are also not equal against other major currencies, to be sure. In the very short-run, I favor further upside for the USD against GBP (lower GBP/USD) and JPY (higher USD/JPY), but greater sideways trading in EUR/USD, AUD/USD and USD/CAD.
The market has been very fickle of late, and this is not uncommon going into the end of the calendar-year, when speculative positioning is typically reduced and liquidity tails off, leaving directional moves with limited follow-through. Risk appetites have increased as the US data indicates a slower, but not recessionary, outlook ahead. Carry-trades (long JPY-crosses, e.g. long EUR/JPY) were put back on in quick fashion after the ADP national employment report surprised sharply to the upside. The strength in the ADP was not fully mirrored by Fridayâ€™s NFP, but the +94K reading was sufficient to convince investors that the world was not crumbling. Market expectations for next Tuesdays FOMC meeting, which have been exceptionally volatile, have settled back in favor of a roughly 75% likelihood of a 25 bp ease/25% chance of a 50 bp cut, according to Fed Fund futures on Friday afternoon.
There is also a very good chance that the Fed will cut the discount rate by more than the Fed Funds target rate (FFTR), further reducing the spread over the target rate. A discount rate cut of 50 bps is likely if the Fed determines that money markets, due to credit risk aversion, are unable or unwilling to pass along the rate cuts the Fed is delivering. By lowering the discount rate more than the FFTR, the Fed will get the discount rate sufficiently below LIBOR lending rates to generate discount window borrowings that are in turn lent out in LIBOR money markets, conceivably un-freezing inter-bank lending. The Aug. 17 discount rate cut failed to inspire significant borrowing back then, due to banksâ€™ unwillingness to lend to each other on credit concerns, and not much has changed in the meantime, so there is no guarantee another discount rate result would have the desired results. Still, Iâ€™m expecting the Fed to cut the FFTR by Â¼% to 4.25% and lower the discount rate by Â½% to 4.50%. Should the twin rate cuts be delivered, I expect to see equities rejoice and risky assets to perform even better, likely vaulting JPY-crosses higher in the process. A lone 25 bp cut to Fed funds, on the other hand, would leave equity markets thirsty and desperate for more, likely leading to a sharp decline, with consequent downside fallout for JPY-crosses, and a slightly USD positive reaction against all but the JPY.
Regular readers of this report are aware that I have been expecting US weakness to eventually cycle around to other major global economies, leading to slower growth elsewhere and lower rates, as the most likely source of USD rebound. That picture, delayed by several months now, is finally starting to develop. The clearest evidence was the rate cuts by the BOC and BOE, but the ECB (via Trichet) managed to throw a stiff-arm into the approaching tackler. Trichetâ€™s hawkish press conference struck me as a rhetorical effort to embellish the ECBâ€™s credibility, but incoming data and revised outlooks continue to suggest that the ECB will remain on hold, before being compelled to lower rates in the middle of 2008. In particular, pay attention to revised outlooks from the IFO and IfW economic institutes in Germany on Thursday next week, with downward revisions likely to weigh on the EUR.
I have also been cautioning traders to be on the lookout for a shift by German officials on the strength of the Euro. In recent months, the Germans have been the main obstacle to Eurozone officials pressing the G7 to take a more convincing stand that the USD is too weak and the EUR too strong. We got that shift this week when German Fin. Min. Steinbrueck indicated that he would bring the issue up at the next G7 meeting in February. The other side of that coin is for US Treasury Sec. Paulson to make a more concerted effort to push the â€˜strong dollarâ€™ policy, and there has also been movement on that front. Paulson has lately been talking more about the strong fundamentals of the US economy and the expectation that the USD would eventually reflect this strength, likely increasing his receptiveness to including language in the communiquÃ© to suggest that the USD is not reflecting economic fundamentals. Together, these developments suggest that EUR/USD upside is limited over the next several weeks, and that strength should be sold.
Turning to the data coming out of the US next week, Monday sees only Oct. pending home sales. Tuesday sees Dec. IBD/TIPP economic optimism and Oct. wholesale inventories, followed by the FOMC rate announcement in the afternoon. Wednesday sees weekly mortgage applications, the Oct. trade deficit, and Nov. import price indexes. Thursday sees weekly jobless claims, Nov. PPI and Nov. advance retail sales, which will be the key report to watch. Friday finishes up with Nov. CPI, industrial production and capacity utilization.
Eurozone data on Monday sees German Oct. trade balance, French Oct industrial production, and the Dec. Sentix Investor Confidence gauge as the main reports. Tuesday sees German Nov. wholesale prices and the Dec. ZEW economic sentiment index for Germany and the Eurozone, another important forward-looking indicator. Wednesday sees 3Q Eurozone employment data and Oct. Eurozone industrial production. Thursday sees French and Italian Nov. CPI reports and 3Q Eurozone labor costs. Friday sees final Nov. German CPI and Nov. Eurozone CPI.
Japanese data begins on Monday morning with Oct. machine orders and bank lending data, followed in the afternoon by the Nov. Economy Watchers survey of small consumer firms. Tuesday afternoon sees Nov. consumer confidence. Wednesday morning sees Nov. corporate goods price index and the Oct. current account/trade balance. Thursday sees final Oct. industrial production in the afternoon. Fridayâ€™s highlight will be the 4Q Tankan survey of corporate sentiment from the BOJ, with all the indexes expected to register declines, as private consumption slows and the global growth outlook deteriorates.
UK data on Monday sees Nov. PPI and Oct. DCLG house prices in the morning followed by Oct. leading economic indicator in the afternoon. Tuesday sees the Oct. trade balance. Wednesday sees Nov. employment data and Oct. average earnings report. Thursday sees the Nov. RICS house price balance and the Dec. CBI industrial trends survey.
In Switzerland, the SNB will announce its interest rate decision on Thursday and no change to the 2.75% mid-rate is expected.
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.