- Sharply weaker US data points to a Â½% rate cut on Jan. 30
- Recession concerns mount, increasing risk aversion
- Multiple Fed speakers to illuminate growth/inflation debate
- ECB expected to hold rates steady but stay hawkish; BOE will cut UK rates
The first week of 2008 trading got off to an ugly start for currencies, and most other markets for that matter, with JPY-crosses trading sharply lower on heightened risk aversion in the face of data suggesting the US may slip into recession. The Dec. ISM manufacturing index dropped below the 50 expansion/contraction line, coming in at 47.7 vs. the expected 50.5 and a prior 50.8 reading. According to that series, then, the US manufacturing sector has begun to contract. Fed minutes from the Dec. 11 meeting also expressed a far more downbeat outlook for the US along with a more dovish indication that the Fed would cut rates further if the economy were seen to be faltering. Any doubt about that was eliminated when the Dec. NFP report showed a lower number of jobs added (+18K vs. exp. +70K) and a larger than expected jump in the unemployment rate to 5.0% from 4.7% (exp.4.8%). If thereâ€™s one piece of data that gets the Fedâ€™s attention, it a sharp rise in unemployment. Fridayâ€™s data tells me that the Fed is now going to need to cut rates by Â½%, and the suddenness of the deterioration in the outlook for the US suggests it may even come before the scheduled Jan. 30 FOMC meeting.
Fridayâ€™s data was not entirely negative for the US outlook, however, as the ISM service sector index posted a smaller than forecast decline from 54.1 to 53.9 (exp. 53.5). The ISM-service gauge, which covers the other 85-90% of the US economy outside of manufacturing, tells a different story, and therein lays the rub for the market outlook. The slowdown currently underway in the US is extremely uneven, with the service sector outlook remaining largely steady as shown by the ISM-services index. Also, I would note that the service sector added +93K jobs in Dec. and +160K in Nov., according to the NFP report. The sectors that are showing the greatest weakness are in well-known soft spots, such as manufacturing (lost -31K in Dec, -13K in Nov.) and construction (shed -49k jobs in Dec., and -37K in Nov.). In other words, itâ€™s a tale of two economies. This suggests incoming data will also continue to tell two different stories and this should continue to keep the outlook uncertain. The Fed is most likely now to cut rates based on the risks to growth, but they can certainly make the argument that the overall economy is not faring as poorly as markets currently believe, and this is the biggest risk to the more aggressive rate cut scenario. There are multiple Fed speakers out next week, including Chair Bernanke and US Treasury Sec. Paulson, and we should have a much clearer picture of their thinking going into the Jan. 30 FOMC meeting by this time next week.
The sharp deterioration in the outlook for the US economy has finally dented the global growth outlook and this has seen commodity prices retreat from many all-time highs, and I suspect we are only at the beginning of such a turnaround. For currencies, the commodity currencies (AUD, CAD, and NZD) in particular were hard hit, falling against the USD on Friday, even as the interest rate outlook in the US shifted drastically lower. This should be a wake-up call to currency traders that interest rates are now a secondary consideration and that growth, or the absence of it, is now paramount in determining medium term currency moves. Interest rates will continue to play in the background, but global growth concerns are now center stage.
Investors have clearly been uncertain and increasingly risk averse over the last several weeks, but that psychology is dangerously close to shifting into outright defensiveness. This is likely to be another theme driving markets in the weeks ahead and is most likely to take the form of heavy repatriation of foreign investments, especially in stocks, leading to sharp declines in global equities. The S&P 500 index on Friday touched a long-term rising trendline dating back to March 2003. Given the margin for error on such a long-term chart, itâ€™s difficult to be precise with the price level, but my charts show 1412 to be where the trendline is as of Friday. Allowing for a margin of error from the charts, a drop through 1400 should prove very ominous indeed. Another bellwether to watch for a shift into defensiveness will be emerging market equities, which have held up very well in recent weeks despite the increase in risk aversion. When emerging market stocks begin to head south, itâ€™s another indication of markets turning defensive and another negative for the global growth outlook, which threatens to become a vicious spiral lower.
What does all this mean for the USD and Forex in general? Itâ€™s difficult to expect anything other than further USD weakness, given the lower growth and interest rate outlooks. But the eroding global growth outlook also threatens to undermine other major currencies as was seen on Friday in the case of AUD, CAD and NZD. That dynamic will keep the USD better supported against such currencies, including GBP, than would normally be the case. The USD is also likely to garner support if markets truly turn defensive, as USD shorts are unwound and US Treasuries are bought on a flight to safety. There is also the argument (which I think is a stretch at this point) that more aggressive Fed rate cuts now will stimulate the US economy sooner, avoid a recession, and result in higher end-level US interest rates in the current easing cycle. I expect continued range trading in the USD against GBP, AUD, NZD and CAD, with a preference for greater USD strength in the near-term. EUR and CHF appear to have the best prospects among the majors vs. the USD in the near-term, as their export markets (Eastern Europe and Middle East) are still expanding, so I would be careful about buying the buck against those two. The clearest trade strategy I can see remains selling JPY-crosses and USD/JPY on strength, which I have been suggesting for many weeks now.
USD/JPY has come down sharply to start the year and this is undoubtedly alarming to the Japanese Ministry of Finance (MOF). I expect to hear from the MOF as early as Monday next week and we have already seen signs of semi-official buying interest in USD/JPY and EUR/JPY toward the lows seen on Friday. Traders should recognize that this may present an opportunity to sell USD/JPY and JPY-crosses at better levels in the days ahead. Selling strength back into the 111-112 area in USD/JPY would be ideal, if the MOF and market cooperates. A drop below 107.20 in USD/JPY and below 158.75 in EUR/JPY, both key daily lows from the collapse this summer, open the door to further multi-Yen losses.
Next week on Thursday, the ECB and the BOE will separately announce interest rate decisions. I and the consensus expect the ECB to hold rates steady, but Iâ€™m going out on another limb and suggesting the BOE will cut another 25 bps. The street expectation is for the BOE to hold steady in January and cut in Feb., but the data out of the UK has continued to be quite soft lately, inflation remains subdued, and the BOE is still lowering rates from restrictive levels, so itâ€™s fair to ask what the point is to delaying a rate cut by another month. ECB Pres. Trichet will hold his usual press conference following the rate announcement, and here I expect him to remain quite hawkish. Eurozone inflation is popping through the roof, at least in the short-term, leaving him little alternative but to threaten and cajole with vows to do â€˜everything necessaryâ€™ to anchor price stability. Beware if he should use any of the code words that in the past have signaled a rate hike at an upcoming meeting. He might use such a tactic to caution firms and producers, only to step back again later at the next meeting due to growth concerns. In the unlikely event M. Trichet should downplay inflation and highlight growth risks, the EUR would tumble faster than we have seen in many months.
Turning to the data/event schedule for next week, there is no US data on Monday, but Atlanta Fed Pres. Lockhart (2008 non-voter) will speak on the economic outlook around noon ET and Treasury Sec. Paulson will speak on capital markets and the economy later in the afternoon. Paulson is likely to try to put the best possible spin on the US outlook, but also likely to little avail. Tuesday sees Nov. pending home sales, a leading indicator for existing home sales, and the Jan. IBD/TIPP Economic Optimism index. Also on Tuesday, Phila Fed. Pres. Plosser (2008 voter; extremely hawkish) and Boston Fed Pres. Rosengren are slated to offer their economic outlooks separately in the morning. Wednesday has only weekly mortgage application data on tap and St. Louis Fed Pres. Poole (2008 non-voter) will speak on sub-prime mortgages in the morning. Thursday sees weekly jobless claims, wholesale inventories and ICSC chain store sales for Dec. On Thursday afternoon, KC Fedâ€™s Hoenig (2008 non-voter) and Fed Chairman Bernanke (voter) will deliver separately their economic outlooks. Friday sees the Nov. US trade deficit, which is expected to widen from -$57.8 bio to -$59.4 bio, and Dec. import price indexes, along with Fed Gov. Mishkin speaking on financial markets, risk and Fed policy.
Eurozone data on Monday sees the Jan. Sentix investor confidence index, Nov. Eurozone PPI, and Dec. Eurozone confidence gauges. Tuesday sees Nov. Eurozone retail sales and Nov. German factory orders. Wednesday sees Nov. German retail sales and trade balance, final 3Q Eurozone GDP, and Nov. German industrial production. Thursday sees French Nov. industrial/manufacturing production followed by the ECB rate decision and Trichetâ€™s press conference. Friday sees Dec. German wholesale prices and the January OECD economic outlook.
UK data has the Dec. HBOS house price index scheduled for release sometime between Monday and Wednesday, but no firm time set. Tuesday sees the Dec. BRC retail sales monitor, a private index of retail sales. Nationwide Building Societyâ€™s consumer confidence index is due out at midnight UK time Wednesday, followed later Wednesday morning by the Dec. BRC shop price index and Nov. leading indicators. Thursday sees the Nov. trade deficit followed by the BOE rate announcement. Friday sees only Nov. industrial/manufacturing production.
Japanese data is light next week. On Thursday afternoon, the preliminary Nov. leading economic index will be released. Friday morning sees Dec. bank lending data followed in the afternoon by the Dec. Economy Watchers survey, a key measure of consumer-level businesses.
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