The Week Ahead updated July 24, 2009

FX risk trades not confirming stocks rally Stock markets continued to outpace gains in other risky assets, with shares breaking to new highs for the year on the back of a series of better-than-expected 2Q earnings reports. We are extremely skeptical of the sustainability of the current rally in stocks, based on both the fundamental outlook (see below) and the lack of confirmation seen in other risk asset markets. Among key markets failing to make new highs for the year, the CRB commodity index, oil, 10 year US Treasury yields, gold, and the Baltic Dry Index (a proxy for commodity demand) are all well below their highs for the year, and in most cases still below their most recent highs seen at the end of June. In FX, the USD approached lows for the year against most other currencies ex-JPY, but has failed to break down as stocks broke higher. Carry trades (e.g. long EUR/JPY, GBP/JPY, AUD/JPY, etc.), while following stocks higher over the last two weeks, have similarly failed to surpass their most recent highs from the end of June, much less their highs for the year.

Importantly, the lack of inter-market confirmation so far of the fresh highs in stocks is no guarantee that stocks will falter or that those other key asset markets will not play catch-up and move higher in the weeks ahead. But given the still weak fundamental outlook, it does suggest exercising extreme caution in regard to chasing stock market gains in other risky asset classes. Overall, however, given that it's stocks that are likely exceeding fundamentals based on 2Q earnings, we're more inclined to fade further gains in FX risky trades, selling JPY-crosses on strength and buying USD on weakness. There are still a few weeks left of earning reports yet to be delivered and the positive sentiment could run still further, so we won't hang on to counter-trend positions (short JPY-crosses/long USD) beyond the extremes seen at the end of June/start of July. But after the end of earnings data, what's left to drive stocks higher? Rising unemployment? Stagnating consumer demand? Incoming data will continue to drive short-term sentiment and we will remain alert for clearer technical signals of a more pronounced reversal to the downside. Of particular note in the JPY-crosses, a number of pairs have closed above the top of their Ichimoku clouds (EUR/JPY 134.22; GBP/JPY 155.80; AUD/JPY 76.66; NZD/JPY 60.45; CAD/JPY 85.67), which is generally a bullish signal. However, the lack of follow-through gains is troubling and potentially sets up a failure and subsequent drop back inside the cloud, which is typically a very bearish scenario. (GBP/JPY already looks set to finish out the week back inside its cloud.)

China-US talks to put USD back under scrutiny Monday next week will see Chinese and US officials sit down for the latest round of the Strategic Economic Dialogue (SED) talks started under Tsy. Sec. Paulson. In recent months, Chinese officials have openly fretted over the value of the USD and its impact on the value of their vast FX reserves and US Treasury holdings. More recently, though, Chinese comments have become more USD supportive and we expect that tone to prevail at next week's meeting. The Chinese belatedly realized that questioning the reserve status of the USD is counter-productive to their asset holdings and they have even acknowledged that there are no alternatives to the USD as the global reserve currency in the foreseeable future. From the US side, Treasury Sec. Geithner will need to be seen to be doing the utmost to support the greenback, and we expect to hear the strong dollar mantra chanted yet again. Elsewhere, finance officials in Japan, Australia, Canada, and New Zealand have all voiced concern over excessive strength in their own currencies, suggesting there is a broad consensus that the USD should not weaken significantly further. Positive comments from Chinese officials on the USD or an additional public commitment to keep buying US Treasuries could see the dollar bottom out and begin to turn higher.

Risk rally really long in the tooth Talk about irrational exuberance! The S&P 500 rallied 13% from the July lows, which coincidently were hit the day 2Q earnings season began on Jul 8. Now, earnings have beaten estimates broadly with about 75% of companies reported thus far posting a positive surprise and earnings coming in about 11% better than estimates. That said, the better bottom-line numbers are on the back of massive cost-cutting measure mainly at the expense of jobs - the unemployment rate isn't at 9.5% by accident. If one looks at what sales have done, they've actually come in about in line with the low-ball expectations.

Considering the state of the US consumer and the de-leveraging still needed before we get back to sustainable debt levels, driving that sales figure will become more and more challenging going forward. The consumer currently holds about 23% of annual disposable personal income in non-real estate debt and we think this number needs to creep closer to 18% to be sustainable. All else equal, this means an additional $525 billion in debt reduction, which will likely come at the expense of retail sales. The just released University of Michigan consumer sentiment index posted its first decline since February and the expectations component remained depressed. If the first half of 2009 is any indication, the consumer has clearly moved to a higher savings, lower debt and lower spending state of mind. While this is good in terms of building a better economic foundation for the future, corporate earnings will bear the brunt of this shift in behavior.

From a valuation standpoint, the rally looks extremely long in the tooth. The forward price-to-earnings ratio on the S&P 500, at just above 15 times, is the highest since October of last year. Historically the P/E ratio has been about 16.4 on average when we exclude the credit boom - an environment we will likely not revisit to anytime soon. If investors were to pay up for the next twelve month earnings at that rate, the S&P would trade at about 1072. The current economic landscape, however, is far from normal. Credit conditions remain extremely tight, the US consumer is in retrenchment mode and the employment situation is getting worse by the month. Not to mention another headwind from rising oil prices, which when translated to price increase at the pump will mean even less discretionary income. Throughout the last decade, every penny change in gasoline prices has had about a $1.2 billion impact on annual household balance sheets - not trivial when you consider we likely have another 25 cents of upside from last week's $2.50 pump price.

For anyone looking for solace in the so-called improved initial jobless claims numbers, we would just say that the recent weeks were skewed by seasonal adjustment difficulties surrounding the earlier than anticipated auto plant shutdowns in June. The potential for a snap back above 600K as the adjustment process normalizes is very real. And even if the shift in the reported numbers is for real, many continuing claims are merely shifting to extended federal programs that currently total a very non-trivial three million people.

So what does all of this mean for currencies? If past is prescient, we could very well be seeing some short-term tops in what have been deemed the risk trades. While it is true that the market can remain irrational longer than one can stay solvent, the sustainability of the recent gains is suspect. Despite stocks making fresh 2009 highs, EUR/USD has failed to take out its 1.4338 June highs. This level remains the upside risk for now, but the path of least resistance looks to be lower at this point. Should the risk rally reverse, the S&P could be at the 930 pivot in the blink of an eye. This would put EUR/USD closer to the 1.40/1.39 area. The squeeze would also have significant implications for the commodity complex, which has rallied nearly 9% from the July lows. This would help USD/CAD solidify support near the 1.08 area - where the Bank of Canada initially announced concern over CAD strength - and potentially elicit a move back towards the 1.11 zone. AUD/USD would also be vulnerable for a move back to 50-day sma support, which currently lurks at 0.7970. The clear winners become the USD and JPY, and so we would expect the price action in USD/JPY under this scenario to be limited.

GBP softens; BoE QE risk sees some revival on weak data The discussion as to whether or not the Bank of England will announce an extension of its asset buying plan will undoubtedly get further airplay over the coming week. The minutes of the July MPC and comments from the BoE's Sentance have lowered the odds of further QE. Sentance noted that the Bank may pause if it were justified by forecasts while the minutes show that Bank in July saw not enough evidence to support an increase in QE. However, the release last week of the much worse than expected 0.8% q/q contraction in Q2 GDP will keep some speculation of further stimulation at the Aug 6 BoE policy meeting alive. While the GDP data show an improvement from the -2.4% q/q decline registered in Q1, the disappointing numbers illustrate that the economy is finding it tougher than expected to shake off the recession. These poor data put the upcoming release of the Bank's June lending data in the spotlight. May data highlighted continuing weakness in lending to individuals and in net lending secured on dwellings suggesting that QE had not then had a significant impact. June data due on Wednesday are expected to show moderate improvement.

In contrast to Friday's poor UK GDP data, German data brought an improvement in the Jul IFO to 87.3 (from 85.9 in Jun) and a rise in both its manufacturing and services PMIs. The contrast between the data was mirrored in the squeeze higher in EUR/GBP though sterling weakness was also evident vs. the USD and other crosses. In view of the sharp increase in the UK budget deficit (to 13.9% of GDP in 2009 using EIU forecasts), and concerns over fiscal restraint (reflected in warnings in recent months from the IMF and S&P) sterling is vulnerable. While EUR/GBP is still within a bear flag consolidation (suggesting that sterling's uptrend may not yet be over), it has broken up inside the cloud, on daily and weekly views which weakens the GBP outlook. Sterling will find support if the BoE steer away from QE on Aug 6. However, weak economic data in the week ahead could undermine the pound. A move above EUR/GBP0.8700 could trigger the start of a new weaker phase for the pound.

Key data and events to watch next week The US data calendar is relatively busy and kicks off with new home sales on Monday. The Case-Shiller home price index and consumer confidence reports are up Tuesday while Wednesday brings the all-important durable goods report and the Fed Beige Book. Thursday sees the usual weekly initial jobless claims. Friday rounds out the week with the first cut of 2Q GDP and the Chicago purchasing managers index. The earnings season remains hot in the week ahead as well with about 150 S&P 500 companies slated to report.

It is a pretty typical week in the eurozone. Monday starts things off with French jobseekers data, German import prices and the German GfK consumer confidence survey. The highlight on Wednesday is the release of the ECB's bank lending survey and we also see French producer prices and German consumer prices that day. Thursday has the eurozone business climate survey, eurozone consumer confidence and German employment lined up. Friday has eurozone consumer prices and eurozone employment.

The UK calendar is on the light side. The Hometrack housing survey starts things off early on Sunday. Wednesday has net consumer credit and mortgage approvals on tap while Thursday ends the week with the GfK consumer confidence survey.

Japan's week is just modestly busy. Retail trade kicks things off on Tuesday while small business confidence and industrial production are due Wednesday. The highlight on Thursday is the employment report and we also have household spending and consumer prices slated for that day. Friday rounds things out with housing starts.

Canada sees an extremely slow week and industrial product prices on Thursday and GDP on Friday are the only noteworthy events.

The calendar down under is on busy side. New Zealand trade numbers kick it off on Monday and this will be followed by New Zealand building permits, Australian leading index and Australian business confidence on Tuesday. Wednesday sees New Zealand business confidence and the RBNZ interest rate decision. Australian building approvals are due up Thursday while Australian private sector credit rounds out the week on Friday.