US Dollar Sold as Chinese Lending Tops Expectations, Boosting Risky Assets (Euro Open

The US Dollar extended losses in overnight trading as risk appetite improved after Chinese lending surged in August, soothing fears that the government will clamp down on credit growth and take the fuel out of the Asian giant’s economic recovery.

[U][B]Key Overnight Developments[/B][/U]

[B]• Japan’s Economy Grew Less Than Expected in the Second Quarter
• US Dollar Sold as Chinese Lending Tops Expectations, Boosting Risky Assets[/B]

[U]Critical Levels[/U]

The [B]US Dollar[/B] continued to retreat in overnight trading, with the [B]Euro[/B] testing above 1.46 while the British Pound pushed higher past the 1.67 level. Equity markets continued to advance in Asian trading, weighing on the safety-linked currency.

[U][B]Asia Session Highlights[/B][/U]

The final revision of Japan’s second-quarter [B]Gross Domestic Product[/B] report revealed the economy grew less than economists predicted, adding 0.6% versus the originally reported 0.9%. Output expanded 2.3% from the previous year, much less than the 3.7% expansion quoted in initial estimates. Government spending and net exports drove growth higher for the first time in 15 months, supported by both domestic and overseas fiscal stimulus as well as the inventory cycle, while private demand shrank to shave -1.3% off total output. The question now facing Japan as well as most other developed countries is what happens when restocking runs its course and the flow of government cash invariably dries up. At this point, the likely answer sounds far from encouraging: the jobless picture continues to rise, driving spending lower; the trend in current account figures points lower, suggesting little future support from the external sector; and deepening deflation threatens to engineer another “lost decade” in the world’s second-largest economy.

A large dollop of Chinese economic data proved to weigh on the [B]US Dollar[/B], with the [B]New Loans[/B] data of particular interest. Chinese banks lent out 410.4 billion yuan in August, much more than economists’ forecasts for a 320.0 billion result. Traders had been worried that the government would make good on their promises to rein in credit growth on fears that excessively loose monetary policy will produce speculative bubbles in the equities and property markets. The resilience in the loans data suggests there is still ample fuel to drive China’s heretofore robust economic recovery, giving risky assets a push higher and adding yet more selling pressure to the already beleaguered greenback.

[U][B]Euro Session: What to Expect[/B][/U]

The [B]UK Producer Price Index[/B] report is set to show that wholesale costs declined for the fourth consecutive month, down -0.5% in the year to August. Excluding volatile items like food and energy however, prices are set to rebound a bit from the 5-year low of 0.2% recorded last month to grow 0.8%. A bit of a pickup is reasonable as economic growth stabilizes after the sharp declines earlier in the year, seeing support from both domestic and overseas fiscal stimulus as well as the inventory cycle. Indeed, London-based think tank NIESR reported yesterday that the economy grew for the first time in 14 months in the quarter to August, adding 0.2%. Still, NIESR director Martin Weale cautioned that “there way well be a period of stagnation now, with output rising in some months and falling in others…the end of the recession should not be confused with a return to normal economic conditions.” If this proves accurate, prices may fluctuate sideways in the months ahead. However, the mounting budget deficit (expected to average over 12% of GDP this year and in 2010) likely rules out any additional fiscal stimulus while any meaningful downward reversal in risky assets is likely to weigh on consumer confidence, coupling with rising unemployment to undermine private demand. Meanwhile, a stronger currency (up about 13% in trade weighted terms since the lows in December) and the completion of restocking are likely to drive export readings lower. Bottom line, while conditions have certainly improved from the lows in the first quarter, the economy’s ability to at least stay put at current levels seems questionable. On balance, this amounts to a dour outlook on price growth in the months ahead.

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