Week of September 23, 2007

Brian Dolan, Chief Currency Strategist [/B]


USD bearishness hits fever pitch
Risk assets/Carry trades are back in vogue
Credit markets are on the mend, but not out of the woods
Continuing to watch stocks as key gauge to risk seeking/aversion

Brian Dolan, Chief Currency Strategist

The Fed surprised markets (and me) by delivering a larger than expected cut in benchmark interest rates, dropping the Fed Funds rate by 50 bps instead of the expected 25 bps. The result was as if a green light suddenly flashed on, signaling investors to resume risk-taking: equity markets surged, precious metals and commodities soared, and carry trades (long JPY-crosses, e.g. long EUR/JPY, AUD/JPY, and NZD/JPY) were put back on in a rush. Of course, the USD took a drubbing against all but the JPY, dropping sharply (1.5-2%) against European and commodity currencies by the end of the week. As of Friday afternoon, it’s safe to say USD bearishness has hit a fever pitch, with front-page New York Times coverage and nearly every other media outlet running lead stories highlighting the dollar’s weakness. Even the Loonie (CAD) made headlines, rising to parity against the USD for the first time since 1976.

Normally, such excessive sentiment is a signal to put a contrarian’s hat on, but while I think that time is close, it isn’t quite at hand just yet. The major reason is that the post-Fed FX moves are still fresh. The market has a bone in its teeth (the weak USD) and it needs to chew on it for a while longer. The other major reason is a lack of official concern from any of the major currency governments. On the contrary, most officials seemed unconcerned by dollar weakness and strength of their own currencies. ECB Pres. Trichet extolled the virtues of the Euro on Friday, calling it an ‘inspiring’ currency. Canadian Fin. Min. Flaherty indicated the Canadian economy can adapt to a stronger CAD, and pointed out that it was not so much CAD strength as it was USD weakness. And US Treasury Sec. Paulson could manage only a meek repetition of the strong dollar mantra, adding the killer clincher that currency values should be set in open markets. For the moment, then, that silence equals assent to further USD weakness.

The other major market reaction was a return to riskier-asset trades, which in the Forex market equates to re-buying carry trades (selling JPY vs. everything). In recent weeks I have urged traders to follow markets in terms of risk-seeking/risk-averse behavior, using equity markets as the primary barometer of that bias. While equity markets remain buoyant, riskier asset trades will remain in play. Along these lines, though, I would point out that both gold and oil posted doji formations (where the close is equal to the open) on Friday on daily candlestick charts, an indication that the upward price movements may stall. The USD index also looks set to register a doji, suggesting the worst may be over for the greenback. Looking ahead, I’m going to anticipate consolidation next week in the major USD pairs, but with a bias toward further gains in the JPY-crosses. In other words, the USD might slip modestly further vs. non-JPY currencies, but move higher against the JPY.

Looking ahead to the overall outlook for the USD, as I wrote above, when sentiment becomes overwhelmingly one-sided (USD-negative at the moment), it’s normally time to start looking for a reversal. The key signals to watch for are: changes in US Treasury rhetoric, perhaps along the lines that the USD is not reflecting economic fundamentals; more bad news from the credit markets; sharp price reversals in risky assets, such as commodities, gold and oil; or a sharp set-back to equity markets. We are near critical technical levels in many markets (US dollar index all time low at 78.20; DJIA all-time high at 14K; gold at $750/oz; and oil trying to close above $80/bbl on a monthly basis), and traders should keep an eye on the reactions to these levels. At the moment, they look like they are set to hold. I would also note that on a synthetic EUR/USD chart, showing the levels based on legacy currencies (e.g. DEM, FRF, ITL vs. USD), the 1.4102 level represented a significant, multi-year high dating back to Sept. 1992. A monthly failure below that level would suggest EUR/USD gains are more limited, increasing the chances for a reversal.

In fundamental economic terms, there are a number of themes at work, many of which represent a disconnect from current market levels. First and foremost is the notion that the US economy is on the verge of collapse and that the Fed will be forced to cut rates further. In last week’s update, I argued against the idea that the US economy is falling out of bed. The outlook is clearly data-dependent, and until I see further indications of weakness in consumer spending and employment, I’m going to remain relatively upbeat on the US outlook. The disconnect here is that if the US economy is going to do a nose-dive, why are US stocks near all-time highs? Either equities will correct lower, or the USD will recover. In terms of the Fed’s outlook, Bernanke explicitly indicated that the Fed went with a 50 bp rate cut ‘to get out ahead’ of the economy. Implicitly that suggests the Fed believes it has done enough and this week’s rate cut increasingly looks to be ‘one and done’ (barring further data weakness). Markets are far from pricing out further US rate cuts, and it will take several more weeks before enough evidence is in hand to eliminate the prospect of an Oct. rate cut.

As well, EUR strength is taking place against the backdrop of slowing Eurozone growth and diminishing prospects for further ECB rate hikes. Again, the market has yet to price out prospects of ECB tightening, and that too will take time. M. Trichet and Co. are complicit in this, maintaining hawkish rhetoric in the face of slowing growth, but I attribute that more to an effort to maintain credibility rather than a guarantee of higher rates ahead. If you want to see Eurozone sentiment plummet more than it already has, watch what happens if the ECB hikes again this year. Eventually, markets will come to the conclusion that the ECB is done for the rest of the year, at the minimum.

GBP represents another disconnect with reality, as UK credit markets remain in jeopardy, the BOE’s credibility is threatened, housing prices continue to fall, and UK mortgage re-sets undermine consumers. Yes, retail sales rose more than expected in Aug., but that’s the exception to declines in home prices/sales; leading indicators; industrial production, CBI Sept industrial trends, and consumer sentiment. I think GBP remains a sale on strength against the USD (2.03-2.05) and even more so against EUR.

Looking ahead to next week’s US data calendar, July S&P/CS home price data comes out on Tuesday, along with Sept. Conf. Bd. consumer confidence, Richmond Fed index, and Aug. existing home sales. Wednesday sees August durable goods orders, which are expected to give back some of the outsized gains seen in July. Final 2Q GDP is out on Thursday, along with weekly jobless claims and Aug. new home sales. Friday wraps up with Aug. personal income and spending and PCE inflation reports. Fed speakers on the US economy include Plosser on Tuesday; Poole on Wednesday; and Lockhart on Friday.

Key Eurozone data begins with July Eurozone industrial new orders on Monday. Tuesday sees Aug. German import prices, Aug. French consumer spending, and Sept. German IFO business sentiment. Wednesday sees Oct. German GfK consumer confidence and Sept. French production outlook indicator. Thursday has scheduled Sept. German unemployment, Aug. Eurozone money supply and Aug. French unemployment. Friday sees Aug. German retail sales, Sept. French consumer confidence, and Sept. Eurozone confidence gauges.

Japanese data begins with the release of the Aug. BOJ MPC minutes on Tuesday morning along with Aug. corporate service prices. Wednesday morning sees the August merchandise trade balance. Thursday afternoon sees the release of Sept. small business confidence. Friday sees a heavy slate of data: Aug. employment, household spending, Sept. Tokyo CPI, Aug. national CPI, preliminary Aug. industrial production, Aug. retail trade and Aug. housing starts.

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