Highlights
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Is it safe yet? Relief does not spell end of concerns |
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Looming interest rate decisions from BOE, ECB and Fed |
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Heavy data calendars all around |
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Trichet speaks on Monday morning; Bernanke Friday |
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Commentary
Brian Dolan, Chief Currency Strategist
What a difference a week makes. Last Friday the Fed came to the rescue and cut the discount rate in an effort to soothe rattled credit markets. The move appears to have worked, at least for the moment. In the ensuing calm this week, equity markets recovered and currency markets reverted to old habits—selling the USD and buying JPY-crosses (the carry trade). This week was notable for the absence of any significant data reports, meaning the market was left to trade primarily on sentiment and technicals. As the flow of negative credit news abated, again for the time being, sentiment was able to recover, bargain hunting followed, and as prices stabilized, momentum traders added to the recovery.
We're still several hours from the weekly close at this writing, but for the week, the S&P 500 recovered a little more than half of its losses since the highs in mid-July; EUR/USD retraced a touch more than 61.8% of its decline from 1.3840 to 1.3360; while USD/JPY has only managed to recoup less than 38.2% of its decline from 124.40 to 111.60. In other words, the market appears to be going through a normal consolidation following several weeks of outsized volatility.
Looking at overall market conditions, however, I'm still very leery of the idea that everything has suddenly returned to normal. Credit market trading conditions and sentiment remain extremely nervous, and the Fed and other central banks have been forced to continue injecting liquidity. As an indication of the seriousness of the ongoing breakdown in credit markets, the central banks were obliged to offer longer-term injections of capital to spur lending in periods beyond overnight. Vast amounts of potentially worthless mortgage-backed debt continue to erode portfolio values around the world, like acid eating through metal. Mortgage lenders, those that have not gone belly up yet, remain on uncertain footing, with the next crisis of confidence a mere announcement away. In the meantime, hedge fund redemptions are likely to weigh on markets going forward, as positions are sold and cash returned to investors by the end of September.
Interest rate decisions are looming from the ECB and the BOE on Sept. 6 and from the Fed on Sept 18. For the most part, markets are evenly split on whether the ECB goes ahead with its pre-telegraphed 1/4% interest rate hike. Market volatility is the key factor holding back the ECB, and I'm of the view that while trading conditions remain as sensitive as they are, the ECB is going to postpone a rate hike until markets settle down further. But that will not stop markets from speculating on a rate hike in the short-term. On Monday morning ECB Pres. Trichet will speak on productivity and monetary policy at a conference in Budapest, and he may provide some indications of what the ECB will do. Looking ahead, even if the ECB goes ahead and hikes, signs of a slowing growth outlook in the Eurozone, most recently evident in the sharp drops in the German and Eurozone ZEW sentiment index, are likely to preclude further hikes from the ECB.
The Bank of England is far more likely to stay on hold, having hiked aggressively over the past 12 months. In addition to roiling markets further, rising home foreclosures in the UK and indications of cooling in the overall economy are such that the BOE is likely finished hiking rates for the remainder of the year.
All eyes are on the Fed and whether it will cut rates in an effort to further stabilize markets and ease credit conditions. Recent Fed speakers (Poole and Lacker) have indicated that a Fed rate cut on the basis of market losses is unlikely unless such market turmoil undermines the larger economy. We won't have enough data to draw any such conclusions before the Sept. 18 meeting, and the data we do have in hand suggests the US picked up a head of steam in the 2Q and started out the 3Q in solid shape (e.g. sharp gains in July durable goods orders, rebound in new home sales). In my view, the Fed is very likely to hold rates steady and in the process seek to demonstrate both resolve in fighting inflation and confidence in the financial system to recover. Throwing the market a bone with a rate cut smacks of bailing out investors and would seriously jeopardize Big Ben's credibility going forward and this is not something he wants to risk. Bernanke will speak on Friday at the Fed's annual conclave in Jackson Hole, Wyoming.
To sum up, the Fed and the Bank of England are going to stay on hold and the ECB is most likely to postpone its rate hike until Oct., and that is likely to be the last in the current tightening cycle. Compared to market movements this week, USD weakness and EUR and GBP strength are misplaced and subject to unwinding if rate decisions unfold as I expect.
Next week is the last week of August and will start with the UK August bank holiday on Monday and end with a long-weekend ahead of the US Labor Day holiday on the following Monday. As a result, liquidity conditions are likely to remain thinner than normal, and will only get worse if spot volatility picks up again. The data calendar is heavy all around.
US data starts out with July existing home sales on Monday morning. Tuesday sees the Conference Board's August consumer confidence index and the August Richmond Fed index in the morning followed by the minutes from the Aug. 7 FOMC meeting in the afternoon. Wednesday has only weekly MBA mortgage application scheduled. Thursday sees the first revision to 2Q GDP and forecasts are for an upward adjustment from 3.4% to 4.1% and an improvement in personal consumption from 1.3% to 1.5%. Also out on Thursday are weekly jobless claims and the 2Q house price index. Friday sees July personal income and spending, July core PCE deflator (the Fed's preferred inflation gauge), August Chicago PMI, July factory orders, and final August Univ. of Michigan consumer sentiment.
Eurozone data starts on Tuesday with August German IFO business expectations index. Market reports suggest that the ECB will be closely watching how the IFO comes out as part of its rate decision in the following week. Also out on Tuesday is preliminary August German CPI. Wednesday sees September German GfK consumer confidence and July French business confidence. Thursday sees August German employment data and August retail PMI's for France Germany and the Eurozone. Friday sees July German retail sales, August Italian business confidence, and a series of EC-issued August Eurozone confidence indices.
Japanese reports begin on Tuesday morning Tokyo-time with the release of the July BOJ MPC minutes. Thursday sees weekly stock and bond investment flows and July retail trade. Friday wraps up with a heavy deluge: August small business confidence, July employment data, August manufacturing PMI, July household spending, August Tokyo and July national CPI, preliminary July industrial production, and July housing starts and construction orders.
UK data sees British Bankers Association (BBA) home lending data on Tuesday morning. On Thursday, we get Nationwide Building Society house price data for August, July mortgage approvals, and the August CBI distributive trades index, a measure of retail sales. Friday sees the August GfK consumer confidence survey released.
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