Highlights
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Credit conditions remain extremely tight |
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Risk aversion remains high |
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Equity market recovery looks suspect |
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Waiting for the next wave of position unwinding |
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ECB, BOE, and RBA all expected to stay on hold |
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Commentary
Brian Dolan, Chief Currency Strategist
Major currencies spent another week see-sawing in relatively wide ranges as markets continue to assess the fallout from the sub-prime mortgage meltdown and its aftershocks. The USD (in US dollar index terms) looks set to finish out the week mostly unchanged, while stock markets survived a mid-week sell-off and look set to post modest gains on the week. However, judging by the S&P 500 index, stocks appear unable to surpass last week's highs at 1480 and this could be a bearish sign for stocks to start the new month. (Please note, this report was prepared around noon EDT Friday, without the benefit of weekly closing price levels.) A similar weekly price pattern is evident in the JPY-crosses, with 159.60/70 in EUR/JPY serving as the key weekly high. In short, what I'm seeing on the charts is that stock markets and carry trades (JPY-crosses) have stabilized further, but are unable to extend the correction higher. In market terms, buyers continued to emerge on dips, but they've either run out of steam at the weekly highs, or sellers are in abundance there, or a combination of both. In general, that keeps the downside in focus. I would also note that equity market volumes were extremely light in the past week, making the attempts to rally even more suspect.
Next week's price action, whether the weekly highs in stock and JPY-crosses can be taken out or if the sell-off resumes, will be a critical determinant of market trends likely going into the end of the year. I expect September to kick off with a bang and keep going from there. Keep in mind that Monday is the US Labor Day holiday, and markets will be thinner than normal, making them easy prey to aggressive speculative funds. Also, hedge fund redemptions that were requested in mid-August are due to be paid out at the end of September, and this will likely add to position liquidations (asset selling) throughout the month.
Key developments this week were ECB Pres. Trichet stepping back from an earlier signal that the ECB would raise rates next week, as I had cautioned in recent weekly updates. Markets now expect the ECB and the BOE to both remain on hold next week. Fed Chair Bernanke, in remarks on Friday, failed to deliver a much hoped-for signal that the Fed would cut rates at its next meeting on Sept. 18. Instead, Bernanke promised that the Fed remained ready to act to provide liquidity and maintain the orderly functioning of credit markets. His remarks suggest the Fed is continuing to view market turmoil as an ongoing credit and risk-based adjustment by investors and not yet as a threat to the economy as a whole. Bernanke explicitly declared that the Fed's job is not to bail out lenders and investors, a sentiment later echoed by Pres. Bush. I continue to view rate cuts from the Fed as unlikely until incoming economic data show declines in real consumer spending or increasing unemployment. Additionally, Pres. Bush threw markets a bone on Friday, offering federal assistance to sub-prime borrowers facing default or foreclosure. Bush was equally explicit that this was not a government bailout to the financial/lending industry. In other words, 1.5 mio US homeowners at risk of losing their homes now have a bit of breathing room, but the financial sector remains under the gun.
Credit market liquidity remains extremely thin, with banks continuing to pull back from lending to each other, leaving a host of highly-leveraged asset managers (hedge funds, private equity) desperate for funding to maintain existing positions. Just on Friday, Barclays Bank had to extend a $1.6 bio loan to a hedge fund that was unable to rollover outstanding commercial paper (short-term debt financing). Funding conditions appear so dire that normal interbank money markets have been turning to the currency forwards market to access additional USD liquidity. Currency forwards and options markets remain similarly thin, suggesting markets are running out of sources of liquidity. In other words, it's not about the cost of credit, but the available supply of credit that is at the root of the current market mess. Looking ahead to the potential for interest rate cuts, it's not clear to me that lower interest rates (cheaper cost of money) will necessarily increase the availability of credit. If funding conditions remain as tight as they are, I fear more widespread position liquidations are forthcoming, resulting in further global market declines.
What does all this mean for currencies? I expect carry trades (JPY-crosses) to remain exceptionally vulnerable as risk aversion remains high. The JPY should continue to benefit as long-held carry trade positions are exited. I also look for the USD to maintain a firm tone against European and commodity currencies (AUD, NZD, CAD), with the potential to break out higher, both as a currency safe haven of last resort, and as demand for USD-denominated funding continues to exceed available liquidity. The major risk ahead, and it's very real as I discuss in the next paragraph, is that the current credit squeeze undermines the global growth outlook. Markets have lately taken solace in the fact that the global growth outlook remains at very high levels and that the situation would be much worse were it not for rising global demand. If global growth is seen to be faltering, the fallout is likely to be much more extensive than what we have so far experienced. Growth trades have been the basis for the strength of the GBP, EUR, AUD, CAD, and NZD against the USD, and concerns over a global slowdown would trigger a massive unwinding of long positions in those currencies and short-covering (buying) of USD.
I'm obviously pretty bearish on this whole credit market squeeze, but why do I think it may lead to a global slowdown? Because virtually identical housing market meltdowns are brewing in a host of the leading economies. The Spanish and Portuguese real estate markets have already hit the skids and UK home foreclosures are accelerating rapidly. Rapid housing price escalations in NZ and Australia are only now starting to see buyers hesitate. Perhaps most importantly, though, is that higher interest rates are still yet to affect housing markets in many of those countries. Adjustable rate mortgages (ARMs) are hardly confined to the US mortgage market and they have been the means by which buyers in hot housing markets, particularly the UK, NZ and Australia, have been able to afford to buy homes despite double digit annual price increases. ARMs in those countries are and will continue to be re-setting to higher rates in coming months, leaving highly indebted consumers reeling in the wake of higher mortgage payments. That is not a recipe for sustained global growth. In my mind, it's not a question of whether it will happen, but more of how bad it will be.
Turning to the US data schedule for next week, Tuesday sees the August ISM manufacturing and prices paid indexes released along with July construction spending. Wednesday see weekly mortgage applications, ADP national employment report, pending home sales, and the Fed's Beige Book for the upcoming FOMC meeting. Thursday sees weekly jobless claims, final 2Q productivity, and August ISM non-manufacturing index. Friday, of course, sees August NFP report, with forecasts centering on about a 100K increase and a steady 4.6% unemployment rate. Fed Gov. Mishkin will deliver a paper on Saturday at the Jackson Hole Fed symposium on “Housing and Monetary Policy Transmission,” which could have markets buzzing before the Sunday open. Multiple Fed speakers are scheduled for Thursday.
Eurozone data starts out on Monday with a series of manufacturing PMI indexes for Germany, France, Italy and the Eurozone. Tuesday sees July Eurozone PPI and first revisions to 2Q Eurozone GDP. Wednesday sees the August service sector 's PMI's for the Eurozone and individual countries released, followed by July Eurozone retail sales. Thursday sees July German factory orders and the interest rate decision from the ECB. Trichet's press conference will be critical to determining whether the ECB is on hold or has only postponed the planned rate hike until markets settle down.
UK data sees August manufacturing PMI index on Monday, followed by the release of the August BRC retail sales monitor later at night. Tuesday sees August construction PMI survey and Nationwide Bldg. Soc. Consumer confidence at night. Wednesday sees the release of the August services PMI survey and the BRC August shop price index. Thursday's data sees July industrial and manufacturing production reports along with an expected steady rate decision from the BOE.
Japanese data starts out on Monday morning in Tokyo with 2Q capital spending data followed by July labor cash earnings in the afternoon. Weekly stock and bond flow data are out on Thursday morning, with August machine tool orders due in the afternoon. Friday morning sees August official reserve assets followed by the preliminary July leading economic index.
The RBA will hold a rate setting meeting, but no change is expected when the decision is announced on Tuesday evening EDT/Wednesday morning Sydney time.
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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