Week of May 25, 2008

Oil continues to climb, weighing on USD

Oil prices remain in the spotlight as they continue their seemingly inexorable rise to who knows how high. Indications of a price stall last week were quickly overwhelmed by a surprisingly large crude oil inventory drawdown, according to weekly US statistics, even as indicators of gasoline and oil demand have started to decline. The spillover effects into the broader consumer-led economy are only beginning to be felt, but announcements by airlines of additional fare increases and other charges to offset higher fuel costs suggest sky-high oil prices are beginning to affect corporate profitability and will continue to reverberate through major economies. At this point, oil prices need to see back below $130 trendline support to indicate a potential top, and losses below 127.90 to signal the start of a pullback. The USD continues to be affected by oil price gains, but not to the same extent as earlier this year. Still, on the margins, higher oil adds to pressure on the USD, while a stronger USD tends to cap oil price gains.

The USD has reached a number of critical levels and is looking vulnerable as we head into the long Memorial Day weekend here in the States. On Thursday, EUR/USD exhibited signs of a rejection lower after testing briefly over 1.5800 and failing, but was back up knocking on the ceiling again on Friday. The USD index tested the bottom of the Ichimoku 'cloud,' a zone of significant support, and has managed to stay within the cloud as the week closes out. A daily close in EUR/USD above 1.5810/20 is likely sufficient to push the USD index out of the cloud and signal a fresh phase of USD weakness ahead, while a move below 1.5650 is needed to end the EUR's ascent.

The fundamental backdrop has not changed significantly and one could argue that with all the bad news out there, and worse expected to come, the USD is actually holding up relatively well. In the context of a range-trading environment, this is as it should be-prices test the outer bounds of the ranges, sometimes exceeding them, only to fail and reverse back into the range. We saw this happen a few weeks ago with the failed attempt to break below EUR/USD 1.5300/40, and this week has seen the upper end of the range tested and briefly exceeded at 1.5800. This week also saw another coincident flow of data highlighting ostensible Eurozone resilience (stronger ZEW and IFO) contrasted with weaker US data (higher PPI, gloomy FOMC minutes, weaker existing home sales), providing a neat explanation for EUR/USD strength beyond oil.

Taking a second look at this week's data, however, I can see the seeds of a reversal-Eurozone May flash PMI's on Friday declined more than expected (PMI composite (services and manufacturing) fell from 51.9 to 51.1 vs. expected 51.5) and US data was not as weak as feared (LEI actually rose 0.1% for the second month in a row; initial jobless claims declined slightly). Additionally, EU officials (Noyer, Juncker, Almunia) spoke out against renewed FX volatility, code-speak for opposition to further EUR strength. Most importantly, the FOMC minutes and comments by Fed speakers Kohn and Kroszner confirmed the market's view that the Fed is on hold for the next few months, removing lower US interest rates as a source of immediate USD weakness. In the big picture, the EUR has yet to significantly adjust to the unfolding economic slowdown, leaving it ripe for a setback. But looking ahead to next week's data, there are a number of reports that could expose the USD to fresh weakness, namely housing prices, new home sales and durable goods orders. In short, we're on the brink of the USD entering a new and largely unanticipated phase of weakness, or we're being set up for a reversion back into recent ranges. The outlook is clouded by potential volatility surrounding the US holiday on Monday and the end of the month, a period of reduced liquidity when speculative players like to test sensitive price areas. Stay alert for technical breaks (that need to be sustained on a daily closing basis) and watch commodities (gold & oil) for signs of a reversal to see where the USD is going.

Stocks finally respond to gloomy reality

Whether its higher inflation eating into corporate profitability, slower growth eroding consumer demand, or higher energy and commodity prices squeezing margins, the outlook for stocks is on the ropes. The FOMC minutes provided a gloomy outlook for the US economy and indicated that interest rate cuts are unlikely to be available even if the US economy softens further. Stocks got the message and the selling began in earnest post-FOMC minutes. Along the way, key trendline support that guided stocks higher since mid-March was broken, bringing shares back in line with other markets' downbeat expectations. In recent months, downdrafts in equities have usually resulted in sharp declines in USD/JPY and the JPY-crosses, but that has not materialized this time around, or at least not yet. USD/JPY remains vulnerable to further stock weakness, and a drop through the 102.20/50 area suggests fresh weakness in that pair. EUR/JPY looks set to give it up if below 161.70-162.00.

GBP and NZD recover on false hopes

Two of the biggest movers this week were GBP and NZD, with both jumping sharply higher mid-week on unexpected news developments. But I think most of the reaction was due to over-extended short-positions being squeezed out, leading to an over-shoot to the upside. Last week, for GBP I suggested that the switch to a steady interest rate bias by the BOE was likely to see GBP move higher as rate cut expectations were taken back. I 'm looking at the move to the 1.9800/50 area as just such a development, and I'm now reverting back to my bearish stance again on GBP from these levels. The immediate catalyst for GBP's break higher (at least the last 150 pips) was that retail sales did not fall as much as expected. The outlook for the UK remains for further slowing in the months ahead, and this process is likely to be exacerbated by lack of interest rate relief owing to concerns over inflation. I like to use the current GBP strength to average into a short GBP/USD position between 1.98-2.00, looking for a multi-week return to recent lows in the 1.9350/9400 area.

Kiwi had a similarly sharp rebound, with the catalyst being tax cuts announced in the government's budget proposal, but I think heavy short-NZD positioning was responsible for at least half of the reaction. Markets looked at the tax cuts as a stimulus effort that would allow the RBNZ to hold rates steady for longer, dashing expectations for a June rate cut. But just a day after the budget news, Fin. Min. Cullen was speaking out indicating that markets had over-reacted to the budget and the proposed tax cuts, which I took to be an indication of displeasure with renewed NZD strength. Make no mistake, the NZ economy has slowed rapidly in recent months and the government, with an election looming on the horizon, is eager to deliver some relief, hence the tax cuts. The strength of the NZD is killing NZ exporters and contributing to the slowdown and has been a source of irritation to the government for some time now. The RBNZ is unlikely to skip cutting interest rates, but may opt for only 25 bps in the opening salvo rather than the 50 bp I have been expecting. Either way you slice it, based on sharp economic slowing or impending rate cuts, or both, I think the NZD is set to weaken again. I like to use this rebound to re-sell NZD/USD between 0.7850-0.7900, and even up toward 0.8000, looking for an eventual return to the 0.7300-7500 area in coming weeks.

Key data and events to watch next week

The US has a national holiday on Monday and North American trading action is likely to be thin and vulnerable to higher volatility as a result. US data begins on Tuesday with the March S&P/CaseShiller Home Price index, which is expected to show further price declines. May consumer confidence is also out on Tuesday and with gasoline approaching $4/gallon and stocks lower its hard to imagine anything but a decline, the only question being 'how much?' Tuesday also sees May Richmond Fed index and April new home sales. Wednesday sees April durable goods orders. Thursday sees the first revision to 1Q US GDP, expected to see the advance 0.6% rate adjusted higher to 0.9%, along with weekly jobless claims. Friday finishes out with April personal income and spending, PCE-core inflation readings, May Chicago PMI and final May Univ. of Michigan consumer sentiment. Fed speakers on the economy include Yellen on Tuesday; Stern on Wednesday; Bernanke on Thursday; and former Chair Greenspan on Friday.

Eurozone data begins on Tuesday with final 1Q German GDP and related reports, the June German GfK consumer confidence survey, and French and Italian business sentiment gauges. Wednesday sees April German import prices, March Eurozone current account, and May German CPI. Thursday sees European Commission sentiment gauges for businesses and consumers along with May German unemployment. Friday concludes with April German retail sales, April French PPI and May Eurozone CPI.

UK data is relatively light, beginning on Tuesday with April BBA mortgage lending data. Thursday morning sees May Nationwide Building Society's house price index and the May CBI distributive trades report, a privately calculated retail trade survey. At midnight Thursday local UK time, the May GfK consumer confidence survey will be released.

Japanese data sees only April corporate service prices on Monday morning. There is no data until Wednesday afternoon when May small business confidence is released. Thursday morning in Tokyo sees April retail trade and large retailers' sales. Friday morning sees April employment data, household spending, CPI, and preliminary April industrial production, followed by April housing starts and construction orders in the afternoon.

Market Directions Sunday May 25, 2008

The Dollar Holiday Blues

What did not happen this week was more interesting than what did. Jobless Claims did not deteriorate, the Dow did, oil boomed, the United States housing market swooned and for all the negative news the dollar gave ground only grudgingly against the euro. The dollar did not collapse. It ended Friday three figures higher than where it began the week, but despite the provocation currency traders seem no more inclined to buy the euro beyond 1.6000 than they were three weeks ago. The US economy is in no worse shape than it was last month and the newest threat to an American recovery, the price of oil, is an equal opportunity danger. Crude oil at $131.00 and rising will hurt the EMU economies as much or more than the US. American GDP for the first quarter will likely be revised higher to 1% or more this coming week. That is not a great deal lower than recent projections for the EMU. If the US is still growing at one percent and higher with the prolonged housing decline shaving percentage points from economic growth, and after the liquidity crisis and its attendant problems and the Europeans are at that growth level without having suffered any appreciable economic trauma what does that say about the next several months as the oil prices begins to bite hard into growth potential? Will EMU growth hold up under the flail of vastly higher energy prices and without any of the stimulus applied by the Federal Reserve? It is not likely. At least it is a bet currency traders seem reluctant to make. The US economy, a far more flexible and integrated entity than the EMU fell from 4.9% GDP growth in the third quarter of 2007 to 0.6% growth in the fourth. Is the EMU, with a far less active consumer sector, not capable of such a dramatic fall? The bad news absorbed by the usd over the past two months is considerable: job losses for four months running, generational lows in consumer sentiment, a sub 50 manufacturing ISM, weak retail sales, and stocks and housing as mentioned above. One might ask what else the market needs to see before it takes the euro higher. Or to ask the question another way, is there any statistic that will convince traders that, for one-- the Europeans will not shortly have a slowing economy of their own to contend with and two—the ECB will not soon begin lowering EMU rate? Yes, spokesman for the ECB have been adamant and on message -- inflation is our concern, inflation is the target, price stability is paramount, we will fulfill our mandate. But to judge from the trading levels of the euro there is deep skepticism in the currency markets for that program. The market expectation for an eventual ECB rate decrease is not just a wish. Traders and analysts are not simply talking their book knowing that lower rates are good for business or helpful to bank profits. The market 'expectation’ for a lower ECB refinancing rate is an expression of its collective judgment on European monetary policy and on how the ECB will respond to a future economic situation that is deemed to be distinctly possible. If the market’s judgment differs from that of the ECB and its public policy pronouncements, that does not negate its validity. The ECB has several reasons, not all of them economic, for retaining its public anti-inflation mandate. Remember that the US markets had priced in rate cuts long before they occurred and remember too the Fed statements in the weeks between the onset of the financial and sub prime crisis in August and its first rate cut in mid September. Or recall Chairman Bernanke’s very deliberate rhetoric for much of the subsequent time. It is only recently that the Fed has publicly subordinated inflation to growth. Even so, the Fed has been accused of caving to market desires. The ECB has even more policy strictures because of its inflation mandate so it also has a grater need to preserve its independence and credibility. Currency traders continue to place more emphasis on what is happening in the States than across the Atlantic. A great deal more has happened in the US and a great deal more is expected happen here. As we have noted before, expectations are fine and good, and can drive the markets a long way, but until the US economy delivers on the Fed promise, no trader will stake long term profit on the dollar. The limit of expectation has a very concrete aspect for traders; it is 1.5250.