Data and earnings focus

Friday’s round of US data were generally upbeat, highlighting that consumer spending is coming back to life. Inflation pressures however, remain benign at least on the core reading highlighting the Fed’s concern that inflation is running below the level consistent with its mandate. In other words it will be a long time, probably late into 2012 before policy rates increase.

While the Fed is no hurry to raise rates despite a few hawkish rumblings within the FOMC the European Central Bank (ECB) in contrast appears to have become more eager to pull the trigger for higher rates. ECB President Trichet’s hawkish press conference last week set the cat amongst the pigeons and marked a clear shift in ECB rhetoric towards a more hawkish stance.

A very big problem for the ECB is that the eurozone economy is not performing along the lines that its hawkish rhetoric would suggest, especially in the periphery. Growth momentum in the core in contrast, as likely reflected in the January ZEW investor confidence and IFO business confidence survey data this week in Germany, remains positive. Both surveys are likely to stabilize at healthy levels but how long can the likes of Germany drag along the eurozone periphery?

There will be relatively more attention on the meeting of Eurogroup/Ecofin officials, with focus on issues such as enlarging the size of the European Financial Stability Facility (EFSF) bailout fund and development of a “comprehensive plan” to contain the eurozone crisis. Don’t look for any conclusive agreements as this may have to wait until the European Union (EU) Council meeting on 4 February assuming (optimistically given ongoing German resistance) some agreement can even be reached.

Following the success (albeit at relatively high yields) of the eurozone debt auctions last week, sentiment for peripheral debt will face further tests this week in the form of debt sales in Spain, Belgium and Portugal.

The US Martin Luther King Jr. holiday will result in a quiet start to the week for markets but there will be plenty to chew on. This week’s key earnings reports include several banks scheduled to release Q4 earnings. Financials are a leading sector in the rally in equities at present and these earnings will be critical to determine whether the rally has legs.

The US data slate includes January manufacturing surveys in the form of the Empire and Philly Fed, both of which are likely to post healthy gains whilst existing home sales are also likely to rise. This will not change the generally weak picture of the US housing market, with high inventories and elevated foreclosures characterizing conditions. As if to prove this, housing starts are set to drop in December. On the rates front, the Bank of Canada is likely to keep its policy rates on hold this week.

After coming under pressure last week much for the USD will depend on the eurozone’s travails to determine further direction. Concrete evidence of progress at the Ecofin may bolster the EUR further, with resistance seen around 1.3500 but don’t bank on it. The ability of eurozone officials to let down often lofty expectations should not be ignored. In any case following sharp gains last week progress over coming days for the EUR will be harder to achieve.


US Dollar Tensions

There was considerable relief, most acutely in the US administration, that the US August jobs report revealed a better than expected outcome. To recap, private sector payrolls increased by 67k vs. an upwardly revised 107k in July whilst total non farm payrolls dropped 54k. The data sets the market up for a positive start to the week in terms of risk appetite despite Friday’s drop in the August US non-manufacturing ISM index, deflating some of the market’s upbeat mood.

Once again I wonder how long positive sentiment can be sustained with so many doubts about recovery prospects and limited ammunition on the fiscal front as well as some reluctance on the monetary front, to provide further stimulus should a double dip become a reality.

Markets will be treated to several major central bank decisions including from the Bank of Japan, Bank of England, Bank of Canada and Reserve Bank of Australia this week. These meetings are set to prove uneventful, with unchanged decisions across the board expected although the Bank of Canada decision is a tough call.

The main US release this week is the Fed’s Beige Book on Wednesday, a report which will help the Fed to prepare for the FOMC meeting on September 21. The evidence contained within it is unlikely to be positive reading, with consumer spending set to be relatively soft and evidence of recovery likely to remain patchy.

On Thursday the US July trade deficit is set to reveal some narrowing and as usual the deficit with China will be of interest given the renewed tensions over FX policy. FX tension seems to be intensifying once again due to the relatively slow pace of CNY appreciation since the June de-pegging as well as political posturing ahead of November US mid-term elections. A deterioration in US trade data, a factor that largely contributed to the soft Q2 GDP outcome in contrast to a strengthening in China’s trade surplus will have added fuel to the fire.

The firmer risk backdrop has put the USD on the back foot, with the USD index dropping sharply overnight. Nonetheless, speculative USD positioning as reflected in the CFTC IMM data reveals further short covering up to the end of August, implying USD speculative sentiment is actually turning less negative.

Another country which has a different sort of tension regarding the USD is Japan. Improving risk appetite will likely prevent the JPY from visiting previous highs against the USD but will do little to reduce FX intervention speculation. Indeed, there was more jawboning over the weekend on the subject, with Japan’s finance minister Noda reiterating that Japan would take decisive action to stem the JPY’s appreciation but adding that coordinated FX intervention was a difficult option. Clearly Japan us unlikely to succeed with unilateral FX intervention.

Political events have added to the debate on FX policy as focus turns to the election for leader of the ruling DPJ party next week, with a battle looming between current Prime Minister Kan and challenger Ozawa. Although Ozawa is unpopular with the electorate he yields plenty of political power, and appea rs to be more inclined towards FX intervention. Having failed to sustain a move above 85.00 the pull back in USD/JPY suggests little appetite to extend gains, likely leaving USD/JPY in a relatively tight range, with strong support around 83.55 and resistance around 85.23.

Risk appetite dented

The surprise decline in the Michigan reading of US consumer confidence which dropped to 63.2 in August put a dampener on risk appetite at the end of last week helping to fuel a sea of red for most US and European equity markets at the close of play on Friday.   Nonetheless, FX markets remained range-bound, albeit with the dollar taking a firmer bias at the end of the week.

The impact of the drop in confidence is likely to prove short lived as risk appetite continues to improve this week although don’t look for big market moves as summer trading conditions continue to dominate.  For the most part the data releases should not throw any spanners in the works over coming days as a positive tone to data is set to be retained.  

The highlights this week include more GDP data from Japan and Norway following surprise increases in growth from Germany and France in Q2 last week.  Japan’s release showed a marginally softer than expected 0.9% QoQ increase in GDP with growth led by external demand and government stimulus measures.  In contrast, capital spending continued to remain weak.  

US numbers are set to show further improvement as likely reflected in manufacturing surveys including the August Empire survey and the Philly Fed.  Similarly housing data including housing starts and existing homes sales will point to more stabilisation whilst Fed Chairman Bernanke is set to deliver a similar tone to the recent FOMC statement. 

The highlight of the European calendar is the German ZEW survey and flash August PMIs.  Firmer equities point to a higher ZEW whilst manufacturing indices are likely to reveal a slower pace of contraction.  In the UK the minutes of the BoE MPC meeting are likely to reveal a unanimous vote for extending QE policy. 

On balance, the beginning of the week is likely to see a bit of a risk aversion led sell off in risk currencies including commodity currencies such as the Australian and NZ dollars as well as weaker Asian currencies led by the likes of the Korean won but the pressure is unlikely to last for long.  Nonetheless, Commodity currencies will face another layer of pressure from the sharp drop in commodity prices at the end of last week as reflected in the drop in the CRB index.

Recovery hopes spoiled by the consumer

News that US Q2 GDP dropped by less than expected, with the 1% fall in GDP over the quarter far smaller than the annualised 6.4% drop in the previous quarter, adds to the plethora of evidence highlighting that the US recession is coming closer to ending.  The bad news, albeit backward looking was revealed in the downward revisions to growth in the previous quarters, which indicated that the recession has been more severe than previously thought.  

Within the Q2 GDP data the details revealed that consumer spending weakened by far more than expected. The recession is also breaking all sorts of records as the annual 3.9% decline in growth was the biggest since WWII and the fourth quarterly decline in a row was the longest on record. Nonetheless, inventories look a lot leaner following their sharp drop over the quarter and the deterioration in business investment appears to be slowing.  The data also showed that the Fed´s preferred gauge of inflation (core PCE deflator) remained relatively well behaved.

The downward revisions to past data and the fact that growth was boosted in Q2 by government spending as well as very weak consumer spending will takes some of the shine off the less than forecast drop in GDP.  Nonetheless, the data is still backward looking.  The evidence of recovery highlighted in recent housing data as well as some bottoming out in manufacturing conditions, taken together with less severe readings in jobs data  are difficult to ignore.  This was echoed in the Fed´s Beige Book which revealed that economic deterioration was becoming less marked.

The most worrying aspect of the report and something that cannot be downplayed however, is consumer spending. Massive wealth loss, rising unemployment, tight credit conditions, reduced income and consumer deleveraging all point to a very subdued outlook for the US consumer in the months ahead and only a gradual pace of economic recovery. The US savings rate is set to move higher even from its current 15 year high and spending on big ticket items will remain fragile at best.   Although the upcoming US jobs report will likely show a less severe pace of Job losses in July, the drop in payrolls will still remain significant and hardly  conducive of a turnaround in spending. 

Although some policy makers have indicated that policy should not be kept too loose for too long the weak consumer outlook suggests that inflation is likely to remain subdued for a long time to come.  So whilst it is easy to get excited about the signs of recovery increasingly being revealed in economic data this should not be taken as a cue to reverse policy. The recovery process remains a “long, hard, slog” and the massive excess capacity in the global economy, especially  in developed countries suggests that interest rates will remain at ultra low levels for many months.

Some clues to central bank thinking will be seen over coming days as interest rate decisions in Australia, UK, and Eurozone move into focus. Although none of the Banks are expected to tighten policy it will be interesting to see whether the rhetoric becomes more hawkish. The RBA in particular will likely indicate that the room for further rate cuts has diminished. In Europe, following the very soft inflation data in July the ECB will be comfortable in its current policy settings.  In the UK attention will focus on the BoE´s asset purchase programme and the possibility of increasing purchases from the current GBP 125 billion, especially after the MPC surprisingly did not increase purchases at its last meeting.

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