Week of March 9, 2008

Highlights: Friday's price action may signal a short-term bottom for the USD. Oil prices and US slowdown will apill over into slower global growth. Fed increases lending to banks, but credit markets still jammed. Commentary Brian Dolan, Chief Currency Strategist Friday's price action may signal a short-term bottom for the USD The USD continued to decline for most of the week, buffeted by weakness in the ADP national employment report and a downbeat Beige Book, with a hawkish ECB thrown on top for good measure. Friday's NFP report vindicated the weakness seen in the ADP report, for a change, and offers further evidence that the US economy is contracting at the moment. But the price reaction of the USD after the jobs report was significant and may signal a short-term bottom for the greenback. It's next to impossible to construct a fundamental argument over why the USD should recover, which leaves market technicals and positioning as the only potential source of a recovery. After the weak February NFP report (-63K jobs lost; unemployment rate fell from 4.9% to 4.8% on frustrated job seekers dropping out of the labor pool), the USD's initial reaction was a quick drop, but the weakness did not last long. The USD had been heavily sold earlier in the week in anticipation of just such a weak NFP report, and once it materialized, profit-taking buying of USD emerged. The resulting pattern, most clearly seen on candlestick charts, is a major rejection from just below the key 1.5500 level. Similar patterns, 'hammers' after a decline and 'shooting stars' after a rally, are evident in other major USD-pairs and on the USD index. It's also the first 'down' candle since EUR/USD broke above the 1.5000 level two weeks ago. As well, reports of significant option barrier interest at the 1.5500 area appear highly plausible and suggest a near-term top. As I wrote last week, a lot of funds and other speculative players missed out on the initial move higher in EUR/USD and subsequently scrambled to get long from levels mostly north of 1.5150/5200. As a result, my sense is that the conviction to hold long EUR, short USD positions is relatively weak at the moment and increases the likelihood of a short-term shake-out in favor of the USD. But let me stress again that the USD is borderline catatonic at this point, so I would favor buying EUR/USD pullbacks into the 1.4950-1.5050 area, with an exit plan on further weakness below 1.4880. Oil prices and US slowdown will spill over into slower global growth As the USD has weakened more substantially in recent weeks, oil prices surged over $100 and are currently trading around $105/bbl. A large amount of the strength in oil prices is attributed to the ever-weakening greenback. The USD is weakening because the US economy is slowing and very likely contracting at this point. Weaker US demand is translating into slower global growth expectations, though concrete evidence of this is only appearing with a lag. Higher oil prices are another force for consumers the world over to contend with and sustained oil prices over $90/bbl remain a significant headwind to a recovery in personal consumption. The US outlook has already been marked significantly lower, and while further weakness has to be anticipated, the degree of discounting for the USD is far greater than most other currencies. If, as I suspect, we are looking at a more protracted US downturn based on housing markets imploding, a situation which does not lend itself to a quick turnaround, then we need to reckon with greater spillover effects into other major economies. By far, the erosion of global growth outlooks is the dominant theme likely to drive major currencies for the rest of 2008 and into 2009. For most of January, incoming data suggested that US weakness was indeed affecting other major economies, as Japanese exports fell and Eurozone growth forecasts were downgraded, for example. In February, current Eurozone data stopped deteriorating and stabilized even as US indicators fell more markedly. I believe that divergence is primarily responsible for the current bout of USD weakness. It also suggests that current USD weakness and EUR strength will be affected if incoming data provides fresh evidence of slowing growth elsewhere. Traders will need to remain especially alert to signs of softening growth in the UK, Eurozone and Japan. The divergence between weak US data and better-than-expected reports from others is unlikely to persist much longer. Next week sees important Eurozone sentiment indicators, including the Sentix Investor Confidence index (Monday) and the March ZEW survey of investors and analysts for Germany and the Eurozone (Tuesday). Fed increases lending to banks, but credit markets still jammed On Friday, the NY Fed announced plans to increase the size of the Term Auction Facility (TAF) from $60 bio to $100, a vehicle to provide additional cash to banks in exchange for certain bonds as collateral, to effectively get banks back in the business of lending. The NY Fed also announced plans for a new repo facility to prove an additional $100 bio to the banking sector. These moves were precipitated by a deterioration in credit market conditions over the past few weeks that saw lending spreads widen out to levels beyond those seen in the August 2007 turmoil. In short, credit market conditions were getting worse, not better, despite Fed easing and massive write-downs. Banks remain unwilling to lend as they continue to sit on assets whose value continues to fall in line with the housing market. As home prices fall and delinquencies and foreclosures rise in a vicious cycle, banks securitized assets also continue to fall in value, reducing capital available for new lending. While the Fed's move is a valid attempt to improve lending conditions, banks balance sheets are simply not up to the task. Perhaps the Fed's plans can stop the bleeding, but we're a long way still from the patient getting off the table. The severely reduced availability of credit is beginning to be felt by credit-worthy borrowers, both among individuals and businesses, and this is adding fresh weight to an already struggling economy. Banks are essentially biding time, refraining from fresh lending, while they recapitalize by borrowing cheaply from the Fed and lending to only the most credit-worthy of clients under existing loan obligations. Additional Fed easing can speed up that process of bank recapitalization by further reducing banks' cost of funds, but it does not suggest that banks will pass it through to the economy by lowering borrowing rates or increasing credit availability. While the credit markets remain off-line, stock markets will remain under pressure, which will also keep carry trades (long JPY-crosses like EUR/JPY and AUD/JPY) a sell on rallies. Key data and events to watch for next week US data is relatively light in the first half of the week, beginning with Jan. wholesale inventories on Monday. Tuesday sees the Jan. trade deficit (forecast -$59.6 bio; prior -$58.5 bio) and the March IBD/TIPP economic optimism index (forecast 41.5; prior 44.5). Thursday sees Feb. import prices and business inventories, but the keys will be Feb. advance retail sales and weekly jobless claims. Friday sees Feb. CPI (core ex-F&E forecast at 0.2% MoM; prior 0.3% MoM) and the preliminary March Univ. of Michigan consumer sentiment index (forecast 70.1; prior 70.8). There are no Fed speakers scheduled to speak on the economy or interest rates, though Fed Chair Bernanke will speak on home ownership on Friday. Eurozone data begins on Monday with Jan. German trade and current account balances, Jan. German imports and exports, Jan. French industrial production and the March Eurozone Sentix Investor confidence index. Tuesday sees German Feb. wholesale prices and March ZEW investor sentiment index for both Germany and the Eurozone. Wednesday sees Feb. French CPI and Jan. Eurozone industrial production. Thursday sees only final 4Q French employment and French Jan. current account reports. Friday sees Feb. German and Eurozone CPI and Feb. Bank of France business sentiment. Japanese data begins Monday morning in Tokyo with Jan. machine orders and Feb. bank lending data, followed by the Feb. Economy Watchers survey in the afternoon. Wednesday morning sees final 4Q GDP, Feb. domestic corporate goods price index and the Jan. trade and current account balances along with Feb consumer confidence later in the afternoon. Thursday afternoon sees final Jan. industrial production and capacity utilization. UK data begins on Monday with Feb. PPI and Jan. industrial and manufacturing production. Tuesday at midnight GMT sees the release of the Feb. BRC retail sales monitor, the RICS house price balance and the NIESR GDP estimate. Tuesday sees Jan. DCLG house prices and the Jan. leading indicator index. Wednesday sees the Jan. UK trade balance and the budget statement by Chancellor Darling.