Week of April 6, 2008

Highlights:

1. Rebound in risk appetites looks set to falter
2. EU Finance Minister meeting this weekend; G7 next Friday
3. BOE and ECB interest rate decisions
4. Key data and events to watch next week

Rebound in risk appetites looks set to falter


Friday's NFP report provided further evidence that the US economy remains on weak footing, as if any more were needed. But a strange thing happened on the way to the recession. Market sentiment appears to have embraced the view that the US downturn will be relatively manageable, if not downright mild. I'm not about to embrace that view, but I can understand where it's coming from. In the Week Ahead of March 21, I suggested that risk appetites (and USD/JPY and JPY-crosses) were set to rebound after aggressive Fed actions significantly reduced the potential for a US financial system failure. Indeed, since then risk appetites have come back, with JPY crosses up roughly 8 yen since March 21. Stock markets have recovered and commodities are stabilizing after sharp corrections.

But the horizon for the financial sector is far from clear and many risks remain. Inter-bank lending rates (LIBOR, EURIBOR) are actually making new highs since the credit crunch began last summer, suggesting the root problem—confidence between financial firms based on transparency (who's sitting on what size losses)—has yet to be remedied. Looking ahead, major US banks are set to begin announcing 1Q earnings after the middle of April and there are likely to be additional sizeable losses and disappointments, potentially rekindling fears over financial sector solvency. As a reminder of the potential for unwelcome surprises, as I'm writing this on Friday afternoon, Fitch ratings has just cut its AAA rating on the largest US bond insurer, which only recently avoided downgrades from other rating agencies by raising additional capital. At the minimum, then, I suspect the rebound in risk appetites has likely run its course already and is more likely to fade than extend. In currencies, the proxy for risk appetite is USD/JPY and JPY-cross strength. If USD/JPY falls back below 101.20/50 key support zone (EUR/JPY equivalent support is 159.00/30), it's a good indication risk aversion is re-surfacing and that carry trades are headed south again, pulling stocks and commodities down with them.

The financial sector is only one of the patients in the Fed's emergency room, the other being the broader US economy. Recent data (Chicago PMI and ISM sentiment) have given the 'glass half full' crowd reason to celebrate and expect that the US downturn will be both brief and relatively shallow. Even a larger than expected decline in March NFP jobs was greeted with the view that it was "bad, but not 'that' bad." To me, the market reaction looks more like wishful thinking, and probably a fair amount of willful denial. The headwinds facing the US consumer economy are substantial and show no signs of abating—high energy prices, falling home values, restricted credit, and now rising unemployment. As much as I would like the US downturn to be brief and mild, I have to reckon with further weakness in the immediate future. Perhaps a weekend spent digesting the implications of the NFP report will see a more realistic reaction in markets early next week.


EU Finance Ministers meeting this weekend; G7 next Friday

Eurozone finance ministers are meeting this weekend in Ljubljana, Slovenia for their regular monthly conclave. But this weekend's meeting comes just a week before the G7 quarterly meeting of finance ministers and central bank heads in Washington, DC. Recent comments from European finance sources suggest Eurozone officials want to raise the strength of the Euro as an issue in discussions at the G7. In the run-up to the last G7 meeting in February, US officials effectively refused to even discuss currency issues outside of Asian currencies needing to appreciate. That rebuff was at least partly responsible for the EUR blasting off from around 1.45 through 1.50 up to where we are today. I do not think the US Treasury has changed its stance, so Eurozone officials are left hollering into the wind. Traders should not expect the G7 communiqué to include any new language on currencies.

That the G7 is unlikely to address what is arguably excessive EUR strength does not mean that Eurozone finance ministers are powerless to express dissatisfaction with the strength of the Euro. On the contrary, I get the sense that Eurozone officials might finally embark on a rhetorical campaign to limit additional EUR gains. If this materializes, I would expect comments from key Eurozone finance officials to materialize over the weekend, seeking a 'shock-value' to start the week off in FX. Likely candidates are German Finance Minister Steinbrueck and Bundesbank Pres. Weber, who are scheduled to hold a press briefing on Saturday around 0600ET. Unilateral market intervention still does not seem likely at this stage; further EUR gains above 1.6000 would be needed to trigger that.


BOE and ECB interest rate decisions

The Bank of England (BOE) and the European Central Bank (ECB) are set to deliver interest rate decisions on Thursday of next week, with very different outcomes expected. The BOE is widely expected to cut its benchmark rate from 5.25% to 5.00%, though there are a few dissenters who expect a steady rate. The UK economy is undergoing a similar housing-led downturn, which is already spilling into the broader economy. The credit crunch is also fully evident as UK banks have actually raised mortgage lending rates to cut back on loan demand and preserve capital. GBP should remain on the defensive going into the BOE decision and is most likely to weaken on the GBP-crosses, rather than against the beleaguered USD. Should the BOE hold the line and keep rates steady, I would expect GBP to briefly rally, only to later come under even greater pressure, as continued high rates would be seen as potentially tipping the UK into a deeper slump, requiring even larger rate cuts down the road. I favor selling GBP on rallies, and with positioning likely to tilt toward short-GBP, a short squeeze higher would provide just such a rally to sell into.

The ECB rate decision is expected to see the benchmark rate held steady at 4.00%. With inflation running at 15-year highs and growth holding up for now, there is little else the ECB can do. M. Trichet has been adamant that fighting inflation is the sole task of the ECB and he is likely to retain a hawkish tone in his press conference following the announcement. His comments on the economic growth outlook will be significant, and may undermine his hawkish inflation rhetoric if he expresses a sense of alarm. He is also likely to be grilled by the media on his thoughts on EUR strength. When questioned at the last press conference on March 6, when EUR/USD was around 1.5300, he avoided making any criticism of EUR strength, triggering a rally to 1.5900 over the next 2 weeks. If he decides to take a stand, he may use the term 'brutal' to describe the Euro's gains, and the EUR should weaken. But if he demurs and sticks with the G7 language and refers to the US strong dollar policy, it's another green light for the market to take EUR/USD to 1.6000 and beyond.


Key data and events to watch next week



US data next week kicks off on Tuesday with Feb. pending home sales and April IBD/TIPP economic optimism index in the morning, followed by the minutes from the March 18 FOMC meeting in the afternoon. The minutes are likely to reinforce the notion that additional aggressive easing from the Fed is less likely in the future, but otherwise keep the focus on US weakness ahead. Wednesday sees weekly mortgage applications and Feb. wholesale inventories. Thursday's highlights are the Feb. trade deficit and weekly initial jobless/continuing claims. Friday concludes with March import prices and the preliminary April Univ. of Michigan consumer sentiment survey. US Treasury Sec. Paulson is speaking on Monday and will provide a G7 briefing after the close on Friday. Fed speakers on the US economic outlook include Vice Chairman Kohn on Monday; Dallas Fed's Fisher (dissenter at 3/18 FOMC) on Wednesday; and Fed Chairman Bernanke on Thursday.

Eurozone data sees the April Sentix investor confidence on Monday along with Feb. German industrial production. Wednesday sees German Feb. trade and current account balances and final 4Q Eurozone GDP. Thursday sees French and Italian Feb. industrial production prior to the ECB rate announcement. Friday finishes out with German March wholesale prices and Feb. OECD Eurozone leading indicators.

UK data will see March HBOS house prices sometime during the week, but no fixed time has been established yet. The March Nationwide Building Society consumer confidence index will be released at midnight on Tuesday night UK time. Wednesday sees Feb. industrial/manufacturing production and the March BRC shop price index, a private gauge of retail inflation. Thursday sees the Feb. trade balance report prior to the BOE's interest rate announcement.

Japanese data begins on Monday afternoon Tokyo-time with the preliminary Feb. leading economic index. Tuesday afternoon sees the March Economy Watchers survey. Wednesday afternoon is expected to see the BOJ hold rates steady at 0.50% when the MPC concludes its meeting. Thursday morning sees Feb. machine orders, bank lending data, and the Feb. current account report. Friday sees only the March domestic corporate goods price index (CGPI).