Market Directions Sunday, November 4, 2007
On the strength of an idea, the Euro marches on
The Mid Atlantic rift in GDP
ECB and BOE ponder their rate future
Dollar worriers abound on both sides of the Atlantic. In the US they fret that the housing collapse and the credit market crisis will terrify consumers. Scared consumers stop spending; GDP growth and job creation falter, consumers have less money to spend and the end result is a US slowdown or even recession. Advantage to the Euro. In Europe they fear that the return of inflation, said to have been imminent for the past year, will so paralyze the ECB that it will not lower rates for growth. Again, advantage to the Euro.
The currency markets have interpreted both the economic and rates side of the Euro US Dollar equation to the detriment of the Dollar for more than a year. If the EMU is growing faster, that is good for the Euro. If inflation is rising on the continent, keeping ECB rates high, that is also good for the Euro. If the Fed reduces rates to protect the American economy that is bad for the Dollar; it means that the US economy is in even more trouble than publicly acknowledged, which is worse for the Dollar. Both interpretations cannot be true for ever. Lower interest rates normally spur economic activity; higher rates eventually suppress it. If the US economic and rate curve is, as it appears to be, six months to a year ahead of the European, then the US will return to higher growth first; central bank rate policy will follow in due course.
Let us look at the economic side first. In the four quarters from April 2006 until the end of March 2007, that is quarters two, three and four in 2006 and quarter one in 2007, the European Monetary Union (EMU) area averaged 3.05% GDP growth. During the same period the US averaged 1.41%. The Euro began rising against the Dollar in the first quarter of 2006 and has continued, accelerating after the September 18th Fed 50 basis point rate cut.
Since the end of the first quarter 2007 the picture has changed considerably. In the second and third quarters the US economy has averaged 3.85% GDP growth. The EMU area registered 2.5% in the second quarter and will not deliver third quarter data until November 14th, but 2.5% or less is expected. The potential gap favors the US by a minimum of 1.3%.
The Fed ceased raising rates in mid 2006, the ECB in mid 2007. The Fed response to the financial market crisis in August has been to cut rates 0.75%. The ECB has, so far, done nothing and is not expected to cut this coming Thursday. Central bank rate policy has a six to twelve month lead time to economic effect. The response in US GDP growth in 2007 to the Fed change in policy in 2006 fits the rate time lag. There is no reason to assume the European economic growth will not obey the same rules. Those rules suggest that even if the ECB is finished raising rates the slowdown in EMU growth from the increases of the past two years is still to come. The Eurozone is still on the top of the economic slope looking down into a valley that the US has already crossed.
Oil prices remain near record levels, even when adjusted for inflation. Oil is the world’s most basic commodity. Record crude oil prices must exert inflationary pressures on the world’s economies. These pressures are the same on both sides of the Atlantic. However, the reaction of each economic area, the US and the EMU, to higher oil prices might not be at all the same.
If record gasoline prices are beginning to affect demand in the developed world, automobile ownership and use is roaring ahead in India, China and the Middle East. The rise in oil prices has been largely demand driven. If amity and coexistence suddenly broke out in the Middle East oil prices would fall $20 or even $30 dollars a barrel. They would not return to where they were ten years ago. The economic fact of rising commodity prices is the same everywhere in the world. But how individual economies cope with these prices changes is not uniform. Economic flexibility, technological innovation, labor mobility, lower taxes and a certain willingness to endure social dislocation are rewarded, the opposites punished. The US has a greater share of all these qualities than its continental competitors.
Economic logic does not prescribe trading decisions and changes in economic logic can take a long time to make their way into the currency markets. One of the truest market clichés is “The market can remain irrational far longer than you can remain liquid”. That caveat applies to the market’s ruling economic assumptions as well at to an individual trader’s equity account. Because economic logic dictates that a currency should move in one direction does not mean it will do so at any given time. For any one economic argument there is always an opposite. For any argument that says the Dollar must necessarily strengthen there is another, often equally well argued if not currently as true, that the Dollar must remain weak. Markets are psychological creatures. Like an individual they tend to stick to the current story until forced to change, especially if that story has been very profitable. But stories age and go out of style and the facts that once supported them may not do so any longer. The signs are gathering that the Dollar story is due for a change.
The ECB and Bank of England (BOE) meet on Thursday for policy decisions. Neither central bank is expected to alter rates from their current 4.00% and 5.75%. Officials from both banks have emphasized the threats from inflation in recent statements and downplayed economic dislocation.
Central Bank Rate Actions
The United States Federal Reserve Bank cut the federal funds target rate 0.25% to 4.5% and the discount rate 0.25% to 5.0%; the vote was 9-1 in favor. The FOMC adopted either a neutral or hawkish ‘bias’ depending on one’s interpretation of the accompanying statement.
BOJ kept rates at 0.5%; the vote was 8-1 in favor.
The Week in Review October 29 – November 2
United States
The Federal Reserve 0.25% rate cut on Wednesday was universally expected and brought little new volatility to the currency markets. If the Fed’s equal balancing of risk between growth and inflation may have signaled a bottom in US rates, you would not know it from the market reaction which set several new lows for the US currency subsequent to the announcement. The crucial phrase in the revamped statement was, “The Committee judges that, after this action the upside risks to inflation roughly balance the downside risks to growth”. In the current economic situation both sides of the growth and inflation policy equation are heavy with risk. The 75 basis points in cuts seems to be as far as the Fed is willing to go without further debilitory evidence from the economy. Certainly 3.9% GDP growth in the third quarter, two months of which took place after the credit market debacle began in early August, and 166,000 jobs on the October payroll, all of which were created after, will not advise Mr. Bernanke that more rate stimulation is required. The housing market has been falling for 18 months if not more, that is not a new economic fact. It is also not a prescription for further rate cuts this year.
Eurozone
The ECB rate decision is on Thursday, no change in policy expected despite pronounced EMU and German weakness in Manufacturing PMI. The EMU October reading was the weakest in more than a year and the German the lowest in over two. The German PMI was the steepest one month decline in the history of the series. HICP inflation at 2.6% in the latest month will keep the ECB fixated on its inflation guardian role.
United Kingdom
BOE rate decision is on Thursday. Like its counterpart across the channel the central bank is expected to keep rates on hold. Recent inflation numbers and good retail sales are likely to weigh more heavily with the Monetary Policy Committee than economic spillover from housing and the credit market scare.
Economic Releases October 29 – November 2
United States
Tuesday: Case Shiller Home Price Index fell 8.7% in August to 197.16; it was the sharpest plunge since June 1991. This index of year over year price changes had fallen on average less than 1.0% per month since March.
The Conference Board Consumer Confidence slid to 95.6 in October from 99.8 in September. It was the weakest reading in more than a year.
Wednesday: the ‘advanced’ (first issue) for third quarter GDP at 3.9% was much stronger than the 3.0% forecast and on par with the second quarter result of 3.8%.
Wednesday: the Chicago Purchasing Manager Index (PMI), the regional version of the Institute for Supply Management (ISM) report came in at 49.7, the first reading below 50 since February. September had been 54.2. Weakness in auto manufacturing weighs more heavily Chicago than nationwide.
Thursday: Personal Income rose 0.4% in September a marginal improvement over the +0.3% reading in August. But personal spending was only 0.3% higher, half the 0.6% gain in August. The Core PCE price Index added 0.2% in September twice the hike in August; the yearly rate was unchanged at 1.8%.
The ISM Index for October registered 50.9, considerably less than the 52.5 predicted and lower than the September result of 52.0. New orders’ declined to 52.5 from 53.4; employment rose to 52.0 from 51.7; prices paid scored 63.0, September had been 59.0
Friday: Non Farm Payrolls more than doubled the median estimate for October at 166,000, economists had been expecting 80,000; September and August were revised for a combined loss of 10,000. The US unemployment rate was unchanged at 4.7%
Eurozone
Wednesday: Flash (1st release) for the October Harmonized Index of Consumer Prices (HICP) at 2.6% was much higher than the 2.3% increase expected and the highest since September 2005. The September reading was left unrevised at 2.1%. The unemployment rate for the EMU area dropped 0.1% to 7.3% in October.
Germany
Friday: Manufacturing PMI for October was very weak falling to 51.7, more than four points below the September result of 54.9, the lowest reading since September 2005 and the sharpest fall in the life of the series, (since 1997).
United Kingdom
Thursday: manufacturing PMI in October came in at 52.9, much lower than the expected 54.2 and a substantial drop from the September reading of 54.7. New orders fell to 53.6 from 55.2 in September the lowest since August of last year. Export orders dropped to 50.9 from 52.6, their lowest in more than a year, both statistics reflected the ascendancy of the Sterling.
