Market Directions Sunday September 2, 2007

• Ben Bernanke, the Federal Reserve Chairman looks for a way to do two things with one rate cut
• The ECB erases the rate slate and starts over
• Japan to go it alone on a rate hike?

The Week in Review August 27 - August 31

United States

The chief, one might say almost the only speculation in the markets this week has been, What will the Fed do? Can the markets force Ben Bernanke to cut the Fed Funds rate despite his obvious reluctance to do so? Individuals often hear what they want to hear. It is no different with markets. The reactions of the equities and currency markets to the Fed Chairman's speech on Friday provide an excellent illustration.

Mr. Bernanke has made it clear that he views the problems in the credit markets with great seriousness but that they are primarily a financial market confidence problem. He has also made it patent he will not be stampeded into premature action. His speech in Jackson Hole, Wyoming to an annual gathering hosted by the Kansas City Fed, led to a dramatic collapse in the Yen crosses. The selling began exactly at 10:00 am when the embargo on the text of the speech was lifted. The EuroYen fell over 150 points in the next 75 minutes, the EuroUsd 50 points and the Dollar Yen 100 points. What had the currency markets heard? In a rather long analysis of the ramifications of the sub-prime issue in the United States Mr. Bernanke said 'The financial stress has not been confined to mortgage markets....global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. More generally, investors have become less willing to assume risk". When the Fed cites increasing risk as a factor in its calculations the markets will assume that it knows more than it is saying and that the future is fraught with danger. The reaction was swift and unequivocal; risk is the avowed enemy of the carry trade.

But just three paragraphs later Mr. Bernanke stated, "The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets. It is not the responsibility of the Federal Reserve-nor would it be appropriate-to protect lenders and investors from the consequences of their financial decisions. But developments in the financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy". The middle sentence is a plain warning to those who are calling for the Fed to ride to the rescue of lenders and speculators who have overindulged in the easy credit conditions of the last few years. But when the warning is bracketed by one promise to act to ensure orderly financial markets and another to take into account the wider economic effects of financial market panics, the equities heard the siren song of lower rates. At the close the Dow was higher by 119.01 points.

In fact the two reactions stem from different stages in the same worrying scenario. In the first stage financial markets problems worsen, banks are increasingly reluctant to lend and solvent firms are forced into default or bankruptcy. This is the risk that Mr. Bernanke cited and that led to the reaction of the Yen crosses. It would only take one or two more failures of hedge funds or mortgage companies for the credit markets to freeze. As it was two weeks ago, it would not be a matter of actual risk but of perceived or unknown risk. This is also the risk that President Bush attempted to address with his proposals for the housing and mortgage markets. By insuring home owners against default the administration would try to put a floor under the risk profile of the various mortgage backed securitized products on the markets. With less risk in the securitized instruments, because the underlying mortgage are in effect insured, in theory banks and other potential buyers will be less reluctant to purchase such products and more willing to participate in the money markets.

Mr. Bernanke had clearly implied that he does not want to give the financial markets the famous 'Greenspan put' on risk. But he also knows that functioning financial markets are not a luxury but a necessity and that prolonged inhibitions in private lending are a sure way to create the economic effects that he mentions in his speech. So he has also given the equities substantial reason for hope that a rate cut is pending, hence the happy Dow. If the risks ahead are as substantial as he has stated, then what choice will the Fed have except to give the markets what they want, a 0.25% cut on September 18th. Mr. Bernanke has, as we have noted several times, a demonstrated intent in letting the markets know his intentions ahead of time.

Despite the very creditable 4.0% growth in the second quarter, the resilient consumer sentiment numbers, the healthy personal income and expenditures figures and the positive Chicago Purchasers Index, the markets had a singular focus this week, nerves are stretched and ears acute for panic in the credit markets.

Eurozone

Both the German government and the new French administration of President Sarkozy have made their wishes very plain, the ECB should forego a rate cut at the September 6th policy meeting. Mr. Sarkozy has said this since before he was elected and his finance Minister Christine Lagarde said so again this week. But in an unusual move, an unnamed German government official was quoted as saying "Naturally the federal government would welcome it if the European Central Bank would delay its interest rate hike". It is highly unlikely this official spoke without higher government approval, but the German administration does not want to be seen interfering with the independence of the ECB. Even the European Parliament, in the person of Ms. Pervenche Beres the head of the Economic and Monetary Affairs Committee, joined the commentary saying, [ECB President Jean Claude] Trichet is always saying that the economy is healthy. Well if the economy is healthy we should be able to survive this crisis without raising rates". France and Germany are the founders and still the central axis of the European Union and the ECB. Mr. Trichet has said that the considerations for a rate increase will have to begin anew since the August 2nd meeting. The chance for a rate increase narrow daily.

Japan

BOJ board member Atsushi Mizuno, who was the lone vote for a rate increase at the last BOJ meeting, said that any cut by the Fed would not necessarily hamper the BOJ form hiking its own target rate. "The background is more important. It's not as simple as a Fed rate cut will block the BOJ from raising rates". The next BOJ policy meeting is September 18th and 19th, just as the Fed is deciding the fate of the Fed funds rate. Although the BOJ had in earlier statements proclaimed its independence from Fed and ECB policy considerations, it is clear that the world economic background is much on the minds of Japanese central bankers. If the Fed does not cut rates might this embolden the governors of the BOJ to hike 0.25%, and if the Fed does cut will this once again stymie the Japanese?

Economic Releases August 27 - August 31

United States

Monday: Existing Home Sales from the National Association of Realtors (NAR) were 5.75 million units in July, very close to the expected 5.70 million units. June was revised to 5.76 million from 5.75 million. The supply on market rose 5.5% to 9.6 months; the June market supply was revised higher to 9.1 months from 8.8. July's market supply is the highest on record, (since 1999). The median sale price was $228,900, 0.1% lower on the month and 0.6% lower on the elapsed year. Re-sales are 85% of the US housing market.

Tuesday: Case Shiller Home Price Index for June fell 0.5% to 217.07 bringing the figure for the year since last June to -4.1%. In June the figure was 218.37. Conference Board Consumer Sentiment for August fell as expected to 105.00; July was revised down to 111.9 from 112.3, which had been the highest reading for this series in more than a year. All categories were down but inflation expectations were unchanged. Softer labor markets, the housing market and financial markets turmoil were cited as reasons for the decline.

Thursday: Weekly jobless claims for the period ending August 25 gained 9,000 to 334,000 well beyond the -2,000, 320,000 forecast, and reaching the highest level in more than four months. It is likely that layoffs in the mortgage and construction industries are beginning to show up in the statistics. The second release of second quarter GDP, officially named the 'preliminary' issue- the initial release is called the 'advanced'- added 0.6% bringing the annual rate to 4.0%. As predicted by the International Trade Balance results exports were revised upward and imports down. There was little reaction from the credit, equities or currency markets.

Friday: Personal Income rose 0.5% in July well over the expectation for a 0.3% increase; Personal Expenditures expanded 0.4% as predicted. The PCE core gain was 0.1% in July (0.13040%) a 1.9% yearly rate. It was the second month in a row that this price measure, the one most associated with the Fed, was below the 2.0% target. The June rate was 1.9%, the May rate was 2.0%. These results put the three month annualized core deflator rate, using the unrounded figures, near +1.5%. Factory Orders gained 3.7% in July, substantially ahead of the forecast of 3.2%. The July Durable Goods statistic, released last week was revised up 0.1 to 6.0%. The Chicago Purchaser Index for August was a bit better than predicted at 53.8, the median expectation was 53.0; July was 53.4. The final release of the University of Michigan Consumer Sentiment number for June showed a 0.1 gain to 83.4.

Eurozone

Tuesday: The European Monetary Union (EMU) money supply (M3) shot up 1.1% in July, well ahead of the June increase of 0.8%. The annualized return also rose to 11.7%, much stronger than the forecast of 11.1% and the June result 10.9%. The three month moving average gained as well, reaching 11.1%, the prediction had been for 10.9%; June was 10.6%. This is the third straight month that this primary ECB statistic has accelerated and it is the seventh month in a row that it has been in double digits. The official ECB target is 8.0% annually, though it has not been mentioned recently by ECB spokesmen.

Friday: the EMU Economic Sentiment Index for August came in at 110.0, a trifle under expectations of 110.3 and lower than the July reading of110.0. The recent peak for this indicator was 111.9 in May. The Business Climate Indicator rose in August to 1.41 from July's 1.35, but it remains below the recent top of 1.62 in April. The EMU unemployment rate was unchanged in 6.9% in August from July. And finally the Harmonized Index of Consumer Prices (HICP) gained 1.8% in July as it had in June. That makes the twelfth month in a row that this indicator has been below the ECB 2.0% target.

Germany

Tuesday: the IFO Survey of Business Sentiment for August scored 105.8, slightly in front of the expected 105.5 but exhibiting a steady decline over the past five months: April 108.6, May 108.6, June 107.0, July 106.4. Every month the IFO group polls about 7000 German firms for their view on the current economic situation and six month outlook for their businesses.

Wednesday: GfK consumer expectations for August fell well short of forecasts coming in at 7.6 on median predictions of 8.5. The July number was adjusted down to 8.5 from 8.7. The market research firm said in its press statement that "Recent turbulence in the financial markets had fed consumers fears".

Thursday: VDMA Machinery Orders rose 15% in August year on year; in July orders rose 21.0%. Though the slowest increase in three months, VDMA chief economist Ralph Wiechers said in a press statement accompanying the release that, "The latest results do not reveal a weakening of growth". In fact this statistic has varied greatly in the past year, from a low of +8.0% in December to a high of +47.0% in March. The German unemployment rate held steady in August at 9.0%, the same as July and only a trifle over the 8.9% prediction.

United Kingdom

Monday: Hometrack House Price Survey recorded a 5.4% increase in August over prices a year earlier.

Thursday: Nationwide House Prices gained 0.6% in August to a 9.6% annual rate.

Friday: GfK Consumer Confidence for August was better than expectation at -4, -7 had been predicted.

Japan

Thursday: Retail Sales sank 2.2% in July over the prior year. Following the 0.4% drop in June it was the biggest decline since June of 2005. Retail sales have ebbed in nine of the past ten months.

Friday: National Core CPI fell 0.1% year to year in July a rate unchanged from June and in line with market predictions. Central Tokyo CPI in July was unchanged as well at -0.1% the same as June. The nationwide unemployment rate in July dropped to 3.6% from 3.7% in June. Household spending in July slipped for the first time in seven months, losing 0.1% over a year ago. Economists had expected a rise of 0.2%. And lastly on a busy day for Japanese statistics, the preliminary Industrial Output declined 0.4% in July after June's 1.3% gain; a 0.3% decline had been predicted.

China

No statistical releases

The Week Ahead August 27 - August 31

United States

Monday: US markets closed Labor Day holiday

Tuesday: ISM Index for August at 10:00 am ET; expected 53.0, July 53.0. Construction Spending for August at 10:00 am ET; expected 0.0%, July -0.3%.

Wednesday: ADP National Employment Report for August at 8:25 am ET. July +48,000. Federal Reserve Beige Book Report on Economic Activity at 2:00 pm ET; expected 'moderate expansion'.

Thursday: Jobless Claims for the week ending September 1 at 8:30 am ET; expected -4,000 to 330,000, prior week +9,000 to 334,000. Non Farm Productivity for the second quarter at 8:30 am ET, second release; expected+2.5%, first quarter +1.8%. ISM Non Manufacturing Index for August at 10:00 am ET; expected 54.5, July 55.8.

Friday: Non Farm Payrolls for August at 8:30 am ET; expected +100,000, July +92,000. Manufacturing Payrolls for August at 8:30 am ET; expected -10,000, July -2,000. Unemployment Rate for August at 8:30 am ET; expected 4.7%, July 4.6%. Average Hourly Earnings (y/y) at 8:30 am ET; July +3.9%.

Eurozone

Tuesday: Second quarter GDP, second release at 9:00 GMT; expected 2.5%. Industrial PPI for July at 9:00 GMT; expected +0.2 m/m, +1.7% y/y, June +0.1 m/m, +2.3% y/y.

Thursday: ECB Rate Announcement at 11:45 GMT. Retail Trade for July at 9:00 GMT; June +0.4 m/m, +0.9 y/y.

Germany

Thursday: Total Manufacturing Orders for July at 10:00 GMT; expected +3.2% m/m, +11.1% y/y, June +4.6% m/m, +16.0% y/y.

Friday: Second Quarter Labor Costs at 6:00 GMT; first quarter -0.1% q/q, +0.4% y/y. Industrial Output for July at 10:00 GMT; expected +0.7% m/m. +4.8% y/y, June _0.5% m/m, +6.1% y/y.

United Kingdom

Monday: BRC Retail Sales for August y/y at 23:01 GMT; July +1.2%.

Tuesday: Nationwide Consumer Confidence at 23:01 GMT; July 96.

Wednesday: CIPS Services PMI for August at 8:30 GMT; expected 56.5, July 57.0. Manufacturing Output for July at 8:30 GMT; June +0.2% m/m, +0.9% y/y.

Thursday: BOE Rate Announcement at 11:00 GMT.

Friday: DCLG House Price Index for July at 8:30 am GMT; June +12.1%.

Joseph Trevisani
FX Solutions
Chief Market Analyst