Before June 22nd’s employment data, there were many who could still see global markets heading higher. For the near term, that opinion now appears out of favor. The debate is now whether markets will continue their mostly horizontal tight trading ranges of the past month or more, or if their retreat from May’s highs will now prove to be the beginning of a new down trend to test support levels.
For those who missed the fireworks, here’s a recap.
Is July the Turning Point? Or Just Another Move Down Within Price Channels?
Markets were nervous on Thursday before the Non-Farms Payrolls report came out, with Asian, and European stocks already solidly down on Thursday before the report came out. The results confirmed the fear.
Context Is Everything
To understand the impact the July 2nd NFP employment data had, consider the context.
- News over the last weeks of June had been mixed and markets were waiting for an important indicator like the monthly US NFP results.
- Major World Stock Markets were typically sitting on gains of 20-30% since the rally began March 3rd from surprisingly good Q1 US financial results. Yet in fact there had been little fundamental data to suggest that employment, GDP, earnings, or any other meaningful measure of improvement would show similar gains over the coming year. Thus in June most global equity, commodity, and currency markets reflected this concern by trading in tight horizontal channels awaiting news to clarify if the growth already priced in with the current rally was really coming. Confidence in the rally was fading, markets were nervous.
- During these final weeks of June, the biggest news (and biggest drop in most global markets) came when the World Bank announced downwardly revised estimates for even greater global economic contraction. Markets recovered from the drop, due to no small degree to a more optimistic picture from the OECD that served to balance the World Bank’s more pessimistic outlook. However, the very basis for the OECD forecast was a more optimistic view of US growth, which it believed would outweigh a worsening situation in other regions. Thus the NFP report struck at the foundation of the OECD's view, undermined it, possibly leading traders to conclude the World Bank was right and that real recovery( in the US or elsewhere) is not coming soon, and that growth related assets were likely to fall in value.
Unemployment is Key for the US
In short, the NFP report served to tip sentiment firmly negative, furthering the belief that recovery would not be as soon or as strong as hoped. With about 70% of US GDP coming from consumer spending, the NFP report hit expectations for the US especially hard, since
· Worsening employment directly undermines consumer spending. Not only were more jobs lost than expected, but average hourly wages were flat and average hours worked declined. Thus even the US worker/consumer who still has a job is earning less.
· Bank stress tests’ worst cast unemployment for 2009 was 8.9%, and it’s now at 9.5% with no strong sign of slowing. More unemployment means more deterioration in bank mortgage and credit card portfolio valuations, more defaults, more need for additional bailouts.
· Mortgage rate resets are coming in waves in 2010-11, and will result in much higher mortgage payments, further increasing the default rate for a poorer US homeowner and further weakening the banks.
Remember, news about the health of the US financial sector has been the root of all major market moves over the past two years since the current crisis began.
The news really was bad. The U.S lost 467K jobs in May, about 29% more than the 363K forecasted and 45% above April’s surprisingly small (at least in today’s market) loss of only 322K jobs. This report, issued at the beginning of June, had fed hopes that the worst might be over, and kept world stock and commodity markets mostly, trading in a horizontal range near their highs for the year, awaiting further news to justify the 20-30% gains in stocks since the beginning of March and nearly 100% gain in crude oil since 2009 began.
This report dashed those hopes, causing a predictable sell off in US trading on Thursday in “risk-appetite” assets that appreciate with optimism about the world economy stocks, commodities, and higher risk currencies (the AUD, NZD). Safe haven assets, particularly the JPY, USD, and CHF currencies rose against other currencies deemed riskier.
Since Tuesday July 7th, most markets have settled into tight trading ranges
Big Themes For the Coming Week
The S&P remains the key market to watch
It’s the best single best indicator of global stock markets, which are the best indicator of fear/pessimism, which is what drives commodity and currency markets.
Note the correlations between the daily S&P chart, that of other major international stock indexes, and those of a few representative currency and commodity. Note the moves on July 2nd (when the US NFP data was released, sparking the recent sell off) and beyond, and how well they correlate.
Comparison of Daily Stock Index Movements with Representative Commodity and Currency Markets
Q2 earnings season is now in full swing, and perhaps the most important news that could move the USD, and the markets, will be Q2 results from the financial sector, especially from the 20 largest institutions that Washington won’t let fail. Again, this sector has been the root of both the market collapses and rallies, and surprises from Wall Street could easily outweigh other events this week. Their fundamentals are, if anything, eroding along with US jobs and spending.
However, will this weakening show up yet? Many, such as noted economist Nuriel Roubini, believe the banks may be able to somehow exploit laxer accounting rules to present a decent picture for the next quarter or so. However, there are too many potential time bombs due to go off in the next 2-4 quarters to really believe the nasty news is still to come for the banks, and thus, for all global markets awaiting recovery.
Thus if an overall positive or negative theme emerges from Q2 earnings, especially financial earnings, THAT could easily be THE market moving news of the week.
Thus the rally in world “risk assets” like stocks, commodities, and riskier currencies like the AUD and NZD may indeed still be well ahead of world growth prospects, and thus vulnerable to pullback. Resulting risk-aversion would be likely to include:
- Gains by safe-haven currencies (JPY, USD, CHF) against riskier and commodity-based export currencies (AUD, NZD, CAD)
- Downward pressure on commodities, and stocks, either in the form of an outright downtrend, or continued trading in the current ranges established over the past 4-8 weeks, with risk assets approaching or testing support levels, and safe haven assets like USD, JPY, and CHF currencies moving in the opposite direction
- If March lows tested in global stocks, possible long opportunities, especially for buy and hold income stock investors
US Dollar: Declining Risk Appetite Favors It Against Riskier Currencies, Now Awaiting Next Big News, Probably from Q2 Earnings, Especially Financial Sector Earnings Coming This Week
Overall USD Outlook for the Coming Week: Neutral
Risk Appetite Has Been the Key Factor in Currency Markets, So Rising Fear Could Boost the USD Toward Its Upper Range Against Riskier Currencies, however its steep drop against the JPY appears overdone.
Summary & Potential Market Movers for the USD
Overall USD Outlook: Neutral – But More Fear Could Well Boost the USD
- IMF upgrades its forecast for the US, downgrades most of the world including Euro zone and Britain, but upgrades Japan, Canada
- Consumer confidence declines for first time in 5 months
- G8 avoids talk about replacing USD as reserve currency
- Biggest news this week for the USD: The overall theme of US Q2 Earnings, especially financial sector earnings. Also: Tuesday’s monthly Core Retails Sales, Wednesday’s Core PPI and FOMC minutes, Thursday’s TIC Long-Term Purchases, Friday’s New Building Permits
USD Has Been Moving on Fear, Not Fundamentals, Awaits the Next Big News
Risk aversion, certainly not fundamentals, has made the USD one of the the strongest of the majors in the past weeks. In May there were those who questioned whether the dollar was still seen as a safe haven. Both the World Bank downgrading of world economic growth and the recent US jobs data driven market drops have reaffirmed the USD’s safe haven status. This past week’s IMF report revised its forecast upward for the US (less contraction), which these days passes for a good report.
For the later part of the past week, the markets seemed to have digested the increased fear levels and the dollar has mostly settled into a tight trading range against other majors, and is likely to begin the week that way as currency markets await the next big news that moves the prevailing fear level up or down.
The big exception may continue to be the USD/JPY which has been diving without any clear reason. Some propose a combination of factors has converged to drive the pair down, such as narrowing interest rate spreads between US and Japanese government bonds, concern about Japanese exporters dumping dollar holdings, etc. However, in the end this is all speculation and thus, lacking any evidence otherwise, we must assume it is an over-reaction vulnerable to correction. Those continuing to sell this pair should proceed with caution, since such steep declines as seen with this pair don’t tend to last.
Since the current crisis began, bad news, especially from the still most economically important US, has paradoxically strengthened the dollar in the short term because it is still seen as a safe haven.
However, given the worsening employment and wage picture, the longer term picture for the USD is worrisome, since fewer jobs and lower earnings means less consumer spending, which is about 70% of the US GDP. Of course that means lower exports to the US for the rest of the world’s economies, which would also weigh on their currencies. Thus the dollar need only be the least ugly currency of the bunch to be the strongest.
It’s also a major problem for the US banks, as poorer consumers mean declining value for both residential and commercial mortgage portfolios. The bank stress tests assumed a worst case 8.9% for 2009, and we’re already officially well above that at 9.5%. The real figure could easily be far worse, due to the way US employment data is gathered.
Q2 earnings season is now in full swing, and perhaps the most important news that could move the USD, and the markets, will be Q2 results from the financial sector, especially the 20 largest or so that Washington won’t let fail. Again, this sector has been the root of both the market collapses and rallies, and surprises from Wall Street could easily outweigh other events this week.
Euro Likely to Remain in Tight Trading Range Barring Breakdown in Stocks
Overall Euro Outlook: Bearish
- Emerging overall theme from US Q2 earnings, especially from banks, may be the biggest influence
- Euro bounces on financial risk sentiment, German Trade Balance data
- German Industrial Production gains most in 16 years
A relatively busy economic calendar in the week ahead suggests we can expect a pickup in intraday price moves, but low volatility expectations give little scope for a sustained EURUSD breakout.
Potential Market Movers for the EUR
News that might move the pair this week includes:
- Tuesday’s German ZEW institutional investor sentiment
- Tuesday’s Euro-Zone Industrial Production
· While there is potentially market moving news on the calendar, the recent past shows that if there is news that moves the S&P, could outweigh all others.
The recent downturn in global financial and economic sentiment suggests that future outlook for business conditions may have suffered through the month of July, and there are noteworthy downside risks to consensus forecasts. Ditto the Euro Zone Industrial Production numbers.
Recently published German Industrial Production reports showed that output grew at its fastest in 16 years in the month of May, and similarly robust figures out of France boosted forecasts for upcoming Euro Zone data. Consensus forecasts now call for a noteworthy 1.5 percent month-on-month gain in European industrial output—a welcome sign of hope for the industrial sectors. Substantial declines in consumer demand have meant that spending has fallen by record amounts across the Euro Zone, and highly export-dependent countries such as Germany have felt the pinch. We will need to see upcoming Industrial Production numbers impress to keep hopes of sustained recovery alive. And though Euro Zone Industrial Production figures have not historically produced major EURUSD volatility, traders should be on the lookout for any post-event reactions on the data.
It will otherwise remain important to monitor trends in broader financial markets—especially the US S&P 500, which fell near its lowest levels in over two months, causing a by now predictable drop in the Euro, this time by nearly four percent against the Japanese Yen, on flight-to-safety flows. Similar flare-ups in market tensions could once again drive EURJPY price moves, but note that the Euro has held firm against the US Dollar.
Last week commentators noted that forex options markets pointed to limited Euro/US Dollar volatility expectations and suggested that the EURUSD would remain stuck in its recent range. Flare-ups in financial market tensions leave 1-week Implied Volatility levels on EURUSD options marginally higher on the week, but we doubt that these point to a Euro breakout. Given such an environment, we may have to wait until a material shift in financial market sentiment before calling for extended EURUSD moves. Until then, expect the Euro to remain choppy within a wide trading range against the US Dollar.
To be continued in Part II
I have positions in most of the above mentioned investments.
The views of the author are not necessarily those of AVAFX