Summary: A Coming Shift in Forces Driving Markets? How Long Can the Rally Continue?
Stocks continue to be the prime mover of commodity and currency markets, but there are signs the correlation may be weakening. We consider the evidence both for why this is and what new forces are appearing.
The emerging theme from earnings season: poor results beating worse estimates, but that’s enough excuse to launch a rally back to 2009 highs, sometimes beyond. Seems like a sign of underlying weakness, but could this determined focus on the positive indicate short term strength?
Introduction: Review for the Sake of Preview
As expected, movements in stocks continued to set the general direction for currency and commodity markets, though the connection is showing signs of loosening.
At first glance, the second week US Q2 earnings reports could be seen as a repeat of the first week, with markets hyper-focused on just one question: did earnings beat estimates? Because they mostly did, the market went higher. Never mind that the estimates were very low, and that a closer look usually revealed a declining business and ominous signs for Q3 and beyond.
Stock indexes generally continued to lead markets for other risk assets risk, with commodities, commodity based currencies, and higher yielding currencies (which are bought as carry trade volume rises) following stocks indexes’ general direction.
However, we started to see signs of possible divergence in both timing and magnitude of how currencies and commodities track equities. Regarding timing, there was more daily variation from this rule, with stocks rising one day while other risk assets remain flat, or vice versa. Concerning the magnitude of moves, there are more obvious divergences. That is, stock indexes are near or at 2009 highs, however, most other risk assets are not at comparable levels.
Stock Indexes: Rising despite declining demand? A sign of near term weakness- or strength?
Last week we suggested that the strong rise in equity indexes, despite generally unimpressive earnings performance, could indicate that the markets were biased to further gains, facts be damned. That is indeed what happened.
Earnings for the most recent quarter largely came out ahead of expectations, with 111 beats, 10 in-line and 21 misses. But the earnings beats were largely due to cost cutting measures, not upside surprises on the top line. Specifically, 72 companies posted revenue that failed to live up to expectations, and 102 reported year-over-year declines in revenue.
For instance, Microsoft met analyst EPS estimates in its fiscal fourth quarter at $0.36, but the software giant's revenue decline of 17% y/y to $13.1 bln was well short of the $14.4 bln consensus. Shares of MSFT fell 4.0% for the week.
There were 11 other Dow components that reported -- Merck (MRK), United Tech. (UTX), DuPont (DD), Coca Cola (KO), Caterpillar (CAT), Boeing (BA), Pfizer (PFE), 3M (MMM), AT&T (T), McDonald's (MCD), American Express (AXP) -- all of which topped EPS expectations. Yet the revenue results reflect the difficult corporate environment -- only two companies posted positive (nearly flat) y/y revenue, and seven missed the consensus revenue estimate. The market's reaction to the earnings reports were mostly positive, led by a 23.6% surge in shares of CAT.
Two major banks reported this week, Morgan Stanley (MS) and Wells Fargo (WFC). MS missed estimates and WFC increased its loan loss reserves, driving their shares down. Yet given enough news that the market took positively, the markets were able to hold and ultimately continue moving up despite news from the banks.
While the above sounds like stocks are ready some kind of correction, there is another way to view this dubious rally. That stocks could still keep gaining despite growing evidence of weakness in the big financials and cyclical stocks suggests at least some short term resilience and strength, rational or not.
Conclusions for Equities
- While stocks are already near highs and there is plenty of bad news for short sellers to latch onto, stocks have nonetheless managed to keep going up, so short term traders should be taking what gains the market can give on the long side, but must ready to play the short side when, if, the market turns.
- Longer term investors should be preparing their lists of buy targets if / when stocks tumble
Forex and Commodities
As noted above, followed stocks higher overall though the week, though they did not follow stocks lock-step each day.
Beyond of the rally in USD/JPY and the sell-off in USD/CAD, range trading has been the dominant theme .The euro and British pound for example ended the week virtually unchanged against the dollar while the Australian and New Zealand dollars strengthened marginally. The listless action in the currency market has many traders wondering what the chances are for a breakout in the dollar next week.
The dollar showed unexpected strength this week given that rising stocks and risk appetite have generally hurt the USD recently. This led many to wonder if the dollar might start to trade higher not only as a safe haven when markets decline, but for a new reason-- improving US fundamentals. This makes for an uncertain future when combined with the fundamental influence that the 2Q GDP report will have on the currency. Now, not only do traders have to interpret the data, they will also have to judge whether it has a greater impact on risk appetite or growth considerations for the beleaguered dollar.
Forex Preview: Key Trading Info for the Coming Week
The short version: First, look to earnings and equities for direction in FX and commodities, then second, other economic news. However, look for key news, especially US GDP results on Friday, to become more influential, especially if earnings fail to provide any positive surprises.
Are US economic fundamentals beginning to counteract risk appetite?
Forecast for US Dollar: Bearish
- Fundamentals support an eventual recovery in US and global growth. But when?
- Will improving US fundamentals support the USD, or will the ensuing rise in risk appetite hurt the dollar?
- Bernanke sees signs of stabilization, calls focus on the deficit
Do technical indicators suggest continued decline or reversal?
Assuming that the dollar continues to move inversely with stocks and risk appetite, the most immediate threat to the greenback’s stability is the intensity and direction of risk appetite. While this currency is deeply mired in speculation surrounding the economy’s leading or lagging growth potential, interest rate expectations, and deficit projections among other influences; risk appetite, driven by equities has proven itself to be the key factor in the USD’s movements .
With the Federal Reserve vowing to keep the benchmark lending rate at levels that insure a carry status when conditions do turn around and politicians ensuring the economy will struggle with record levels of debt for years to come, there seems little doubt that the dollar will maintain its position on the opposite of risk appetite.
Or is there? Considering the stalled progress most of the dollar and yen crosses saw last week, despite rising risk appetite as manifested in the stocks and other risk assets, are traders beginning to again consider positive fundamentals of the underlying US economy in favor of the USD?
With EURUSD and GBPUSD just off of key levels of resistance, the pressure is growing. However, the primary source of momentum over the past weeks – the second quarter earnings season – is already showing weakening influence as we appear to be getting the overall theme: beating already very low expectations with declining revenues and/or earnings that do NOT suggest coming real growth.
So, it’s not surprising that while equity indexes are approaching or hitting new highs, commodities, fixed income and risk-sensitive currency pairs have not pushed to comparable levels, though they have certainly followed the same direction. Oddly enough, one of the most likely catalysts for risk going forward also happens to be the most attention grabbing indicator on the US docket: US GDP, to be announced this coming Friday
Given that it will be taken as a gauge of global economic health, we again wonder whether risk appetite or US fundamentals will exert the bigger influence on the USD.
If the GDP reading is seen as positive, the ensuing rising risk appetite could outweigh the implications for US returns and actually drag the dollar down; and vice versa. Another important consideration is the timing of this release. Due Friday, speculators may decide to move the dollar before the data crosses the wires. If this is the case, the GDP report could factor into long-term projections but not short-term volatility.
Major Economic News for the USD
From the U.S., we have housing market data, consumer confidence, durable goods, the Fed’s Beige Book report and second quarter GDP numbers due for release. Of all these reports, the most important will be the Q2 growth numbers on Friday. A further slowdown is expected for the second quarter but the contraction should be more modest. In Q1, the U.S. economy shrank by 5.5 percent. The current forecast for Q2 growth is -1.5 percent. The earnings season also continues with 25 percent of the S&P 500 companies reporting this week, putting us more than half way through earnings season.
The focus will be on oil companies, financials, telecom and media. Some of the big names reporting include ConocoPhillips, Exxon, Chevron, Deutsche Bank, Daimler, Sony and Colgate.
Although there are enough event risks to trigger an upside or downside breakout in the U.S. dollar, outside of the U.S. GDP figures, none of the numbers are likely to surprise the markets. For the most part, we know that the housing market has stabilized, consumer confidence is improving and manufacturing activity is increasing. Even if the data disappointments, it will only confirm the general belief that it will be a long and hard recovery.
Therefore we think that the chances are in favor of more range trading than a breakout in the coming week.
Watch stock indexes
However equities are still likely to be the key influence on the USD, at least until Friday’s GDP report. If equities continue to push higher, we may see an upside breakout in currency pairs such as the EUR/USD, but the rise in VIX futures suggests that risk aversion is returning and therefore equities could face a correction.
If stocks pull back
Rising stocks have fed risk appetite, strong new demand for AUD, NZD, and EUR versus the USD.
Based upon the latest CFTC Commitment of Traders report, for the week ending July 21, forex traders on the futures market added to their short dollar positions. Their demand increased the most for Euro, Australian and New Zealand dollars. In fact, net long euro positions surged from 13,899 contracts a week earlier to 34,722 on July 21. This is the largest amount of long positions since March 2008 and the sharpest gain that we have seen in a very long time. Long Australian dollar positions also increased to the highest levels since August 2008.
Whenever there is such a strong increase in net long positioning, it suggests that the currency pair is prone to profit taking on any piece of bad news. Depending upon the severity of the news, the reversal could also be very sharp.
Deflation and US bond auction pose threat
Fundamental Forecast for Euro: Bearish
Deflation Risk Rising:
- German Producer Prices Fall Most in Over Two Decades
- Euro Zone, German PMI Results Top Expectations, Stay in Below 50
- Sentiment Points to Continued Euro Gains Against the US Dollar
US Bond Auction Could Help USD vs. the EUR
The Euro looks vulnerable in the week ahead as headline inflation figures point to the increasing likelihood of deflation while the US Treasury holds a record-setting bond auction that stands to boost the Dollar at the expense of the single currency.
Germany’s Consumer Price Index is set to show the annual pace of inflation turned negative for the first time in 23 years in July after holding at a standstill in the previous two months. The broader Euro Zone measure of consumer prices has already turned negative, shedding -0.1% in June and likely to slip another -0.4% in July. If expectations of falling prices become entrenched, the currency bloc could be facing a long-term period of stagnation as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.
For their part, the European Central Bank has seemingly struggled to formulate an effective policy response to the deflationary threat thus far. Jean-Claude Trichet and company have focused on banks as the vehicle through which to make money cheaper and put a floor under falling prices, promising unlimited lending to the region’s financial institutions including an unprecedented 442 billion euro in 12-month bank loans. The ECB will also implement a 60 billion bond-buying scheme. To the central bank’s credit, borrowing costs have indeed moved lower: although the ECB publicly maintains target interest rates at 1%, it has allowed the average cost of overnight lending (referred to as EONIA) to drift far below that. Indeed, borrowing in Euros has been consistently cheaper than doing so in British Pounds since late June, even though the Bank of England’s stated interest rates are substantially lower at 0.5%.
However, the lower cost of credit between banks has not translated into lending, and so has offered little stimulus to the overall economy. Indeed, loans to Euro Zone businesses and households grew just 1.8% in May, the lowest since records began in 1991. Banks may be choosing to hang on to cash as a buffer against $1.1 trillion in as yet unrealized losses linked to the subprime mess, according to the IMF, as well as the fallout from looming defaults and/or devaluations among the EU’s newly-minted central European members.
Thus traders may yet punish the Euro as the ECB’s inability to ensure that looser monetary conditions translate beyond the interbank market make deflation all but certain.
US Bond Auction
An unprecedented bond auction in the United States may also weigh on the Euro. The US Treasury’s announced last week that it will sell a record $115 billion in bonds next week in a bid to help finance the rapidly growing public deficit, pushing 10-year notes to register the largest daily loss in nearly seven weeks and sending yields to the highest level in a month.
Many believe that the US Dollar will benefit as the government floods the market with new debt: Treasury prices will head sharply lower, putting tremendous upward pressure on the long-term interest rates. This will make USD-denominated assets attractive to yield-seeking investors, driving demand for the greenback.
Because the Euro is the second-most traded currency after the greenback, it often serves as the de-facto anti-Dollar, with short term studies showing a hefty -85.8% correlation between average indexes of the two units’ values. Meaning that any real turn in sentiment in favor of the US Dollar will weigh heavily on the Euro, not just in the pairing against the greenback but also against other currencies.
Other Euro Considerations: Coming News to Note
Better than expected economic data has lifted the Euro against the U.S. dollar. Based upon the Euro zone PMI reports, manufacturing and service sector activity contracted at a slower pace in July. This improvement was seen across France and Germany with German business confidence also rising for the fourth month in a row to the highest level since October 2008. Stronger consumer spending and higher factory orders have made German businesses more optimistic.
Although these numbers may suggest that the recession is over, the Euro zone economy still faces a lot of uncertainty. Growing unemployment and the rise in the EUR/USD this month could sap domestic and external demand. Don’t forget that the IMF expects the Euro zone to be the only region still contracting in 2010.
The outlook for the Euro zone economy is still unclear but next week’s economic data should help clarify the current economic picture. Germany will be releasing its inflation and employment reports while more sentiment indicators are expected from the Euro zone. We believe that the odds are skewed towards a correction in the EUR/USD in the coming week, though the 1.38 to 1.43 trading range is likely to remain intact. As for Switzerland, the KoF leading indicator report is due on Friday. Stronger numbers are expected, but with Swiss National Bank sitting at 1.50, we do not expect a major breakdown in EUR/CHF.
End Part 1