Is it coincidental that the trading week begins with Yom Kippur, the Jewish Day of Judgment? This could well be the week of judgment for the current rally, for good or bad.
A packed news week, climaxing in the critical US Non Farms Payroll and Unemployment Rate reports, collides head on with an aging rally in risk assets on low volume which many believe to be overvalued and long overdue for a pullback.
How long can stocks resist their own historical tendency to revert to some sort of mean, given the weight of fundamentals against them? Just a few points to consider:
- S&P 500 is now up more than 60% from the low, despite mostly flat or still falling revenues. When will fundamentals ever catch up to this level of valuation? After a 60% rally, we are typically well into in the next business cycle, seeing the job creation to sustain and grow the consumer spending makes up 70% of US GDP. Since the rally began in March, the US alone has shed 2.5 million jobs (as may as were lost in the entire 2001 recession). The most optimistic expectations are for continued job losses at a slowing pace. Even for those still holding jobs, this puts downward pressure on wages. The US consumer is still getting poorer, meaning further declines for that 70% of GDP.
- US exports are down 25% from their June ’08 peak
- Credit growth remains negative
- Home sales continue to drop despite record low interest rates, deeply cut prices, and tax breaks for first time buyers
- Business inventories continue to fall
- Looming need to cut stimulus, raise interest rates
- No economy big or healthy enough to replace the US as primary economic engine of the world
- If risk appetite is so strong, why are yields FALLING on US government bonds? It doesn’t sound like the bond market is expecting a very robust recovery. Pimco, the world’s largest bond fund, is already in this trade. They have been loading up on treasuries of late – bringing them to their highest relative weight in 5 years.
Following stocks for now, this does not bode well for commodity prices.
Bouncing Higher on Flight-To-Safety Sentiment, Coming Big News Week To Test the Move
Fundamental Outlook for US Dollar: Bullish
- Falling stocks boost USD, override weak US housing and durable goods orders
- The Federal Reserve left rates unchanged, but signaled a more optimistic outlook
- University of Michigan consumer confidence jumped to a 21-month high in September
- US durable goods orders tumbled 2.4% in August, marking the steepest drop since January
The US dollar ended the past week marginally higher after the Federal Reserve issued a more optimistic outlook on the economy. In the coming week, though, there will be a variety of growth indicators on hand that may clarify whether the US recession really ended in Q2. That said, the US dollar index will have to contend with resistance just above 77.00 at the start of the week, and EURUSD support at 1.4615.
Tuesday, the September reading of the Conference Board’s measure of US consumer confidence is expected to rise up to a one-year high of 57 from 54.1 in August. Last week the University of Michigan’s consumer confidence index show that sentiment improved greatly in September, with the index hitting a 21-month high of 73.5 from 65.7. Note however, that consumer confidence has yet to translate into sustained spending growth.
On Wednesday, two big events:
- ADP Non-Farm Employment Change report, the first big hint at Friday’s official and more important US DOL reading. This is arguably the climactic event of the week, if not the month, since it’s the key indicator of future consumer spending, which is 70% of US GDP.
- Final US Q2 GDP estimates are due to hit the wires, but the results will only be market-moving if we see surprising revisions. The final reading is forecasted to be revised down to -1.2 percent from -1.0 percent, though this would still represent a sharp improvement from Q1, when GDP plunged 6.4 percent. Better-than-anticipated results could lead carry trades higher, especially in light of speculation that the recession may have ended in Q2.
On Thursday, the ISM manufacturing index is projected to rise for the ninth straight month in September to 54 from 52.9, which would be the highest reading since April 2006. With 50 being the point of neutrality, this would also be the second month that the index signals an expansion in activity, adding to evidence that the sector is experiencing a recovery in business activity. As with the last release, overall risk aversion will dominate the USD that day. However, the report will still be useful because of its employment component as a leading indicator for the big news on Friday: US non-farm payrolls.
Barring major surprises, The US non-farm payrolls (NFPs) index should be the climactic news of the week. It is forecasted to show job losses for the 21st straight month in September, though the rate of decline is anticipated to slow further. At the time of writing, Bloomberg News was calling for NFPs to decline by 187,000, which would be the smallest drop since August 2008. Meanwhile, the unemployment rate is projected to edge up to 9.8 percent from 9.7 percent, but ultimately, the NFP result will be the event to watch as it is extremely volatile and is one of the very few reports that impacts the US dollar from a pure fundamental point of view. A better-than-anticipated result is likely to provide a boost to the US dollar, but it will be interesting to see the impact of disappointing results as weak US data tends to weigh on risky assets and push the greenback higher amidst flight-to-quality.
Big news week For Both EUR and USD Suggests The EURUSD Trend May Be At Crossroads
Fundamental Forecast for Euro: Neutral
- Risk sentiment reflected in the S&P likely to continue to drive the pair, override news
- Euro breaks key technical short-term trend line
- Candlestick charts suggest a potential Euro reversal
- German IFO improves for sixth month
A late-week breakdown in risk sentiment sparked a flight to safety across forex markets—predictably to the Euro’s detriment, because it tends to move opposite the USD, which usually rises in such conditions. Near-term Euro forecasts will very much depend on the trajectory of risk assets, and a busy global economic calendar promises no shortage of volatility through the week ahead.
While just a few days of declines doesn’t necessarily signal a major top, the EUR/USD lost much of its short-term momentum—having broken below short-term technical support and threatening further declines. Fundamentals will likely play a fairly significant role in the days ahead as the combination of German and US Employment figures will illuminate economic conditions in both key countries. The reports may confirm recent waves of economic optimism or temper them. No one disputes that there have been improvements, the debate is all about whether risk assets are overpriced in relation to likely results over the coming year.
Early-week German Consumer Price Index numbers and Euro Zone Consumer Confidence figures could produce surprises, but most traders look forward to market-moving German Unemployment Change figures due Wednesday. Prior results showed unemployment actually fell for the second consecutive month through August, but the numbers were distorted by government stimulus payments inducing firms to keep workers on their payrolls, thus their significance was limited. Forecasts for September results call for a far less sanguine 20k jump in unemployment. Given that Germany is largely considered the bellwether for the broader Euro Zone economy, any disappointments could led to a noteworthy correction in the Euro exchange rate.
For the days leading up to and following it, Friday’s US Nonfarm payrolls result could likewise have a pronounced effect on Euro pairs. US and European markets have proven especially sensitive to major surprises in the monthly payrolls number. Consensus forecasts call for the eighth-consecutive improvement in the jobs release, and any disappointments could clearly make a dent in broader forecasts for growth out of the world’s largest economy.
The critical question remains whether we can expect further equity market gains. Much like the Euro, the S&P 500 showed early signs of reversal through late-week trade. A continuation of said tumbles could easily force the Euro to move in kind.
Risk Sentiment, Along with Intervention Threats and Data Drive Yen Higher
Fundamental Forecast for Japanese Yen: Bullish
- Recently relatively steady with rising stocks, strong with falling stocks, thus offering more reward than risk.
- Finance Minister Fujji reiterates his opposition to FX intervention
- Policy officials start reducing the stimulus that has supported the most aggressive rally in decades
- Exports shrink 36 percent in the year through August, exacerbated by sharp appreciation of the yen
The Japanese yen was clearly biggest mover and gainer amongst the majors this past week. However, we can’t attribute this appreciation to risk appetite alone. Other risk sensitive assets (equities, bonds funds, commodities, high-yield currencies) have pulled back over the same period; but not to the degree of increase in the yen. Underlying sentiment no doubt prompted the trend; but early signs of policy withdrawal and confirmation from the new Japanese Finance Minister suggesting the days of FX intervention has passed provided the fuel for momentum. Whether this trend continues will depend on overall risk appetite, which in turn will be influenced by the markets’interpretation of the G-20 commitments; weighing the fair value of the yen; and the outlook for the domestic recovery.
While the first concern is related to the G-20 meeting and commitments that were announced this past week, the fundamental relation to the yen is risk appetite. In the six-month rally from anything and everything that can bear a yield above the risk-free assets that traders took shelter in during the worst of the crisis, we have seen an early upsurge in demand for return and an elemental redistribution of capital. There have certainly been earlier adopters to the market reversal and those lured in by the steady capital gains; but most of the inflow of wealth is simply coming from the market sidelines and is seeking an investment with stability and steady returns.
Given the trend’s duration and movement, it wouldn’t take much to spark fear of a reversal and catalyze a wave of profit taking; but it is the money that is flowing back in for the long haul that will decide the larger trend. Both these short-term and long-term dynamics can be impacted by the G-20’s joint statement and individual government’s efforts going forward. The impressive recovery in market levels this past year is in large part due to the guarantees, liquidity injections and bailouts by the world’s policy makers.
It is unclear whether speculator confidence in the balance of risk and reward will be anywhere as strong as it has been without the government safety net. However, with German and the US cutting down its programs last week while the global call for ‘exit strategies’ grows to a roar; we’ll know soon.
It is generally true that the majors are free-floating currencies and economics indeed sets exchange rates; but perfection only exists in academic theory. In reality, the Japanese yen has carried the burden for potential intervention from the Bank of Japan for years. As a major export nation, the former DPJ administration considered a ‘weak yen’ policy essential to economic stability. However, new LDP Finance Minister Fujii has explicitly said that the currency should reflect economics. The first time, the policy makers made this statement the week before last, the yen responded with a sharp appreciation. With a reiteration of the same this past week (despite the yen being at relative highs), the currency moved on to another leg of its rally. How much pressure has been priced in due to intervention fears? Only time will tell. What’s more, how will the economy handle this steady appreciation? Domestic demand has long been lacking for Japan.
Of course, this all assumes Fujii-san actually means what he says, not a given in politics, particularly when exporter pressure becomes extreme.
As the currency appreciates, a critical artery of growth is slowly pinched off. In line with the G-20’s commitment to balance savings, domestic demand and trade; Japan will have to compensate for the potential loss in exports with domestic demand at a critical time for the economy. In the midst of a fragile recovery, we will watch key economic data due over the coming week to check Japan’s progress in getting out of its worst recession on record.
The 3Q Tankan surveys, industrial production, employment, household spending, housing activity and inflation will offer tangible evidence.
See Part II for Continuation
DISCLOSURE/DISCLAIMER: Opinions expressed are not necessarily those of AVAFX. The author has positions in the above instruments.