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Posted: Aug 7, 2009 @ 1840 ET

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THE WEEK AHEAD

Economic Outlook
Monday Aug 10 - Friday Aug 14, 2009  

• The USD bounces back from the brink • Growth outlook may overtake sentiment as the driver • BOE expands asset purchases, raising inflation fears • Key data and events to watch next week.

The past week was characterized by the USD breaking down below its lows for the year against other major currencies (excluding JPY), only to come roaring back on a better than expected US July employment report. At the end of the week, the greenback was back inside the ranges that have dominated the summer so far, and our suggestions to sell EUR/USD near to 1.45, sell GBP/USD near to 1.70, and to sell AUD near to 0.85 look to have played out well. Normally, when a range break in one direction is not sustained, markets will reverse and test the other side of the range. However, Friday's rebound in the USD was largely driven by US bond yields surging higher (10 year US Treasury yields gained nearly 40 bps on the week), and if that's the basis for further USD gains in the near-term, we're not especially optimistic.

While the improvement in NFP was significant, the labor market and the real economy remain exceptionally weak and fragile. In our view, the Fed, which meets next week, is not prepared to signal tighter policy while weekly claims are still above 500K and monthly job losses number in the hundreds of thousands. We expect the Fed to downplay the prospects of an earlier-than-expected exit from accommodation, which will likely take yields off the boil. The only catalyst we can see to higher US rates ahead is another boat load of US Treasury debt auctions next week ($75 bio), for which markets may demand an even steeper premium. To date, however, massive US Treasury auctions have met with more than sufficient demand, and we expect that to be the case in the weeks ahead. In fact, given the back up in yields, the ostensibly improving US outlook, and a rebound in the USD, investor demand may be surprisingly strong, leading yields to move lower again. Since the near-4% peak in 10 year US Treasury yields in early June, which incidentally came following the surprisingly strong May jobs report, yields have held mostly between 3.30-3.88%. We will be watching the 3.88/4.00% highs as the key to whether further USD gains are warranted. In the meantime, we will be extremely protective of USD longs, using trailing stops beginning at 1.4250 EUR/USD, 1.6850 in GBP/USD, and at 0.8450 in AUD/USD (effectively break-even).

Growth outlook may overtake sentiment as the driver.

Over the past many months, traders could be excused if they have come to believe it's carved in stone that good news is USD negative and JPY-cross positive, and bad news is USD positive and JPY-cross negative, so strong have those correlations been. In retrospect, it fits that it was a NFP-Friday that saw that correlation come unhinged, with the USD rallying across the board on better employment news. But this past Friday may have been a turning point in that relationship and we need to be alert to more traditional fundamental factors coming back to drive FX. In that regard, a brightening US outlook may increasingly begin to support the USD, but we would caution that there will be many bumps on the road to recovery. We will be paying more attention to interest rates and bond yields in the days ahead, bearing in mind that the fastest way to short-circuit nascent improvements in housing and personal consumption is for interest rates (or commodity prices) to move higher.

One relationship that did not change very much this past week was that JPY-crosses remain supported by better news and risky asset performance, though they mainly held their ground in the post-NFP action. On the week, though, many JPY-crosses have made new highs for the recent run-up, and that raises the question of how much more room there is to run? Looking at other asset markets, we would note that the S&P 500 looks to have stalled for the moment at the 38.2% Fibonacci retracement of the move down from the 1576 all-time highs to the March lows of 667 at between 1015/20 (depending on whether one uses highest highs/lows, or daily close highs/lows). We would also note that oil is running into difficulty near recent highs at $73.00/50 WTI crude. On commodities in general, much attention is being paid to this past week's sharp decline in the Baltic Dry Index, a proxy for global commodity demand, especially from China. On its face, an improved US outlook should have been bullish for commodities, but USD strength may have kept those markets in check in the immediate NFP-aftermath. Lastly, risk-asset markets have had a significant run higher over the last several months, all based on the view that the outlook was going to improve. Now that we have a stronger basis to declare the worst is over, but still remaining exceptionally cautious on the road ahead, what's the catalyst to further gains? We will be closely monitoring commodities and stocks in the weeks ahead, but remain increasingly inclined to favor consolidation at the minimum, and more pronounced risks for a pullback at the extreme.

BOE expands asset purchases, raising inflation fears.

Not only have the BoE’s actions with respect to Quantitative Easing (QE) this month led to inferences that the economy could be in worse conditions than had been believed but it has had the coincident, albeit opposite, effect of stoking longer-term inflation fears. The publication of the Bank of England’s latest Inflation Report on August 12 will give it an opportunity to calm market fears and clarify projections for growth and inflation going forward.

It follows that the BoE would not have exceeded market expectations with respect to its GBP 50 bln extension of QE if it had serious concerns on the trajectory of inflation. In its previous Inflation Report published in May, inflation was projected to be in the region of 1% at the end of this year. June CPI registered 1.8%, but the ‘stickiness’ of CPI on the downside does suggest that BoE may be a touch less sanguine on the ability of price pressures to disperse particularly against the backdrop of a relatively soft pound and the extension in monetary policy stimulus. That said the Bank will be keen to emphasize that it sees no significant price pressures since a sharp increase in BoE rate hike expectations could, through their impact on market rates, damage economic recovery prospects.

The BoE’s central projections for growth in May suggested little chance of growth before Q1 2010. However, the rhetoric in the May report did recognize that conditions were already improving. Stronger economic data in recent weeks may see the Bank’s growth expectations bolstered moderately. Following the selloff in sterling that followed the Bank’s QE decision, sterling would likely find support on better growth projections. The outlook for cable is complicated by the outlook for the dollar which may begin to find support on the improved US growth outlook. Since strengthening growth expectations should gnaw at JPY strength we would be looking to levels to buy GBP/JPY at dips back to the 162.00 level. GBP/JPY is still 30% lower than its pre-Northern Rock crisis level.

Key data and events to watch next week.

Next week sees a lot of top-tier data around the globe and incoming news will be critical to determining whether current trends can be sustained.

US data kicks off on Tuesday with 2Q non-farm productivity/unit labor costs, June wholesale inventories, and the Aug. IBD/TIPP Economic Optimism index. Wednesday sees weekly mortgage applications and the June trade deficit, followed by the FOMC decision/statement in the afternoon. Thursday has July import prices, advance retail sales, weekly jobless claims, and business inventories. Friday wraps up with July CPI, industrial production/capacity utilization, and preliminary Aug. Univ. of Michigan consumer sentiment.

Eurozone data start on Monday with French July business sentiment, June French industrial production and the Aug. Sentix investor confidence index. Tuesday sees German July wholesale prices and final July German CPI. Wednesday is light with only June EZ industrial production of note. Thursday will be important with 2Q advance GDP reports from Germany, France and the EZ as a whole. Friday see July EZ CPI as the main release.

UK data starts on midnight local UK time on Monday with the July BRC retail sales monitor, July RICS house price balance, followed by June trade balance, and June DCLG home prices on Tuesday morning proper UK time. The data week finishes out on Wednesday with July jobs data and with the all-important BOE quarterly inflation outlook.

In Japan, Monday morning sees the June current account/trade balance, June machine orders, and July bank lending data, followed by the July economy watchers survey in the afternoon. Tuesday afternoon will see the BOJ MPC decision (no change expected) and July consumer confidence. Wednesday morning sees domestic CGPI and final June industrial production in the afternoon. Friday finishes out with the May BOJ MPC minutes and the June Tertiary industry index.

Data from NZ and Australia on Monday sees Australian June home loans and investment lending. Tuesday sees NZ July credit card spending and Australian July NAB business confidence. On Wednesday we'll get Aug. Australian Westpac consumer confidence and the 2Q wage cost index. Thursday sees NZ July business PMI and food prices, and Australian Aug. consumer inflation expectations. Friday has NZ June retail sales and the RBA Governor's semi-annual testimony to parliament.

In Canada, we'll see July housing starts on Tuesday, June international merchandise trade on Wednesday, and June manufacturing sales on Friday.

Also, of special note, China has a number of important releases that will drive global sentiment and markets. Monday will see July PPI/CPI; Tuesday will see the July trade balance; and Wednesday will see July retail sales and industrial production.

Brian Dolan.   .
Chief Currency Strategist   .

Source: Gain Capital Group, LLC.

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