The Speculative Urge

    The ECB rate bias fizzle
    European rhetoric and reality
    American gloom

Did Jean Claude Trichet, the European Central Bank (ECB) President really put the central bank on a neutral bias last week? After the bank held rates at 4.00%, citing “downside risks to growth” and Mr. Trichet noted that “4.00% allows price stability” it certainly seemed that the European bankers were preparing the market for a change in policy. From a neutral bias to an easing bias, from stable rates to falling rates and a depreciating euro, is a short step mediated only by a central bank’s need for deliberate and studied movements in policy. The euro fell two figures against the dollar after the ECB announcement and traders were set to take it lower. But without follow through even a central bank pronouncement dies a quick death. European GDP did not show a faltering economy in the fourth quarter. Mr. Trichet and Axel Weber, ECB board member, President of the German Bundesbank and staunch inflation hawk quickly returned to their anti-inflation rhetoric and the euro slowly climbed back to the middle of range it has held against the dollar since late November.

Had the US economy delivered stronger figures this week or the EMU weaker ones, the ECB rhetoric would have mattered little and the euro would likely have continued to fall. A rate neutral ECB is a new factor in currency market assumptions and one that normally leads, in time, to lower interest rates. Declining ECB rates are clearly not priced into the current euro dollar levels, hence the plummet last Thursday. But even without corroborating European and American statistics the euro would probably have continued to fall against the dollar, if Mr. Trichet and company had kept silent. But they did not. Why would the ECB adopt a neutral rate outlook one week and then publicly contradict it the next?

One thing central bankers do not want, if they can prevent it, is for rapid changes in currency rates to become a factor in their own calculations or to add a complicating factor to an already difficult economic environment. Put plainly they do not want the currency markets to anticipate too much or too quickly. The change in ECB bias from tightening to neutral was deliberate– the next ECB move will be a rate cut. But the subsequent talking up of inflation was just as deliberate.

If the euro rapidly deflates on speculation that the ECB will soon cut, as would be natural after an unchecked change in bias, then the pressure for the bank to act as the market anticipates becomes that much greater. The European bankers are anticipating lower economic growth otherwise why put the bank on a neutral base after months of strident anti-inflation rhetoric. EMU economic activity is supported by exports and exports are curtailed by a strong euro. Market speculation on an impending ECB rate reduction cycle world, if left uncountered, quickly drive the euro lower. Similar speculation on a US economic slowdown after the credit crisis erupted last August drove the euro 12% higher in only three months. And there is nothing to prevent the reverse happening now. However, though the ECB governors may have concluded that they will have to cut rates at some point in the future, they do not want their timetable affected by currency traders, or at least they want to minimize such effects.

If the euro deflates rapidly between now and the March ECB meeting and the governors determine then that the time is not yet ripe for a cut and they do not, then the euro could easily reverse and flood higher. The turmoil that such violent currency moves create in the world financial system confounds the bankers’ attempts to restore calm and insure financial stability. The last thing the world’s central bankers want in the current tense state of the world’s financial system is complication. Calm and deliberate adjustment in currency rates is the bankers’ goal. Unfortunately for them the world’s currency markets are not calm and deliberate places. Thus we have seen the back and forth of ECB rhetoric and the screen of words hiding a true change in intention.

But there is another complicating factor in the central bankers view, uncertainty. The world economy has evolved rapidly in the past ten years. Asia has added huge amounts of wealth and consumer spending to the world’s economy. But whether Chinese and Indian consumers can prevent a US recession is unknown. Add to this the waves of deleveraging losses washing through the banking and financial system and the unresolved crisis of confidence in the credit markets and you have a situation primed for speculative upset.

The G7 meeting last weekend in Tokyo produced small changes in the communiqué and none in economic policy or forex outlook. The general forex statement was unaltered; it has been basically unchanged since 2004. “Exchange rates should reflect economic fundamentals”, and “excess volatility and disorderly economic movements are undesirable”, are the venerable mantras. The wording of this section was identical to that of the prior communiqué. The Chinese were chided ever so slightly to keep yuan appreciation on track. The text of the communiqué from the previous meeting in Washington said “we encourage” the Chinese to appreciate the yuan. This time the text read “we stress its [the Chinese] need to allow accelerated appreciation” of the yuan. It was less than a minor change, in fact it was an acknowledgment of the doubling of the yuan rate of appreciation from 2006 to 2007 and the influence Chinese reserves and debt holdings have with the finance ministers and government officials of western industrialized nations.

Central Banks
Federal Reserve
Federal Reserve Chairman Ben Bernanke’s testimony before the Senate Committee on Banking, Housing and Urban Affairs broke no new ground. He repeated the Fed stance that the economy is beset by credit, housing and employment risks to economic growth but that the governors do not expect a recession. He predicted that the stimulus effect of rate reductions will work through the economy generating moderate growth in the third and fourth quarters. With rates at 3.00 %, the result of a 225 basis point reduction in a little more than four months, the Fed is likely to be approaching, at least in planning, the end point for reductions. Patience is a possible theme for future Ben Bernanke pronouncements though it was not much in evidence this week. Every indication is that more cuts are coming at the March 20th – 21st FOMC meeting.

European Central Bank
Jean Claude Trichet, president and monetarist did not sound like a banker preparing to cut rates when he said, paraphrasing American economist Milton Friedman, that inflation is ultimately a monetary phenomenon. European Monetary Union (EMU) money supply growth, 11.5% in December, is almost 50% higher than the stated ECB target of 8.0%. It is not a statistic Mr. Trichet would draw attention to if a rate cut was in immediate contemplation. Mr. Trichet also tended the economic side of the rate policy argument by noting that economic conditions are not the same in the US and the EMU. And, he said, the ECB is doing what is necessary in its own circumstances by insuring price stability.

Axel Weber, Bundesbank Governor and ECB board member returned to his normal position on the inflation watch warning that inflation and price stability at the only sights on the ECB horizon. “Against the backdrop of these [economic] prospects the current interest rate expectations in financial markets do not—at least not for a stability driven central banker—reflect an appropriate evaluation of the inflation risks’. It was an unusual personalization of his position, but the message could not be clearer, do not factor rate decreases into your positions.

Bank of England
The Bank of England quarterly Inflation Report was a warning that the pace of rate reductions postulated by the market may be overdone. The report predicted that inflation will be just over 2.2% in two years under the current market expectation that rates will fall from where they are now, 5.25%, to 4.8% in the second quarter and to 4.5% by year end and to 4.4% in 2009 before rising again. Inflation would peak at 3.00% in the second quarter of this year under this scenario. At a constant 5.25% rate inflation would be well below 2.0% in two years. The bank’s GDP forecast was reduced below 2.0% for 2008 and with expressed concern for downside growth risks. The best reading of the report is for two more 0.25% cuts, with the timing front loaded in 2008.

As with its American counterpart, the British central bank is more worried about growth than inflation and will probably cut rates again before the May inflation report. But the governors do not want market expectation to get ahead of themselves. “In the central projection higher energy, food and import prices push inflation up sharply in the near term. Inflation then eases back to a little above the 2.0% target in the medium term as the near term rise in energy prices drops out of the 12 month rate and capacity pressures moderate”. “Overall the risks around the central projection to growth lie to the downside while those to inflation are balanced”.

Japan
The Bank of Japan left the overnight call rate at 0.5%; the vote to do so was unanimous. The bank last changed rates one year ago, when it added 25 basis points bringing the rate to 0.5%. It was then only the second hike of its “flexible and gradual” policy which started in July 2006 after a prolonged period of zero percent interest rates. The bank spokesman characterized monetary conditions in Japan as accommodative.

The Week in Review February 11 – 15
United States
The US economy has slowed. Job creation and GDP have dropped and unemployment claims have risen to near recession levels, but retail sales, durable good orders and manufacturing ISM are holding above contraction rates. Unemployment is below 5.0%, a rate that in past economic eras, say 15 years ago, would have been viewed thankfully by all concerned. The recession question is still unanswered.

The joint testimony of Ben Bernanke, the Fed Chairman, and Hank Paulson, the Treasury Secretary, before Congress was sober and economically downbeat. “The outlook for the economy has worsened” said Mr. Bernanke in his prepared statement. With the American economy weaker than previously thought, the Fed’s insurance rate cuts, which began six months ago are beginning look very prudent. Considering his now longstanding commitment to respond to economic conditions, the Chairman’s statement promises further rate reductions. Even though the extant statistics are poor but not terrible, Mr. Bernanke expects worse times ahead.

Eurozone
The EMU trade balance moved sharply into deficit in December at -€2.1 billion, and the November surplus was downgraded by almost 1/3 to +€2.0 from +€2.7 billion. Exports fell 2.5% and imports rose 0.7%. With these new figures it is estimated that exports will not make any contribution to GDP when the revised fourth quarter numbers are issued. The preliminary GDP figure was 2.3% year to year, 0.1% higher than the forecast and could be adjusted lower.

Australia
Buoyant commodity markets and prices have been good for the Australian Dollar. World demand for commodities has been the main driver of prices, but with the world economy set to slow, the downside risk for the aussie has increased. Not withstanding the recent Reserve Bank of Australia’s 0.25% hike, inflation and growth pressures on the Australian economy should subside in the months ahead, bringing the negatives for the currency into sharp relief.

Economic Releases February 11 – 15
United States
Wednesday: retail sales gained 0.3% in January well ahead of the median forecast for a contraction of 0.4%. December’s -0.4% reading was unrevised. Retail sales minus automobile sales, the ‘ex-auto’ number also grew by 0.3% , better than the +0.2% forecast; December’s figure was adjusted 0.1% higher to -0.3%, November and October were each revised down 0.2% , November to +0.8% and October to +1.5%. The January number is not quite as positive as it first appears because gasoline prices pushed up the headline number, without its inclusion the retail sales number would have been +0.1%. If the 2.0% rise in gas station sales is subtracted from the ex auto number the result is flat for the month.

Thursday: the International Trade Balance registered -$58.8 billion in December a surprise 6.5% improvement over November’s $63.1 billion deficit; -$61.5 billion had been forecast. It was the best month to month performance since October 2006 when the deficit shrank 9.3%. Imports fell $2.2 billion, -1.1%, even though the importation of oil and related items rose $1.3 billion as volume fell but the total value rose based on the record price of $82.76 per barrel. Exports rose 1.5%.

Only the deficit with the OPEC nations increased, reaching a record $12.3 billion; in November it had been -$11.8 billion. The gap with China fell to $18.8 billion from $24.0 billion and that with Japan slid to $0.5 billion to $6.6 billion. The non-oil deficit was $34.8 billion, the lowest since November 2003.

Exports are growing a 12% yearly clip, more than three times the growth rate of imports. This disparity could add up to 0.3% to 4th quarter GDP upon revision because the actual trade balance is better than the estimate that was used to generate the advanced GDP figure. In 2007 the total deficit was $711.6 billion, 6.2% smaller than the 2006 deficit of $758.5 billion.

Jobless claims for the week of February 9th dropped 9,000 to 348,000, 340,000 had been predicted. The four week moving average gained 12,000 to 347,250 as the low numbers for early January drop out of the average. It is the highest average since October 2005. The trend higher in the moving average is worrying but it is not yet at recessionary levels of 375,000 or more.

Friday: University of Michigan Consumer Sentiment fell precipitously in February to 69.6 from January’s 78.4 level; 75.0 had been forecast. Except for a few months immediately before the Iraq invasion in 2003 this is the lowest reading since 1993 and it has a recessionary feel about it. ‘Current conditions’ fell to 85.4 from 94.4 and ‘expectations’ sank to 59.4 from 68.1.

The Treasury International Capital System information (TICS) gathered by the Treasury Department recorded 56.5 billion in net Long Term Securities Purchases in December. Foreigners purchased $69.1 billions in US securities and US residents bought $12.6 in foreign instruments. Of the total overseas purchases $33.3 were by private sources, down from $58.5 in November; $35.8 billion were bought by governments or associated entities, almost triple the $11.8 billion bought in November. Foreign governments have not curtailed their acquisition of American debt instruments. In 2007 the average monthly net purchase of long term securities by foreigners was $61.76 billion, more than adequate to fund the monthly average international trade deficit of 59.18 billion.

Industrial production rose 0.1% in January half the +0.2% predicted; Capacity utilization moved up 0.1% to 81.5.

Eurozone
Tuesday: the ZEW Survey “economic expectations’ improved to -41.4 in February from -41.7; ‘current conditions’ plummeted to 21.8 from 47.8.

Wednesday: industrial production contracted 0.2% in December well below the expected 0.6% expansion; November’s result moved up 0.1% on revision to -0.4%. The year on year rate fell to 1.3% in December barely half the +2.7% rate in November, +2.4% had been anticipated. Including revisions the fourth quarter gain of 0.1% was far less than the +1.4% jump in the third quarter. Industrial production has declined 0.9% since August of last year. Flash fourth quarter GDP was up 0.4%, slightly better than the +0.3% prediction and rating +2.3% on the elapsed year, 0.1% better than predicted. There was no currency market reaction to the numbers.

Germany
Tuesday: the ZEW Survey of ‘financial experts’ showed a bit of positive movement in the ‘economic expectation ‘ category rising to -39.5 in February from January’s -41.6; -45.0 had been the median forecast. It was the first rise in 9 months for the expectation index which had been at a 15 year low, but it remains well below the long term average of 30.7. In contrast the ‘current conditions’ component fell for the eighth straight month to 33.7 in February from 56.6, exhibiting the sharpest drop in month to month results since July 2001. It was also the lowest reading since August 2006; the forecast had been for a small decline to 50.0. Most of the data was collected before the ECB moved to a rate neutral stance last Thursday. Total retail sales for December were revised substantially lower to +0.4% from the preliminary +2.2%, with the yearly number falling to -9.1% from -8.3%. Both numbers are seasonally adjusted. In 2007 these sales fell 3.28%. These figures are collected by the German Bundesbank. The response of the German consumer to a real or potential economic slowdown is very different than that of his US counterpart. In the States consumers practically have to be threatened with foreclosure before they curtail their free spending ways, while in Germany they seem to pull back at the first sign of future trouble. The historical and cultural differences are striking. So too is the effect of higher tax rates in Germany which leave much less disposable income in the hands of the German consumer.

Wednesday: wholesale prices rose 1.4% in January, a rather shocking +6.9% yearly rate. Prices had fallen 0.5% in December, which was +5.1% on the year. Flash GDP for quarter four was +0.3% and +1.6% year on year, as expected. It was the slowest quarterly growth since the second quarter of 2007, positive exports and equipment orders were offset by moribund consumer spending.

United Kingdom
Monday: the Department of Communities and Local Government (DCLG) House Price index cooled a bit in December rising 9.1% year on year; the November figure was revised higher to 9.7% from 9.5%. This index is based on completed mortgages rather than asking prices so it provides a better gauge of actual selling price levels. The Producer Price Index for input prices gained 2.6% in January and a hefty 19.1% year on year. Output prices were 1.0% higher, up 5.7% on the year. Core output prices rose slightly less at +0.8% and +3.1% year on year.

Tuesday: CPI in January was better than expected at -0.7% for the month and +2.2% for the elapsed year; +0.6% and +2.3% had been predicted. December’s readings were +0.6% and +2.1%. Nevertheless the January year on year number was the highest since June of last year. Core CPI fell 1.0% in January, far lower than the +1.5% prediction and December’s +1.4% rise. British Retail Consortium (BRC) retail sales rebounded in January with ‘like for like’ sales rising 2.6% after December’s +0.3% fall with ‘total sales’ more than doubling to +4.9% from +2.3%. The BRC warned that the increase could be due to higher prices adding to the value of sales.

Wednesday: the Royal Institute of Chartered Surveyors (RICS) House Price Balance for January sank to -54.7%, its weakest since December of 1992. The record low is -63.0%. The International Labor Organization (ILO) standard unemployment rate dropped to 5.2% in December from 5.3% in November. Average earning including bonuses added 3.9% as expected in December, just under the 4.0% reading of the prior month. With employment rising there can be some question about the degree of economic slowdown predicted for the next several quarters by the BOE and others.

Japan
Wednesday: consumer confidence fell 0.5 to 37.5 in January the lowest in 4 ½ years and the fourth consecutive drop.

Thursday: preliminary fourth quarter GDP was much stronger that expected a t +0.9%, a +3.7% annual clip. Even though the annual rate was more than twice the 1.5% forecast, the BOJ will not be moved to consider a rate response.

China
Money supply (M2) rose 18.94% in January over the same month a year ago. In December the gain was 16.72%.

The Week Ahead February 18 – 22
United States
Wednesday: Housing Starts for January at 8:30 ET; December 1.006 millions. Building Permits for January at 8;30 ET; December 1.080 millions. CPI for January at 8:30 ET; December +0.3%. Core CPI for January at 8:30 ET; December +0.2%.

Friday: Jobless Claims for the week of February 16th at 8:30 ET; prior week -9,000 to 356,000.

Eurozone
Tuesday: Construction production for December at 10:00 GMT; November -0.8% m/m, -0.8% y/y.

Friday: Flash Manufacturing PMI for February at 9:00 GMT; January 52.6 (preliminary). Flash Services PMI for February at 9:00 GMT; January 52.0 (preliminary). Industrial New Orders for December at 10:00 GMT; November +2.7% m/m, +11.9% y/y.

Germany
Wednesday: PPI for January at 7:00 GMT; December -0.1% m/m, +2.5% y/y.

United Kingdom
Monday: Rightmove House Prices for February at 00:01 GMT; January -0.8% m/m, +3.4% y/y.

Wednesday: CBI Industrial Trends Survey for February at 11:00 GMT; January 2.

Thursday: Retail Sales for January at 9:30 GMT; December -0.4% m/m, +2.7% y/y.

Japan
Monday; Revised leading Index for December at 5:00 GMT; November 40.0. Coincident Index for December at 5:00 GMT; November 66.7.

Thursday: Trade Balance for January at 23:50 GMT (prior day); December -20.9% y/y.

China
Monday: Trade Balance for January (release time undetermined); December +$22.69 billions m/m, +$262.2 billions y/y. Exports for January (release time undetermined); December +21.7% ytd, +25.7% y/y. Imports for January (release time undetermined); December +25.7% ytd, +20.8% y/y.

Joseph Trevisani
FX Solutions
Chief Market Analyst

Joe@fxsol.com