The Dollar – Is the Free Fall Over?

Richard Kapsch

November 6, 2009

The Dollar staged a bit of a rally in the past two weeks. Fundamentals regarding the Dollar remain negative, but we feel the likelihood of a major correction is too great to warrant continued Dollar selling. Nor do we foresee a Dollar collapse.

Introduction

On Monday, October 26, the US Dollar hit a 14-month low against the Euro, falling to $1.5061 per Euro. In the two weeks since, however, the Dollar has staged a mild recovery, rising to a one-month high last Monday (to $1.4730) before slipping again the rest of the week. It closed Friday at $1.4847 per Euro. Meanwhile stocks turned in a robust performance with both the Dow and the S&P gaining 3.2 percent in the week, closing at 10,023.42 and 1069.30, respectively.

 

 

Background

The Dollar had been in a virtual free-fall since early March when investors started buying equities as well as all sorts of risky assets in the belief that efforts of governments and central banks around the world would produce a rapid and strong global economic recovery.

There were a number of factors that had contributed to the Dollar weakness during this period. First, the US Federal Reserve was more aggressive than its counterparts in reducing interest rates, meaning that interest rate differential moved in favor of foreign currencies, most notably the Euro, Swiss Franc and British Pound. The Euro and Swiss Franc both experienced substantial upward movements vs. the Dollar. The British Pound, because of its own internal problems, was not as strong.

Second, as international investors moved into risky assets, there was less desire, on the part of investors, to seek out "safe havens" for their funds: in the months immediately following the Lehman Brothers collapse in September 2008, investors poured money into US Treasury Bills, the safest investments on the horizon, pushing up the Dollar in the process. The Dollar's diminished status as a safe-haven currency, after March 9, sent the US currency lower.

Third, as economies around the globe began to recover, the US economy seemed to be moving in low gear. Stimulus packages in Europe, especially in Germany, appeared to generate faster growth than in the US. And China was in a class by itself. By the second quarter, China's economy was recovering at an 8-percent (annualized) rate. Investors had better alternatives than dollar-based investments.

Fourth, there has been a growing concern among surplus nations – those countries that, because of their status as current account surplus countries that have built large amounts of foreign currency reserves, mostly Dollars – that the Dollar should be replaced as the world's major reserve currency. China, with over two trillion dollars in foreign currency reserves, most of it in Dollars, has been the leading proponent for such a shift, suggesting SDRs as an alternative. In the second quarter, only 37 percent of newly-acquired foreign exchange reserves, among developing nations, went into Dollar-denominated instruments, the lowest proportion in recent memory. There is almost no chance that the Dollar will lose its reserve-currency role within the foreseeable future but the trend seems to be moving inexorably against the Dollar. (This week India spent $6.7 billion to buy 200 tons of gold – a small portion of its total foreign currency reserves but a worrying development, for the Dollar, nevertheless.)

Fifth, lower interest rates in the US and the Dollar's attendant erosion saw the US currency replace the Japanese Yen as the currency of choice (for borrowing) in a new round of carry trades (investors borrow in the carry currency and invest in higher-yielding assets elsewhere). This has been a major factor behind the US currency's current weakness.

There were two other factors – less tangible – that contributed to the Dollar weakness as well. As the Dollar sank, loss of confidence in the ability of the currency to come back drove it even lower. And confidence was also eroding in the quality of US leadership. Barack Obama was elected with a clear mandate to effect change. In the first few months after taking office, his approval ratings were unprecedentedly high. However, as the months have passed, he has been able to accomplish very little. And, as he gets nothing done (beyond his rhetoric), he loses confidence among international investors. That too has contributed to the Dollar weakness.

Finally, there is a huge Dollar overhang in the world that, should inflation in the US began to increase or if there is any hint of an increase, those Dollars could come on the market.

In short, there has been little reason to buy Dollars.

The Future

That said, is there any hope for the Dollar? Was the anemic bounce in the last two weeks all we're going to see? Or, is it possible we can still see a sustained rally in the greenback?

Last week's rally was based on two factors. Growing signs of an economic recovery that is stronger than many investors have expected has led a number of those investors beginning to fear that central banks could move toward tighter monetary policy sooner rather than later. There are substantial fears among the central bankers that a rapid recovery could bring about increased inflation (although deflation is still a major worry). Should the banks act precipitously, investors fear the banks could choke off the nascent recovery. And that would prove disastrous for risky assets. Consequently, as economic numbers in the past two weeks proved to be more positive than expected (third quarter GDP grew at a better-than-expected 3.5-percent annualized pace; the Institute of Supply Management's October index came in at 55.7 – up from 52.6 in September, and above the 50-level signifying optimism), investors once more turned to the safe-haven Dollar.

Investors' fears turned out to have been ungrounded. In its credit meeting this week, the Fed once more opted to leave interest rates unchanged, again stating that it would leave the rates at their exceptionally low levels for an "extended period" – believed by Fed-watchers to be at least six months. (The Fed did spell out, however, which indicators it was watching regarding future rate decisions: low levels of rates of resource utilization, subdued inflation trends, and stable inflation expectations. Any aberrations in any of those indicators could lead the Fed to change its interest rate posture). Nevertheless, for the time being, rates will remain low, and the Dollar will remain a carry currency.

Friday's employment report further undermined the Dollar. Nonfarm payroll employment fell by 190,000 jobs in October, compared to an expected loss of 175,000 jobs (although the Labor Department also reported that August's and September's job losses were 91,000 less than originally reported), while the unemployment rate climbed to 10.2 percent, its highest level in 26 years.

What would lead to a Dollar rally? We see several scenarios. First, the Dollar is extremely oversold and a technical correction is overdue. Second, volatility in bonds has increased making it more expensive for investors to borrow the Dollars needed to short the Dollar. And third, a number of observers believe we are in the middle of an asset bubble. The rise in stock and commodity prices has not been justified by the fundamentals. A collapse (or even a major selloff) in these assets would drive the Dollar higher.

In summary, we do not foresee a collapse in the Dollar on the horizon. And we would not continue to sell the Dollar at these levels.

The Group of 20 Meets

Richard Kapsch
 

September 27, 2009

Markets fell this week amid disappointing economic numbers and waiting for the G20 meeting. We expect little positive results from the meeting.

Introduction

Stock markets generally traded lower this week as traders moved to the sidelines awaiting the outcome of this week's G20 meeting. At midday Friday, the Dow Jones Industrial Average was down 166 points for the week (1.6 percent) at 9,654.01, while the S&P 500 Index was 25 points lower (2.3 percent) at 1,043.20.

Economic news released this week was generally disappointing, especially in the housing market. Sales of existing homes fell 2.6 percent in August (when analysts had been expecting a 2-percent increase) and sales of new homes dropped one percent the same month (vs. analysts' expectations of a 2.7-percent increase). Orders for durable goods fell 2.4 percent in August, against predictions of a one-percent increase.

All in all, it was not a good week for either the markets or the economy.

Group of 20

Heads of state from the Group of 20 began a two-day series of meetings in Pittsburgh Thursday. It was the third meeting of the Group in the past ten months. The G20 met in Washington in November in the depth of the economic crisis then met again in London in April as the world was taking its first strides out of recession.

This week's meeting should have been more upbeat than the previous two, with the global economy apparently in the midst of recovery. However, there still remained disagreements among the participants regarding futures courses of action.

The G20 were first established because its predecessor, the Group of 7 (US, Germany, UK, Japan, France, Italy and Canada) was considered to be unrepresentative of the true leaders as the global economy was currently constituted. Countries like Russia (which, in the mid-1990s, caused the G7 to be expanded to the G8), China, India, and Brazil were becoming more important than the old European stand-bys. Consequently, while the G7 continues to meet, a second group, the G20 was formed. As one might expect, however, even though the G20 includes more of the "movers and shakers," its size and unwieldiness preclude any concrete actions from occurring and limit the meetings to mere rhetoric.

April's meeting is a case in point. At the April meeting, the Group's concluding communiqué included five pledges of future action, only one of which has since come to fruition. The Group first pledged to restore confidence, growth and jobs. It is apparent that, although confidence and growth may be in the early stages of appearance, the global economy is still shedding jobs.

The Group also pledged to restore lending. The banks may be somewhat healthier but the lending hasn't materialized. Further, the shadow banking system – loan securitization – is nowhere near its old self. The Group also pledged to strengthen financial regulation and restore trust. So far, there have been few changes in regulation (although regulation reform is slated to be a major topic at this week's meeting).

In April, the Group also agreed to fund and reform banks to prevent future crises from occurring, but the banking structure has not really changed: no large banks (since Lehman) have gone under or been allowed to close and there has been little change in the capital structure of financial institutions. Core capital as a percentage of total assets, among the major banks, has only risen by 0.56 percent, to 7.9 percent of assets.

Finally, the G20 in April also pledged to promote trade. This is the only pledge in which there has been any progress at all. Protectionism, since the onset of the crisis, is up only slightly, and no more than would be the case in any other economic downturn.

So, we should expect little from this week's meeting.

The major issue at the Pittsburgh meeting looks to be the need for global rebalancing. The US is the key proponent of rebalancing and is backed by several European nations and the IMF. The US believes that the world cannot revert to its pre-crisis model of export-dominant nations (in Asia and including Germany) dependent on consumption from countries like the US. It is already clear that US consumption, which was heavily dependent on consumer debt, will not return to its former self. US consumers have been drastically cutting debt for the past year.

The IMF has said that the world needs a "rebalancing of growth and increasing consumption in emerging markets to have enough growth" to counter the loss of growth among the developed nations. The G20, the IMF states, also needs "to develop a long-term growth model."

The US plan includes the establishment of a peer-review process which will allow G20 members to hold each other accountable for implementing policies that move in this direction. (Good luck to the G20 in getting this through.) China's exchange rate policy will probably also be discussed. (By holding the renminbi down, the Chinese have fostered exports but also built up huge amounts of dollar reserves and thus contributed to the current crisis.) It is unlikely that this will get very far either.

The major opposition to the US plan will come from Germany and China. Germany who, along with China, is one of the world's major exporters, believes the conference should concentrate on regulating the global financial system.

China, which is paying lip service to the US proposal, really believes its own course of action – stimulating infrastructure and increasing bank lending – is the right course. China may have a point.

China has been criticized for going back to the same economic model that has enabled it to achieve 8-percent-per-year growth and better for the past two decades: expansion of exports at the expense of domestic consumption. On the surface, it appears the critics have a point. China's stimulus package, enacted in November, has allowed the Chinese to achieve annualized growth of 7.9 percent in the second quarter (after 6.1-percent annualized growth in the first quarter). China's economy is now expected to grow 8.3 percent for all of 2009 and 9.3 percent in 2010.

Household consumption has risen 9.3 percent since implementation of the stimulus package but fixed investment has gained 14.8 percent. According to Martin Wolf of the Financial Times, this rising ratio of investment to GDP could indicate declining returns on capital and the corresponding surge in credit and money could lead to an asset bubble (other analysts have come to the same conclusion).

In China's defense, although consumption was only 35 percent of GDP in 2007 (compared to 70 percent in the US), and approximately 41 percent today, for the past thirty years, consumption has accounted for 60 percent of China's growth. Between 2006 and now, the growth rate of consumption in China was more than 8 percent a year, Asia's highest consumption growth rate.

The G20 may criticize China and its exchange-rate and economic policies, but don't expect any agreement from the Chinese. In fact, don't expect very much from the entire G20 meeting.

Indian Markets

The Bombay Sensex Index was virtually unchanged this week, falling 48 points (0.2 percent) in lackluster trade. The index generally mirrored other world markets. The Indian Rupee was essentially unchanged in the week, closing at 48.15 Rupees per Dollar, up from 48.18 a week earlier.

 

 

 

 

 

Bombay Sensex Index – One-Year Chart 092409

 

Indian Rupee vs. US Dollar – One-Year Chart 092409

Outlook for the Dollar and the Japanese yen

Since the middle of June, the Dollar and Japanese Yen have outperformed other currencies because of their safe-haven status. We think this will continue over the near-term but believe both currencies can move substantially lower in the long run.

Stock markets drifted lower again this week on continued concerns about the strength of the global economic recovery. The Dow Jones Industrial Average finished the week at 8,146.52, down 134 points (1.6 percent), while the S&P 500 Index closed Friday at 879.13, off 17 points (1.9 percent). Meanwhile, the US Dollar and Japanese Yen gained against other major currencies. The Dollar gained 0.4 percent vs. the Euro and 1.1 percent against the British Pound. But the Yen outperformed all currencies, finishing the week with gains of 3.6 and 4.1 percent against the Dollar and Euro, respectively.

For the first six months of the year, the dominant forces driving currency trading have been the desire to acquire risky assets during periods when the economic outlook was improving vs. the need to find safe-haven assets in times of economic uncertainty. From March until the middle of June, traders were encouraged by reports that the end of the recession was in sight and bought the Euro, Swiss Franc and British Pound accordingly. These currencies were considered to be riskier assets.

Since mid-June, however, the economic news has generally been disappointing and traders turned to the Dollar and, especially, the Yen as safe-haven currencies. The Dollar has traditionally been considered a safe-haven currency but putting the Yen in this category seems counterintuitive. The US economy, until late-2008, has been the strongest economy, among developed nations, and would appear to warrant the Dollar's safe-haven status. The Yen, on the other hand, represents an economy that only recently emerged from its so-called "lost decade," during which it struggled with slow economic growth and near-deflation. Even now its economic prospects appear bleaker than those of any other developed nation.

In this article, we will examine the prospects for, first, the continuation of the risk vs. safe-haven scenario and, second, look at the prospects for both the Dollar and the Yen in coming months.

Analysis

In addition to its role as the currency of the largest and strongest economy in the world, there have been two other reasons for the Dollar's status as a safe-haven currency: its continued strong performance from roughly 1981 through 2002; and its role as the reserve currency of the world. There are signs that all three of these reasons are becoming less important to investors.

In most other global recessions, it has been the US that has led the world to recovery. Because of the demand by US consumers for world goods, many countries have come to depend on the US to support their own export-dependent economies. This has been especially evident in the emerging economies, but developed nations like Japan and Germany.

This time the situation could be significantly different. US consumers, who in the past, took on exceptional debt to fund their spending habits have become more concerned about reducing their debt-load, in effect, de-leveraging. As we pointed out last week, consumer spending which, in good times, constituted seventy percent of gross domestic product will not begin to approach that level for years to come. Consequently, US economic growth, as the country emerges from the recession, will be significantly slower than in past recoveries.

Before the US began to slip into recession, there was talk that the world economies were "de-coupling" - becoming less dependent on the US. But when the US economy started to slide, it quickly drove the rest of the world down with it. Now, however, there are signs that some economies, especially among the emerging markets, may be starting to recover without help from the US. China, India and Brazil all seem to be doing well without US help (although there is some question as to how effective, long-term, China's stimulus package will be, and to how quickly Brazil recovers should commodity prices began to decline again). Consequently, we are once again hearing the "de-coupling" talk.

Should the dominant economic role of the US continue to decline, and, as international investors begin to realize this, they could begin to look for alternatives to the Dollar.

In 1981, after Ronald Reagan was elected President, the Dollar became the favored currency among international investors. Part of it had to do with Reaganomics but much also resulted from the global perception of Reagan as a strong leader, particularly after the fall of The Berlin wall and the demise of Communism. It also came from the respect accorded the US in the world.. Most traders that I talked with in those days had one strategy: buy the Dollar on any weakness.

The perception of the Dollar changed with the election of George W. Bush. The US lost respect throughout the world and the Dollar declined with that loss of respect. Perhaps Obama can regain some of that lost respect. Most analysts today, however, appear to believe a further decline in the Dollar is inevitable.

Lately, there has been much talk about the need for a new global reserve currency. In March one of China's top central bankers called for increased use of the IMF's special drawing rights as a partial replacement for the Dollar. More recently, the Russians have joined the chorus calling for a new reserve currency. In the past two weeks, the Chinese have made two more moves toward moving away from the Dollar. One week ago, the Chinese passed several rules authorizing specially-approved companies to begin pricing goods in renminbi. And Thursday, at the G-8 meeting in L'Aquila, Italy, a Chinese official again called for development of a new reserve currency.

Much of the talk about the need for a new reserve currency is politically-motivated. There is widespread resentment of the United States and its apparent attempt to exercise global hegemony. Talking down the Dollar is one way to bring the US down to size.
A short-term move out of the Dollar is not realistic. China, Japan and Russia have substantial amounts of Dollar reserves invested in US treasuries and other securities. Any immediate whole-sale move out of the Dollar would drive the Dollar down and cause massive losses in these countries' portfolios. So any large-scale selling will not happen. But look for these countries to do what they can to ensure future diversification. The US cannot become complacent about its current status.

The strength of the Japanese Yen is harder to fathom. Until a year ago, the Yen was the weakest of all the major currencies. Interest rate differentials had been the most important factor affecting currency values, with traders buying those currencies whose countries had higher interest rates. The Yen had also been a key part of the so-called Yen-carry trade: Traders and investors would borrow Yen at Japan's near-zero interest rates, sell the Yen, and buy higher-yielding securities in other currencies. Ultimately, when the trader unwound the trade he would be able to buy back Yen that had depreciated since the original sale. These trades had been consistent winners.

In 2008, with asset values generally plummeting, traders were forced to liquidate various positions to cover losses on these assets and the Yen-carry trades were some of the first to be liquidated. The massive liquidation of these trades drove the Yen higher. As the Yen began to appreciate, it gained momentum. It soon developed a life of its own and became another safe-haven currency.

There is very little fundamental reason to buy Yen. Japanese interest rates are virtually zero and have been near zero for a long time. As mentioned above, Japanese economic prospects are not good.

There has been some good news out of Japan in the past week. Growth in Japanese industrial output matched a 50-year record in May (albeit from a very low level), exports appear to have stabilized, and Japan's Tankan index showed improvement in the April-June quarter (although still extremely negative). However, Japan's GDP contracted by 3.6 percent and 3.8 percent in the last two quarters and is expected to decline by 6 percent for the entire fiscal year.

Japan faces an output gap (the difference between actual growth and potential growth) of 8.5 percent. One private forecaster has predicted that the Japanese economy will grow at a 2-percent pace in the fiscal year beginning next April. But the government's own Advisory Council on Economic and fiscal policy forecasts only 0.6 percent growth for next year. Economists project that it could take Japan 3 to 5 years to reach the growth rate it achieved in the first quarter of 2008.

Japan's main problem is that its economy remains heavily dependent on exports. Japan thus is reliant on growth in both the US and Europe. Slow recovery in those areas means an even slower recovery in Japan.

One potential negative factor traders should consider when buying Yen is the possibility of currency intervention by the Bank of Japan. Japanese officials are well aware that the strong Yen is making it even harder for Japan's export-dependent economy to recover.

 

Forecast

We expect the economic recovery in the developed nations to be slow and to proceed in fits and starts. The uncertainty associated with this type of recovery should mean that investors will continue to seek out safe havens, specifically the Dollar and Yen, at least for the short-term. As the year progresses and signs of economic recovery become more evident we would be a seller of both currencies.

 

Indian Markets

Indian stocks suffered their biggest weekly decline in eight months. The BSE Sensex Index finished the week at 13,504.22, a decline of 9.4 percent. Selling began in earnest on Monday with the announcement of the budget. The budget emphasized support for the poor and for the economic recovery instead of stressing the economic reforms investors had been hoping for. The Sensex fell 5.8 percent on Monday alone.

The Indian Rupee closed the week at 48.91 Rs. per Dollar, down 2.6 percent for the week. The Rupee suffered the same fate as other risk-oriented currencies, with traders moving into the Dollar and Yen, the safe-haven currencies.

We look for both stocks and the Rupee to continue their trend lower next week.

 

Disappointing Week

Stock markets struggled this week, beset by weaker-than-expected employment numbers as well as other disappointing economic reports. We predict a slower-than-expected recovery and a near-term decline in stock prices.

US stock markets closed lower Thursday, in a holiday-shortened week marked by large swings in the major averages. The Dow Jones Industrial Average ended the week at 8280.74, down 223 points on the day and 188 lower (1.9 percent) for the week. The S&P 500 Index finished at 896.43, off 2.9 percent for the day and 2.4 percent for the week.

On Thursday, the markets were reacting to a surprisingly weak employment report. The Labor Department reported that the economy lost 467,000 non-agricultural jobs in June, compared to a revised loss of 322,000 jobs in May. Economists had predicted a loss of only 367,000 jobs in the month.

The employment numbers, and the market's reaction to those numbers, were disappointing given the fact that the markets had just completed their best quarter in more than ten years. During the quarter, the Dow gained 11 percent, while the S&P rose more than 15 percent. But the market's performance over the past three weeks has been less than sterling, with both indices down more than 5 percent in that time frame.

"Green shoots" - indications that the recession may be mitigating - had been the primary factor driving the "bull" market earlier in the quarter, but solid evidence supporting the so-called "shoots" has been lacking lately, and investors are now not only asking if the bull market can continue, but whether there is really an economic recovery on the near horizon.

In this article, we will take a closer look at the numbers and try to provide our own prognosis for both the economy and the markets.

Background

Earlier in the year, both the Obama administration and the Fed (as well as other central banks) seemed to be making all the right moves in engineering a recovery. The Treasury, in cooperation with the Fed, had finally come up with what appeared to be a workable plan for repair of the banking system. Congress quickly passed a $787-billion stimulus package. Fed Chairman Ben Bernanke, a student of the Great Depression, seemed to be pulling the right wires in order to avoid a repeat of that event. And the economic numbers, while not exactly demonstrating a turnaround, at least were not falling as precipitously.

There were other hopeful signs. Global shipping rates have jumped over 400 percent in the first six months of the year. Commodity prices have doubled.

China, last November, passed a stimulus package of its own, worth $586 billion. Economic reports out of China showed solid growth in the first quarter, and people began to talk of a Chinese-led global recovery.

India also showed promise: the Congress party scored solid gains in May elections, presaging positive economic results and this week the government was expected to forecast that GDP could possibly expand by 7 percent this year.

But there are storm clouds as well. The banking system still faces a mountain of questionable debt that has to be either sold off or written off. A number of analysts believe the government's much-ballyhooed stress test only papered over the real problems. The government has yet to attack the toxic-asset problem and only this week is expected to announce the participants in its partnership program.

The threat of inflation, and the central banks' reaction to the threat, raising interest rates prematurely, could choke off the recovery. However, there is still talk of deflation. Prices in Japan, for example, have fallen sharply and the Eurozone also recently recorded its first drop in prices. Officials in both areas, however, have said that deflationary conditions are not a real problem, only a fleeting occurrence. (Deflation becomes a threat to the economy if consumers and businesses, fearing deflation, decide to wait for lower prices and put off spending.)

Some economists believe that any improvement in the economy as been the result of the administration's stimulus package and the Fed's massive easing, that neither condition is sustainable. This week, administration officials began to talk about the possibility of a second stimulus package, if necessary. But, given all the talk lately about the Federal deficit, and the public's apparent aversion to deficits, we believe another stimulus package may be difficult to come by. And, inflationary concerns may limit the Fed's hand in coming months.

In the meantime, consumers and businesses are not spending. Household, business and even government balance sheets are extremely over-leveraged. Consumers and businesses are extremely concerned about their debt and are likely to continue to de-leverage before they resume their spending.

Some analysts also believe that a recovery may be led by inventory-replenishment - a shortage of inventory, caused by companies working off available stocks before producing new supplies - could provide a boost for the economy. So far, however, there does not seem to be any evidence of this happening (more on this below).

 

The Numbers

US economic numbers this week were, on balance, disappointing.

The Conference Board's index of consumer confidence, released Tuesday was 49.3 for June, a drop from the 54.9 registered in May. Economists had expected an increase in the index to 57.0, so the release came as a shock to traders, and stock markets traded lower on the news. Consumer spending accounted for almost 70 percent of GDP growth prior to the onset of the recession (it is much lower now) and spending would have to regain that percentage for the economy to recover any semblance of its former self. With consumers currently engaged in a massive amount of de-leveraging, as they try to rebuild their balance sheets, the Conference Board index reading doesn't bode well for the consumer sector.

The second key number to confront the markets this week was the Institute of Supply Management's manufacturing index, released on Wednesday. That index recorded an improvement in June to 44.8, from the 42.8 registered in May. The June reading was its highest level since August 2008. Despite the fact that the index doesn't turn "bullish" until it exceeds a reading of 50 (reflecting the fact that more than 50 percent of the respondents are bullish), and even though the reading was slightly less than the 45.0 expected by economists, investors still hailed the number as encouraging for the market and the market staged a nice rally in response.

However, the base reading masked some disturbing underlying numbers. That same report showed that inventories were down 2 percent from the previous month, to 30.8 percent, a 27-year low. In addition, new orders declined 2 percent also, to 49.2. Economists had been predicting that the economic recovery could be led by inventory rebuilding as firms, having run their inventories to rock-bottom levels, were forced to begin rebuilding stocks. Based on the ISM report, that isn't happening yet.

The third area of concern this week was the employment situation. On Wednesday, ADP reported that its survey of employers (taken as a harbinger of the government's employment report) showed employers shedding 467,000 jobs in May, down from 532,000 in May, but still an imposing number. Then, as cited above, the Labor Department reported its larger-than-expected drop in non-farm payroll employment. Investors had been hoping for at least the beginning of a trend of improvement in the labor situation, but that too doesn't seem to be happening.

There were some glimmers of hope among the numbers released this week. The Case-Shiller index of house prices in 20 major cities reported that home prices only fell 0.6 percent in May, compared to April, and were down 18.1 percent from a year earlier. This was a slight improvement on the previous month's reading. In addition, pending home sales were up 6.7 percent in May, from May 2008. Economists cited falling home prices and government tax incentives as the primary reasons for the increase. And, on Thursday, the government reported that factory orders rose 1.2 percent in May, on top of a 0.7 percent increase in April

 

The International Situation

Those investors looking for help overseas had to be somewhat disappointed as well.

Purchasing managers' indices in the UK, the Eurozone and China all showed improvements in the latest readings. But those improvements had to be considered pyrrhic victories. China's PMI recorded the best reading, rising to 53.2 in June, from 53.1 in May. But PMI readings in the UK and Europe remained below 50, with the UK PMI rising to 47 in June, from 45.4 in May (albeit better than expected), while Europe's rose to 42.6, its 4th consecutive monthly increase and a 9-month high. Nevertheless, with the exception of China, all the readings remain under 50, signaling only that the recession may be abating, not that a recovery is underway.

Earlier in the week, the UK reported that its GDP declined 2.4 percent, quarter-on-quarter, in the first quarter, revised from a previously-reported decline of 1.9 percent. The 2.4-percent drop was Britain's largest in 50 years.

Also during the week, Japan reported its Tankan index rose to a reading of minus-48 in the April-June quarter, up from minus-58 in the January-March quarter. Although an improvement, economists had been forecasting an improvement to minus-43. Japan also reported that industrial output rose 6 percent in May, the same increase it reported for April. However, the increase was less than expected (+ 8.8 percent) and industrial production was still down 29.5 percent year-over-year. Next week, the government is expected to predict that GDP will grow between 0.5 and 0.6 percent in the fiscal year beginning April 2010, compared to a forecasted 3-percent decline for the current fiscal year (private forecasters predict Japan's GDP will decline 6.6 percent this year).

Prognosis

We believe that the recovery in the economy will be much weaker than many investors hope for and that the recovery period will be much longer than expected. As a result, we think the stock market will continue to struggle and could undergo as much as a 5-to-10 percent decline from current levels.

Economic numbers will continue to be less than robust. In addition, we think that the recent run-up in commodity prices, instead of being a result of economic improvement, could actually be due to Chinese stockpiling of supplies (on Friday, the Financial Times reported that the spike in oil prices on Tuesday, was due to massive oil purchases by a rogue trader at a London commodity firm, not fundamental factors). We look for commodity prices to back off somewhat in the next few weeks.

China's stimulus may not carry over to the global economy, as hoped. The stimulus package has been mostly directed toward state-owned firms and infrastructure spending, which may not have much lasting impact on its economy. Exports continue to decline.

Global banking will continue to be a problem. We think that the government will not address the toxic-asset problem in a sufficiently aggressive manner. Until banks are forced to recognize and write-off these assets, the lending needed to foster economic recovery will not occur. And, the banking situation in Europe is even worse, especially in Eastern Europe and Russia.

Consumers and businesses will continue to de-leverage, until they regain the confidence in an economic recovery. This week's consumer confidence report shows that resumption of confidence is some distance off.

Finally, we believe the inflation/deflation question is a non-issue, We have faith that Bernanke will be able to negotiate the right course, regarding monetary policy.

Indian Markets

Indian stocks gained this week, on expectations the government will revise its forecast for GDP growth this year to seven percent. Short-covering ahead of next week's budget added to the rally. The Bombay Sensex Index closed Friday at 14,913.05, up 1.7 percent for both the day and the week. We look for the market to move higher next week. The Indian Rupee finished the week at 47.920 Rupees per Dollar, virtually unchanged on the week. We expect the Rupee to lose ground vs. the Dollar next week, as traders run to the safe haven of the Dollar.

An Inconclusive Week

This week's piece will only offer a brief look at the markets.
	Stocks and currencies generally moved in trading ranges this past week with investors and traders appearing to grasp for any piece of news that might support a bullish posture. Stocks finished the week a bit lower, with the S&P 500 doing somewhat better than the Dow. A major sell-off in both indices on Monday was offset by a rally Thursday. On Friday, the markets were down on news that the US savings rate had climbed to a 15-year high. The Dollar was generally lower against most other major currencies in lackluster trading, although it finished the week unchanged vs. the British Pound. In stocks, any news that reflected the current uncertainty regarding the health of the global recovery was met with selling. On Monday, news that the World Bank had lowered its forecast for global growth in 2009 caused widespread selling. However, on Thursday, stocks rallied after the Fed indicated, at the conclusion of its two-day FOMC meeting Wednesday, that it would keep rates low for an indefinite period because of continuing signs of economic weakness. In our opinion, investors seem to be clinging to "green shoots" optimism rather than basing their decisions on a solid grounding of analysis. So far, there has been little evidence of a recovery; rather, all we have seen are numbers that show the economy is not falling quite as fast. Investors continue to believe that, based on talk from the Obama Administration regarding the effects of its stimulus and on the extent of the quantitative easing from the Fed, we will soon be back to the "happy " conditions that existed in 2007. We think investors will be disappointed - and soon. As we have pointed out several times in the past few weeks, we believe the recovery will be slow and drawn out. What's more, the rate of growth that is ultimately reached will be well below what the economy experienced in the years before the recession began. The saving rate, reported Friday, is one indication of that. Before the crisis, consumers borrowed heavily on their home equity and their credit cards. Now they are paying down that debt and may never revert to their old spending habits. We think that he markets are beginning to reflect this realization and that the next major move could be downwards.

Uncertainties Linger Over the Markets

Introduction

Stock markets stalled this week, with economic uncertainty outweighing positive economic numbers. We believe the positive numbers are flimsy while major hurdles must be overcome before the economy, and the markets, can improve. The problem of toxic assets must be addressed with greater steps taken toward global balancing.

Stocks traded lower this week as tepid economic numbers failed to overcome lingering uncertainties. The Dow Jones Industrial Average closed Friday at 8,539.73, down 15.87 for the day, and down 259 points (2.9 percent) on the week. The S&P 500 Index ended the week at 921.23, up 2.86 for the day but 25 points lower (2.6 percent) for the week.

Concerns about the true progress of the economic recovery, particularly the health of the nation's banks, dominated trading. On Monday, news that manufacturing in New York state (as per the Empire State manufacturing survey) was recovering more slowly than expected set the tone for the day. Warnings from the European Central Bank and the IMF about bad bank loans, especially in Europe, added to the gloom.

On Tuesday, news that Standard & Poors downgraded 22 US banks sent the financial sector sliding and with it the entire market. The ratings agency believes that President Obama's new financial regulation plan, released this week, will cause major problems for banks. Also on Tuesday, the Commerce Department reported that industrial production had declined 1.1 percent in May, overriding news of better-than-expected housing starts.

The one positive day for the markets came Thursday, following a report that the total number of people receiving jobless claims declined, for the first time this year, by 148,000. Nevertheless, 608,000 new applicants still filed applications. The market was also helped by better-than-expected readings in the index of leading indicators and from the Philadelphia Fed survey, which said that manufacturing declined at a slower pace than expected. (These are less than momentous reports, we might add.)

Market bulls seem to be grasping at any piece of positive economic news, no matter how flimsy it may be. They are being encouraged by government officials who, almost to a man, appear to believe the worst is over. We believe the global economy still faces major hurdles and that the road to recovery will be rocky. We also believe that officials are beginning to make the same mistakes the Japanese made in the late 90s. Consequently, we foresee some major corrections ahead.

In the rest of this article, we will try to put this week's economic data into perspective. We will also examine two of the major hurdles facing the economy: the problem of toxic assets and the need for global rebalancing.

 

The Economic Data

The three pieces of economic data this week that investors most wanted to hang their hats on were the housing starts data, the weekly jobless claims, and the Philadelphia Fed survey.

Housing starts draws the headlines because it was the decline in the housing market that kicked off the current recession and most economists believe a recovery in the housing market must occur if we want to get back to where we were two years ago. Starts rose to an annualized rate of 532 million houses in May, a gain of 17.2 percent. Yet, three factors must be kept in mind. First, the jump in starts follows some dreadful numbers in prior months. The May gain comes on top of an April decline (annualized) of 12.9 percent. And the May 2009 numbers were still 45.2 percent lower than May 2008. One up-tick doesn't constitute a trend. Second, house prices are still falling. According to the Case-Shiller index of major city home prices, prices are still falling at an annual rate of 19-20 percent. Third, mortgage rates have increased along with the recent rise in long-term bond yields, making it harder for buyers to finance home purchases.

The decrease in the number of people receiving unemployment insurance must also be taken with a grain of salt. Part of the decrease has to be people whose claims have run out, while the number filing new claims continues to exceed 600,000 a week. The unemployment rate is at its highest level in 25 years and the economy is still losing hundreds of thousands of jobs a month. Granted, 500,000 in April and 345,000 in May are better than the better than 600,000-per-month pace we saw earlier in the year, but the economy still lost well over 800,0000 jobs in the past two months alone. Not the sign of a robust economy.

The Philadelphia Fed survey reported that manufacturing in the mid-Atlantic region is declining at a slower pace, yet the Empire State manufacturing survey reported manufacturing in that area declining at a greater rate than expected. So it too does not appear to be heralding a great change in trend.

Over all, we see a lot of wishful thinking on the part of investors as they read these reports, trying to find something that can justify an economic recovery. So far, there's not a lot there.

Toxic Assets

Last October, following the Lehman Brothers demise, the main concern of then-Treasury Secretary Hank Paulson was the amount of so-called "toxic" assets on the books of the nation's major banks. His Troubled Asset Relief Program (TARP) was intended to address this problem.

In March, when current Treasury Secretary Timothy Geithner finally unveiled his bank bail-out program, dealing with toxic assets constituted one of the main pillars of the plan.

Geithner proposed government-sponsored markets in which investors (as part of public-private investment funds), with the help of loans from the Fed and the FDIC, would buy the toxic assets from the banks and then sell them later, hopefully at a profit. The plan, as proposed, however, had a number of problems: number one being the potential unwillingness of the banks to sell the assets at a big loss and take the accompanying write-downs.

Since Geithner's program (which also included the stress tests and the need for banks to raise additional capital) was proposed, the toxic-asset portion of the plan has not gotten off the ground.

Investors are hesitant to take part, afraid that Congress will retrospectively limit any profits they make. And regulators are beginning to ask whether the plan is even necessary.

On June 3, the FDIC postponed indefinitely plans for a pilot program that would have purchased $250-billion worth of the bad assets. Sheila Bair, Chairman of the FDIC, said, "Banks have been able to raise capital without having to sell bad assets which reflects renewed investor confidence in our banking system."

The IMF has estimated that total losses from bad loans and toxic assets could total $1,060 billion, through 2010. So far, banks have written off a total of $564 billion, leaving $496 billion supposedly to come. That's a lot of capital to have to raise. As one analyst noted, "When you have to refill your capital base, you can't make new loans. That's the definition of a zombie bank."

There has been a lot written comparing the current crisis with the Japanese banking crisis of the late 1990s. At that time, the Japanese were reluctant to force banks to write off the bad loans on their books, fearing that a number of banks would be forced to close and that many jobs would be lost.

The Japanese were also criticized at the time for halting their stimulus program too soon. US officials have repeatedly said that their response (to the current crisis) would be different from that of the Japanese. So far, the current response looks an awful lot like theirs.

 

Global Rebalancing

One of the problems that characterized the global economy prior to the current crisis was the imbalance between so-called deficit nations (those with large current account deficits) and surplus nations (countries with current account surpluses). The surplus nations (China, Japan, Germany) were characterized by high savings rates and were export-dependent. The deficit countries (primarily the US) had low, or negative, savings rates, extensive household indebtedness, and bought the exports from the surplus countries.

This system began to unravel with the collapse of home prices. US consumers had been borrowing extensively against their home equity. When that disappeared so did their borrowing (and spending).

Many government officials (and possibly economists, as well) seem to believe that an economic recovery will return the global economy to its status as it existed before the recession began. This is not going to happen for quite a while.

US consumers are scared. They are now in the process of de-leveraging - rebuilding their balance sheets. The US household savings rate has risen from near-zero to about 5.2 percent. It will rise further.

Meanwhile, for all the talk of Chinese stimulus and economic recovery, the stimulus has gone to business investment and not to consumption. They too appear to expect a return to the pre-crisis global economy.

Germany seems to be in the same boat. Chancellor Angela Merkel believes the Germans have spent enough already on stimulus efforts. She too seems to think that US consumers will soon begin buying again.

We think there will be quite a number of disappointed officials and disappointed investors in the next few months.

 

Indian Markets and Gold

Indian stocks snapped their 14-week winning streak this week, finishing the week with a 4.7 percent loss. The SENSEX Index closed Friday at 14,521.89, up 256.36 on the day. Profit-taking, following the three-month rally, was the primary reason for the sell-off. The Rupee lost about one percent in the week, closing at 48.07 Rupees per Dollar. Risk-taking gave way to uncertainty and the Dollar gained against most currencies. Gold marked time, finishing the week with a small loss, at 935.30 per ounce.

We look for the Dollar to gain on the Rupee in the early part of next week, with further selling of Indian stocks. Gold should continue to move sideways.

 

 

 

 

Currency Outlook

Since the beginning of the year, the US Dollar has risen in times of uncertainty and sold off on news of economic recovery, with investors willing to exercise their appetite for risk. There have been signs over the past two weeks that this scenario may be changing, and that the Dollar may now begin to recover on expectations of higher US interest rates. We believe that this is premature and that the Dollar will only respond to more concrete signs of economic recovery.

Most stock markets traded in relatively narrow ranges this week as investors seemed to be awaiting new direction regarding the global economic recovery. The Dow Jones Industrial Average finished Friday at 8,799.26, up 36 points (0.4 percent) for the week, while the S&P 500 Index closed at 946.11, gaining 6 points (0.6 percent). Both averages traded within about a one-percent differential between their highs and lows for the week. Continued indications of economic recovery are pitted against concerns over rising oil prices and higher long-term interest rates derailing the economy.

The US Dollar also traded in narrow ranges vs. other major currencies. The US currency closed at $1.4022 per Euro, up 0.4 percent for the week, and at 98.24 Japanese Yen per Dollar, a gain of 0.6 percent. The strongest currency during the past week turned out to be the British Pound, which finished the week at $1.6472 per Pound, a gain of 3.25 percent. The Pound rallied on encouraging economic data, shrugging off Prime Minister Gordon Brown's political problems in the process.

In this article, we will attempt to project the future course for the four major currencies: the Dollar, British Pound, Euro and Japanese Yen.

 

US Dollar

For the first part of the year, appetite for risk (or the lack thereof) was the primary force driving currency movements. In the depths of the recession, traders who were concerned about the uncertainties surrounding the global economy, sought haven and security in both the Dollar and the Japanese Yen - the Dollar because they thought the US economy would probably lead the rest of the world out of recession, and the Yen because it seemed to show strength regardless of what was happening to its own economy.

Whenever there seemed to be positive signs of recovery, however, traders turned to higher-yielding currencies like the Euro and British Pound both of whose central banks had dragged their feet in lowering their own interest rates in the face of the crisis. Investments denominated in those currencies would likely generate better returns than those denominated in Dollars and Yen, with interest rates in the US and Japan both virtually at zero.

As the world seemed to be rising out of recession (or as the severity of the recession seemed to be diminishing), traders' appetite for risk generally drove the Dollar lower.

Now, however, we seem to be seeing signs of a shift in the manner of traders' decision-making - from one of safe-haven vs. risk-appetite to the more traditional approach of seeking out the best available alternatives.

Over the past two weeks, the Dollar has actually gained against the majors (except against the British Pound) even though economic indicators are continuing to point toward global recovery.

The Dollar's strength over the past two weeks has generally been due to two factors: higher long-term bond yields, as investors began to anticipate higher inflation down the road, and expectations that the Federal Reserve could soon raise short-term interest rates in response to both the strengthening economy and rising inflation.

US economic indicators, while not exactly pointing toward economic strength, do seem to be indicating the worst may be behind us. Last week's employment numbers, with the economy losing "only" 345,000 jobs in May (after dropping over a half-million every other month this year) were one sign. In addition, buried in the employment report were two numbers, which could bode well for the future: temporary employment, which had been averaging a loss of 73,000 jobs a month since the beginning of the year, lost only 7,000 in May; and construction employment, averaging a loss of 117,000 jobs every month this year, dropped only 59,000 in May.

Retail sales in May, reported this week, were also encouraging, gaining 0.5 percent in the month. May's increase was the first in three months. Unfortunately, much of the increase was due to a 3.6-percent jump in the price of gasoline. Excluding gasoline, retail sales were up only 0.2 percent in the month.

On Friday, the University of Michigan index of consumer sentiment rose to 69 for June, its fourth monthly increase in a row.

Economic forecasts are also rosier. A consensus of US economists believes the economy will bottom out in the third quarter, while the Paris-based Organization of Economic Coordination and Development (OECD) believes the US economy will begin to show recovery by the end of the year. The OECD's index of global leading indicators rose 0.5 percent in April, its second up-month in a row after 21 consecutive months of declines.

But for all the good news, there are still many black clouds hovering over the economy. Despite the lower number of jobs being lost, the unemployment rate rose to 9.4 percent, its highest level in a quarter century (and 345,000 jobs lost are still 345,000 jobs lost). The US international trade report, released Wednesday, reported that US exports had declined 21 percent, year-ever-year, in April, and the Fed's beige book, also released Wednesday, said that economic conditions "remained weak".

Last week's job numbers sparked speculation that the Fed, in response to an improving economy, could raise short-term interest rates by the end of the year, possibly to 0.5 percent (from the Fed's current target range of 0-0.25 percent). These expectations were reflected in the Fed Funds futures pit on the CME, where price levels of futures earlier in the week also indicated a probable increase in the fed funds rate to 0.50 percent. By week's end, however, prices had backed off and with them expectations of an imminent hike.

As we pointed out two weeks ago, Treasury bond yields have risen sharply in recent weeks. This week, 10-year bond yields reached a 7-month of high of 4.00 percent (before also receding slightly). The spread between the 2-year note yield and the 10-year bond yield had widened to 2.83 percent. This steeper yield curve was another indication of the growing concerns regarding future inflation. The concern among traders and investors was that these higher yields could choke off the nascent economic recovery before it really gets started.

This week, Jeffrey Lacker, president of the Richmond Fed issued his own inflation warning, saying that the Fed "should not delay in tightening" credit policy.

Despite these comments, we believe the Fed will refrain from raising interest rates until there are more signs of an economic recovery, not simply signs of a decrease in the economic decline. Until we see these signs, we believe the Dollar will continue to drift lower with the "risk appetite" of investors driving higher-yielding currencies higher against the Dollar.

As a postscript, the Dollar has been hurt on occasion lately by talk of some nations with large stores of Dollar reserves switching to other currencies. This week, China proposed buying $50 billion in IMF bonds, with Russia proposing to buy another $10 billion. These proposals may be politically motivated but they are also follow-ups to commitments made by these nations at the recent G-20 summit to increase IMF reserves. An official of China Construction Bank has also proposed establishing a renmimbi-denominated trade finance credit facility. These issues may become a concern for the Dollar down the line, but we see them having no effect on the Dollar's value in the near term.

 

British Pound

Last week, rumors that Gordon Brown would resign as Prime Minister drove the Pound sharply lower. Brown, whose approval rating had been steadily declining as the British economy declined, was further beset by reports of fiscal mismanagement by Labour party MPs, using taxpayers' money for all sorts of questionable (but legal) expenditures, and by a number of resignations in his cabinet. Brown, however, has been able to weather the immediate storm, and the Pound has recovered.

Economic news out of the UK has been relatively positive. The Royal Institution of Chartered Surveyors reported that house prices fell in May at their lowest annual rate since November 2007. In addition, the government reported that industrial production rose in April, for the first time in 14 months.

We believe the political situation in the UK will be a non-factor as far as Sterling is concerned. Brown must hold an election within a year. He will probably be able to hold on until then but there is little doubt that that will be the end of him. From here on out, economic considerations should be the main factors driving the currency. The Pound closed Friday at just below $1.6500 per Pound. We see little upward potential from this level, but we also do not think the currency will encounter much selling either.

 

Euro

Eurozone economic conditions are not as rosy as those in either the US or the UK. Unemployment n the Euro area reached a ten-year high in April. In Germany, which maintains the largest economy in the Euro area, there are some signs of domestic improvement: Germans bought 30 percent more cars in the February-May period than in the same period a year earlier (but only because of a 2500-euro "clunker" subsidy given individual Germans to induce them to trade in old cars and buy new ones).

German private consumption rose 0.5 percent in early 2009 (compared to a decline of 1.3 percent in the UK), but this is generally irrelevant because Germany is an export-dependent economy (the second largest after Japan, among the developed nations). German exports fell 4.8 percent in April (from March) and were down 28.7 percent from a year earlier, the steepest annual decline since records began being kept in 1950.

Also hanging over the Euro are problems among some of the weaker Eurozone members. Ireland was downgraded this week by S&P, from AA+ to AA, the second decline this year. And Latvia is struggling to prevent itself from imploding.We believe there is no inherent strength in Europe to induce one to buy Euros. The Euro will only rise as the Dollar weakens. Should the US economy show more signs of strength, we look for the Euro to decline.

 

Japanese Yen

Economic news from Japan was slightly encouraging this week. The Japanese reported that GDP fell only 3.8 percent in the first quarter, less than the 4-percent decline originally reported. A 4-percent decline in the quarter was the equivalent of a 15-percent annual decline. A 3.8-percent decline is still 14 percent, annualized. In addition, the Japanese reported that retail sales declined in April for the eighth consecutive month.

Japan, like Germany, is highly dependent on exports, in the case of Japan, both to the US and to China. The US economy is still far from reaching its pre-recession level of imports. China, on the other hand, is on the rebound. China's GDP is projected to grow 6 percent this year, which could translate into Yen strength.

Nevertheless, we believe there is little sense in buying the Yen, either because of its own merits or because it is a "safe-haven" currency. We believe it will decline to 100 Yen-per-Dollar and beyond in the next month.

Can This Rally Continue?

Stock markets continue to churn out week after week of gains. Continued "green shoots" of recovery, foreign participation and rising commodity prices all encourage investors. But concerns remain. Is the recovery only an inventory adjustment? And a burgeoning federal deficit could still derail the recovery.

 

Stock markets turned in another positive performance this week, with the Dow Jones Industrial Average gaining 263 points (3.1 percent) and the S&P 500 Index rising 23 points (2.5 percent). The Dow reached its highest level since January 6 on Friday, while the S&P saw its highest point since November 5. The S&P 500 Index moved above its 200-day moving average for the first time since November 2007.

 

Investor optimism over the global economic recovery was the key factor pushing up prices. More green shoots in the US economy, good news from overseas economies, and rising commodity prices all contributed to the euphoria on Wall Street.

 

The US Dollar also turned in a surprisingly strong performance during the week. For the past three months, the Dollar has only risen when there's been concern about the state of the recovery. Investors have consistently sold the Dollar on any good news, preferring to buy the European currencies, in order to satisfy their "appetite for risk". This week, in a break from that routine, the Dollar and the stock market moved in tandem. The Dollar gained more than one percent against both the Euro and the British Pound and almost four percent vs. the Japanese Yen.

 

At week's end, investors were again asking the questions: Is this rally for real? Has the recovery begun?

 

 

 

More Economic "Green Shoots"

 

The encouraging economic numbers really began last Friday, with the report that US GDP had only fallen 5.7 percent (on an annual basis) in the first quarter, compared to the 6.1-percent drop originally reported by the Commerce Department a month ago. The GDP numbers, by themselves, were of scant encouragement. Combined with the fourth quarter, the numbers marked the worst six-month period for the US economy in 51 years. And, should GDP show another decrease in the current quarter, it would be the first 3-quarter contraction since 1975.

 

What was encouraging in that GDP report, however, was the news that corporate profits had risen 3.4 percent in the quarter, after having fallen 16.5 percent in the fourth quarter.

 

 

Corporate profits were still down 18 percent from the first quarter a year ago, however. Nevertheless the news encouraged investors and they were buying from the opening bell on Monday.

 

The bulls were further encouraged by the Institute of Supply Management's manufacturing index for May, which came in at 42.8, ahead of the consensus estimate of 42.0. It marked the fifth consecutive increase in the index, and represented its highest reading since September. Of greater significance may have been the new orders index, which climbed above 50 (50.1) for the first time since November 2007. (Any reading in either index above 50 signifies a positive outlook for the economy - more than 50 percent of the managers polled are bullish.) More on the new orders index later.

 

The second economic report to boost the markets came on Tuesday with the report that pending home sales rose 6.7 percent in April, the fourth increase in the index in the past five months and the biggest monthly gain in more than seven years.

 

Investors also received encouragement from the job front. New claims for unemployment, for the latest reporting week, were 621,000, about in line with expectations, but down from the most recent weeks.

 

And, on Friday, the Labor department reported that the economy only lost 345,000 jobs in May, down from a 504,000-job loss in April (which had been revised downward from a previously-reported loss of 539,000), and significantly below the string of months with job losses of 600,000 or more chalked up earlier this year.

 

So, the economic news this week was encouraging, but not what one might, in all seriousness, call bullish. However, it was enough to set a bullish tone for the markets.

 

 

 

Overseas Economies

The good news from abroad, like the positive US news, also started last Friday: Japan reported a 5.2-percent jump in industrial production in April, while India reported its GDP had risen 5.8 percent in the first three months of the year. India's SENSEX stock index has almost doubled in the last two months.

On Monday, Europe and the UK also reported gains in their purchasing managers' indices. Both reported readings in the 40's (40.7 and 45.4, respectively). Like the US ISM report, neither index signified economic expansion, but both were improvements on previous months and both beat expectations.

Thursday, Europe reported that confidence in the economic outlook for the Eurozone rose to its highest level in six months in April, while German business confidence rose for the second straight month in May.

But the country that investors now think will lead the world out of recession is China. China's purchasing managers' index was reported at a robust 53.5 for May, indicating that expansion in China would continue.

 

 

 

Rising Commodity Prices

Rising commodity prices, possibly reflecting a recovering global economy, have also buoyed investors.

 

Commodity prices hit a seven-month high Monday. The S&P GSCI Spot Commodity Index rose 2.1 percent Monday to reach its highest level since November. The index is up 30 percent so far this year.

 

Among individual markets, the Baltic Dry Index (reflecting rates exporters pay to ship products) has quintupled since last fall. Industrial metals are soaring, with copper up 70 percent and lead up 50 percent (compare these gains to gold, which has risen only 5 percent in the same period).

 

Currencies of commodity-exporting countries reflect the rise in commodity prices: the Brazilian real has gained 27 percent, while the Australian Dollar has risen 33 percent. Brazil's BOVESPA stock index is up 111 percent from its lows.

 

 

 

Technical Factors

 

Bob Doll, vice-chairman and global chief investment office of BlackRock (Financial Times, June 4) believes this rally is the real McCoy. He sees the rally as being based on a combination of a market that was technically oversold in March (when the current rally started), aggressive global policy actions that halted the economic freefall, and a general sense, at the present, that the recession is in the process of moving past its period of greatest weakness.

He believes the market has been demonstrating strong momentum and expanding volumes on the rallies and diminishing momentum and volume on the downside, conditions associated with a bull-market rally.

 

He believes that the fourth quarter of 2008 and the first quarter of this year will prove to be the low points for the recession.

 

The one factor he feels is still required to confirm that this is a bull-market rally would be more solid evidence of the economic recovery.

 

So the market bulls have a lot on which to base their optimism.

 

 

 

Concerns

 

There are still major concerns, however.

 

Some economists fear that what we might be seeing is a V-shaped economic bounce, caused by inventory adjustment, rather than a broad-based U-shaped recovery.

 

Last fall, at the time of the Lehman Brothers failure, inventories were far in excess of new orders, so firms started slashing inventories and stopped producing. The Industry of Supply Management surveys reflect this. In December, the ratio of new orders (see the new order index above) stood at 0.55, the lowest level for that ratio since data began being collected in 1950. Based on the May Indices, that ratio is now 1.50. The new order index is at its highest level since November 2007. Previously, when the ratio reached a level of 1.50, firms started to restock and boost output. Some analysts believe that is what is happening now. (The same thing is occurring in the Eurozone.) Activity of this nature could result in the appearance of a V-shaped recovery and could mean that we could still see some further setbacks before the real recovery takes hold.

 

A second area of concern was voiced by Fed Chairman Ben Bernanke in testimony before the House Budget Committee.

 

Bernanke warned that a failure to bring down long-term budget deficits could result in future debt traps. He cautioned that "we have to persuade (Chinese and other foreign lenders?) that the US is serious about returning to a more balanced fiscal situation going forward." He said that he would not monetize the debt. He also said that Congress should try to stabilize the debt-to-GDP ratio at its pre-crisis level of 70 percent. Failure to do so could lead to a further rise in long-term interest rates, which, in turn, could choke off the recovery.

 

We believe the economic recovery and the current market rally are both extremely fragile. We would urge caution going forward.

 

 

 

The Indian Markets and Gold

The Bombay SENSEX Index recorded its thirteenth consecutive up-week this past week, its best run in four years. The Index closed Friday at 15,103.55, a gain of 0.6 percent (95 points) on the day and 3.3 percent for the week. The primary driving force over the past several weeks has been a massive inflow of foreign investment capital. Approximately $6 billion has been pumped into the market since March. As long as the global economy continues to recover, these flows will continue. However, we believe the market is extremely overbought and is therefore subject to a sharp correction.

 

The Rupee lost ground against the Dollar Friday (as did most currencies) and finished the week with a loss, closing at 47.215 Rupees per Dollar, down from 47.09 a week ago. If the Dollar continues its correction, we would expect to see the Rupee correct on the downside as well.

Gold tool lost ground when the Dollar rallied Friday, the metal closing the week at $955 an ounce, having reached $990 earlier in the week, $1,000 an ounce seems, to us, an insurmountable barrier and we look for a further correction next week.

 

Stocks continued their seemingly relentless climb this holiday-shortened week. The markets opened the week Tuesday with a strong gain, succumbed Wednesday to selling prompted by concerns about rising bond yields, then finished the week with strong performances on Thursday and Friday.

The Dow Jones Industrial Average gained 223 points (2.7 percent) in the week, while the S&P 500 Index rose 32 points (3.6 percent). The markets continue to feed off optimism about the nascent economic recovery. However, worries that rising bond yields could derail the recovery have been keeping investors on the defensive.

The Dollar fell against most major currencies, gaining ground only vs. the Japanese Yen, reflecting investors’ appetite for riskier assets. The Dollar fell 0.7 percent vs. the Euro, 1.3 percent against the Swiss Franc and 1.5 percent vs. the British Pound. The Dollar gained 0.9 percent against the Japanese Yen.

This week, we will focus on the issue of rising bond yields in an effort to determine whether this is sufficient reason to worry about their effect on the markets.



Background

The yield on the US Treasury 10-year bond rose to 3.75 percent Thursday, its highest level since mid-November, before falling back to 3.45 percent on Friday. Thursday’s high point represented a better-than 50 basis-point jump in the yield in a little over one week and compared to a December low of 2.1 percent (when investors were pouring into US Treasuries at the height of the economic crisis).

Longer-term yields have also risen sharply compared to shorter-term maturities, reflected in a considerably steeper yield curve: on Thursday, the spread between the 2-year Treasury note and the 10-year widened to 2.78 percent.

There are two main reasons why yields have risen: Increasing inflationary expectations - investors demanding greater yields to offset the effects of increasing inflation - have pushed up long-term yields. And investors are selling government securities that they purchased at the time of the initial panic in order to shift to other assets. Investors are responding to four major factors: "green shoots" in the economy representing early signs of an economic recovery, an increasing burden of US government debt, the risk of an inflation revival, and a flood of new bond issuances, both by the government and from the corporate arena.



"Green Shoots"

The economic news that the markets responded most to this week was a positive increase in consumer sentiment. On Tuesday, the Conference Board reported that its index of consumer confidence jumped to 54.9 in May, up from 40.8 in April (revised upward from 40.8). A consensus of economists had expected an increase to only 42.6. Then, on Friday, the University of Michigan reported its own index of consumer sentiment rose to 68.7 in May, above expectations of 68.0, and up from 65.6 in April. With consumer spending constituting two-thirds of GDP at the height of the economy, this was welcome news.

Sales of both existing and new homes posted gains in April, although the increase in new home sales fell below expectations. Existing home sales rose 2.9 percent, after falling 3.4 percent in March, while new home sales were up 0.3 percent. Also showing an increase were orders for durable goods (up 1.9 percent in April - their biggest increase since December 2007 - above analysts’ expectations).

The positive news more than outweighed the negative news: the Case-Shiller index of home prices in 20 major cities showed a record drop in prices in the first quarter, with prices in March down 20 percent from year-earlier levels. In addition, the commerce department reported that GDP fell "only" 5.7 percent (annualized) in the first quarter, compared to its earlier report of a 6.1 percent decline.

A survey conducted by the National Association for Business Economics found that more than 90 percent of economists polled believe the US recession will end this year, with about 74 percent expecting the recovery to begin in the third quarter.



The US Debt Burden

With more and more signs pointing to economic recovery, investors are beginning to shift their concern to the growing burden of US debt. Confidence in two key aspects of the government’s program for fighting the crisis - the government’s creditworthiness and the Fed’s ability to manage the money supply - is beginning to waver.

The Obama administration estimates that the budget deficit will hit $1,840 billion this fiscal year - 13 percent of GDP. Unfunded liabilities are currently four times the level of GDP. There are concerns that total public debt, which was 41 per cent of GDP in fiscal year 2008, will climb to 75 percent of GDP by FY2015, and keep rising from there.

The Congressional Budget Office predicts that the US will have a structural deficit (the deficit when the economy is operating at full potential - the economy is currently running about 8 percent below its long-term potential) equal to 5 percent of GDP by 2015. The Obama administration has said that a structural deficit of 5 percent is unsustainable and says it will "adjust" policies if the deficit reaches 3 percent (long-term). The administration has said it is committed to a sustainable fiscal policy.

An unsustainable structural deficit would have to be attacked in two possible ways. Either the government could raise taxes. One economist (John Taylor, Financial Times, May 27) has estimated that it would take ten years at an average tax rate of 60 percent to eliminate the deficit. Or, the Federal Reserve could monetize the deficit. The same economist also estimated that doubling prices over the next ten years could eliminate the deficit - a 100-percent increase in prices over ten years implies an average inflation rate of 10 percent per year. Neither course, I think, would be palatable to the American public.

The debt burden took center stage a week ago when Standard and Poors decided to downgrade its outlook for British sovereign debt to "negative" from "stable." That decision portended the possibility of reducing the UK’s credit rating from AAA to AA. S&P’s decision caused investors to begin looking at the US credit rating as well, with some analysts predicting that the US, too, could be downgraded from AAA. A decrease in the US rating could force more selling of US treasuries and would mean an imminent decline in the Dollar.

This week, however, Moody’s, a second rating service, reaffirmed its Aaa rating for the US. And a number of analysts have said that a US credit-rating downgrade is extremely unlikely in the near future. They also say a possible default by the US will not happen: the US Treasury has taxing power which would allow them to raise taxes to avoid a default. They also point out that a US default would be worse for virtually every other country in the world.



The Risk of an Inflation Revival

With "green shoots" of recovery beginning to appear in the economy, investors are starting to worry about what comes after the recovery kicks in. Both the Administration and the Fed have been spending billions, both to aid the recovery and to avoid deflation. Investors fear that a recovery will lead to runaway inflation, with the Fed, charged with having to mop up this excess liquidity, being overwhelmed with the task.

In the June 1 edition of Business Week, James C. Cooper argues that a rapid return of inflation should not be a concern. He maintains the Fed will have plenty of time to drain the excess. The high level of unemployment in the United States will exert downward pressure on wages and prices for years to come. In addition, the current record amount of idle production capacity in the US will also prevent prices form rising. According to the Congressional Budget Office, at the end of 2009, actual GDP will be running about 8 percent below potential GDP. With potential GDP growing at approximately 2.3 percent per year, actual GDP will have to grow at an annual rate of 4.4 percent just to close the gap by the end of 2011.



The Flood of new Government Debt Issuance

A total of $2,000 billion worth of new government debt is expected this fiscal year. The Treasury has already sold securities totaling $800 billion year-to-date, compared with $922 billion for all of 2008. This past week the government sold $101 billion in securities ($40 billion in 2-year notes on Tuesday, $35 billion worth of 5-years Wednesday, and $26 billion of 7-year notes Thursday). All but the 7-year notes were well-received.

Government securities must now begin to compete with corporate debt, as investors who are willing to seek riskier assets, demand higher yields.

Of concern will be the continued appetite of foreign investors for US government securities. Foreign investors currently hold approximately half $6,000 billion in government securities outstanding. Will they continue to keep buying? In addition, some foreign investors are shifting to shorter-term maturities, shunning the longer-dated issues. According to Credit Suisse, China’s holding of Treasury bills has increased significantly "from just over 1 percent of outstanding bills to nearly 10 percent recently". Their share of note and bond holdings "fell from a peak of 15.1 percent in August 2008 to 13.7 percent in March"



Are Rates High Enough to Derail the Recovery?

As we pointed out, the 10-year yield, currently at 3.5-3.7 percent, has risen from a level of about 2 percent, when the Fed first announced its intention to begin buying bonds - its embarkation on quantitative easing. But they are still well below the 5-percent level reached two years ago when the economy first slipped into recession. We believe yields still have a way to go before they really become a concern.

Stocks sold off in the final hour of trading Friday, turning what had been tidy gains in all the major indexes into losses and almost wiping out all the gains achieved by the markets during the week. The Dow Jones Industrial Average finished the day down 14.81, while the S&P 500 lost 1.33. For the week, the Dow managed to eke out an 8.68-point gain (after having started out Monday gaining 235 points) and the S&P rose 4.12 points (up 26.83 on Monday.
The primary concern among investors was the possible problems the US government was likely to have in funding its debt. Some observers feared a downgrade in the US’ credit rating.
The Dollar touched a new low for 2009 this week (on a trade-weighted basis), dropping three and a half percent against the Euro and four and a half percent vs. the British Pound. Since March 9, when stock markets around the world began their current rally, the Dollar has lost almost 12 percent against the Euro and over 15 percent vs. the British pound.


Background

Since the middle of September, when the US Treasury allowed the bankruptcy of Lehman Brothers and which date serves as the starting point for the current financial crisis, the Dollar has had two significant rallies (from mid-September to mid-November and from the end of December to March 9) and two major sell-offs (November to December and March 9 to the present date).
In attempt to find reasons for these major moves, analysts have resorted to the "safe-haven" theory: In times of uncertainty, investors and traders bought Dollars (and Japanese Yen, as well), despite the United States and Japan having the lowest interest rates among the developed nations, and sold European currencies. When the economic outlook appeared to be gaining some clarity, investors turned around and sold Dollars and Yen, having developed an "appetite for uncertainty", according to the pundits.
Thus, during the period from September to November, when things looked most bleak, the Yen and Dollar both appreciated. From November to late-December, the euphoria over Obama’s election victory and the hopes he carried regarding economic recovery led to strength in the European currencies. Then, just before Christmas, new pessimism set in and back came the Dollar. Finally, in March, when Treasury Secretary Geithner revealed his "bank bail-out package, with stress test details and toxic asset solutions, the Dollar started on its latest (and current) slide.
On Friday, an article in the Financial Times again cited the current aura of economic optimism as the reason the Dollar’s "prognosis is far from good" (implying, of course, that a reversal of this optimism could lead once more to a Dollar rebound). We agree that the Dollar’s prognosis "is far from good", however, we believe there are more deep-seated reasons for the negative outlook for the Dollar other than simply an "increased appetite for uncertainty".


Analysis

During times of "normal" currency trading, investors, taking a long-term view, tend to buy currencies whose countries’ governments are expected to maintain a strong anti-inflationary stance. Inflation is probably the single most important factor that can lead to erosion of the values of one’s assets (or, at least it was until the current financial meltdown). It was this anti-inflationary bias that led the Deutschemark to dominate all other currencies in the period leading up to the establishment of the Euro. The Bundesbank’s main goal, year in and year out, was to keep a lid on inflation.
On a short-term basis, traders tend to buy currencies whose countries offer the highest short-term interest rates. Short-term currency trading involves rapid in-and-out movements. So, in the short run, the currencies offering the highest interest rates tend to be the strongest currencies.

In conjunction with this attraction for higher short-term interest rates, investors also tend move their funds into investments in countries that promise solid economic growth. Higher growth rates usually mean higher interest rates.
Until about 2001, the Dollar benefited from all three of these factors: Historically, dating from the appointment of Paul Volcker as Federal Reserve Chairman in 1979 and continuing with Alan Greenspan, the Fed has produced a solid anti-inflationary record.
In order to retain control over inflation, the Fed, during this period, ensured that real interest rates (nominal interest rates adjusted for inflation) remained positive. Diversified investors prefer high real rates.
Finally, the US economy for most of this period was among the strongest in the world, especially among the developed nations.
There was one other factor that, we believe, contributed to the Dollar’s strength during this period. This was confidence in the US’ political and financial leadership. I remember sitting in a Swiss banker’s office in 1981, shortly after Ronald Reagan’s election as President, and listening while the banker told me how happy he and his colleagues were about Reagan’s leadership. The Dollar began to appreciate shortly after Reagan’s victory. (Margaret Thatcher’s election produced similar results for the British Pound.)
During the nineties, the combination of Fed Chairman Greenspan and Treasury Secretary Robert Rubin elicited similar confidence among investors (although Rubin’s star has since become tarnished in connection with Citigroup’s problems).
Consequently, the Dollar, especially during the 1990s, remained strong.


After 2001, however, the Dollar began to depreciate. There were a number of reasons behind this decline.
First, many economists at the time cited the large US current account deficit. Normally, countries that run large deficits of this nature ultimately have to resort to currency devaluations because they can’t attract the foreign capital necessary to finance the deficit. The US, on the other hand, was in a different sort of boat. We have since come to realize (most of us, that is) that the US needed to run a structural deficit in its current account to counterbalance the current account surpluses run up by export-dependent countries like Japan and, especially, China. Because the US economy was so strong, US consumers were really supporting the rest of the world. The US economy was the only economy big enough to absorb the exports from these countries.
In our opinion, another, and perhaps more important, reason for the Dollar weakness after 2001, was the increasing loss of confidence in the leadership exhibited by the Bush administration after 2001. Midway through this period we also saw a change in the reins of control at the Fed, with Ben Bernanke replacing Greenspan. Although Bernanke may turn out to be an effective chairman (and, in our opinion is doing an extremely creditable job), at the time, his newness sparked concern.


Outlook

We believe the Dollar’s current outlook is related to factors similar to those that led to its decline beginning in 2001.
First, on a short-term basis, because of both the economic and financial crisis, the Fed has been forced to lower short-term interest rates to virtually zero. And because nominal rates cannot go below zero, the Fed has also had to resort to "quantitative easing" - increasing the money supply by buying up all sorts of securities. To do this, the Fed has in effect been creating money. The Fed’s balance sheet has swollen to more than $2,000 billion and could grow larger. Goldman, Sachs has forecast that that the Obama Administration will sell a record $3,250 billion worth of debt in the fiscal year ending September 30.
In normal times, money creation of this magnitude would be extremely inflationary. However, right now, deflation is a more immediate concern. Nevertheless, should the economy turn around, inflation could quickly become the real problem. And many analysts believe the Fed will be hard-pressed to soak up these excess funds. In perhaps an omen of times to come, this week the Fed offered to buy $7.4 billion in bonds and was flooded with $45.7 billion in offers.
This week, Bill Gross, managing director at Pimco warned that the US could be in danger of losing it AAA credit rating. Now, the US has never defaulted on its debt and a downgrade of this nature is probably not an imminent threat. But earlier in the week, Standard and Poor lowered its outlook for the UK’s AAA credit rating to "negative" from "stable", and investors were concerned enough to sell the Pound at the time. The Dollar fell sharply on Gross’s comments.
Treasury Secretary Tim Geithner (more on Geithner below) tried to calm investors’ fears by saying the Obama Administration was committed to minimizing the nation’s budget deficit to 3 percent of GDP by 2015 (this year it is expected to reach 12.9 percent of GDP). The Congressional Budget Office believes the Administration will only be able to reduce the deficit to 5 percent of GDP by 2015 and that it will then remain at that level for some time after that.
There are rumblings of trouble among the developing countries. China has already called for expansion of the SDR as a reserve currency and has established swap facilities (where China will swap its currencies for those of other nations) with a number of countries, especially in South America. And this week, China and Brazil announced they will begin denominating trade between their two countries in Chinese renminbi and Brazilian reals. None of these steps will have much of a short-term impact on the Dollar, especially since the value of global trade is such a small percentage of total currency movements. But, they could be harbingers of the future.
Our main concern about the Dollar, however, centers on the question of confidence in the US leadership at this critical juncture. Geithner’s performance to date has certainly been less than reassuring. His initial announcement of the bank bail-out program in February was a disaster for the markets. His subsequent clarification in March was an improvement in that he provided more details in what was to come. But, subsequent performance hasn’t borne out this promise. The stress tests, in the eyes of many observers, were less than stressful. No banks have been either nationalized or allowed to fail. All will apparently muddle through.
Nothing to date has been done about the toxic assets on the books of the banks and many observers question whether his plan can work.
There are a number of observers who believe that Geithner is in over his head. Unfortunately, many of these control the purse strings of the world’s money managers.
The bright spot, among the American leadership to date, has been Barack Obama. His approval ratings remain well above 60 percent. His speeches have been fantastic. Yet so far he has failed to accomplish anything. He has let Congress have its way on most of the projects he has championed, to the detriment of those plans. His honeymoon with international investors may not last much longer (and may already be nearing an end).
This lack of confidence in America’s leaders, on top of the other tangible factors, could be the factor that sends the Dollar plummeting. Unless, of course, Obama starts getting things done.
But where does one invest? The Euro is one likely candidate, but Eurozone GDP fell 2.5 percent in the first quarter, and is expected to show a 4 percent decline for the full year. Germany’s GDP alone is expected to fall 6 percent this year. The aforementioned UK has its own problems. Japan’s GDP fell 4 percent, quarter-to-quarter, in the first three months of the year, after dropping 3.8 percent, the preceding quarter. That foreshadows a double-digit decline in GDP for the entire year.
Dollar weakness will put upward pressure on the Chinese currency and it will be interesting to see whether the Chinese can continue to keep a lid on the renminbi.