Merkel and Sarkozy need Today’s Philly Fed to Bounce

Currently, the market is betting on “convinced”, Merkel and Sarkozy are convinced that Greece will remain one of its fraternity members. Papandreou looks likely to be receiving the next tranche of IMF funds (EUR8b) to increase the chance that the private sector initiative to reschedule Greek debt will meet the required threshold. In theory, this ‘combo’ eliminates the risk of Greek default until the next IMF review in December.

Ever since Germany and France showed their hand, the EUR has strengthened, but not materially so, as investors, in the ‘house of cards’ play, deal with a Euro-zone debt debacle, tenuous US economic data and a potential Fed policy change that can confirm or reject the rising call for more stimulus. The gravest problem facing the region is the recent collapse in growth indicators. Without more rapid nominal GDP growth the Euro-zone will remain unstable almost regardless of policy action to pass around ‘limited funds’. The last thing the region requires is the US to enter an official recession, they need this morning’s Philly Fed to bounce.

The US$ is mixed in the O/N trading session. Currently, it is higher against 10 of the 16 most actively traded currencies in a ‘subdued’ session.

Yesterday’s US data offers more evidence that the economy stalled in August. Retail sales were well below analyst’s forecasts and July was revised down, even wholesale prices recorded a similar print of being flat. This gives the Fed the green light to do something at next weeks meeting. Consumers are wary to spend. All along they have been the Fed’s ‘go to’ variable. With unemployment remaining high and the recovery weak, retail and food services sales were unchanged for the prior month. PPI showed no momentum either, as lower energy costs offset higher food prices. Fundamentally, the US economy has hit a brick wall, flat sales and wholesale prices, no job growth, unemployment rate on hold (+9.1%) and inflation moderating adds up to a whole lot of nothing happening in the US economy. If we included the Euro debt debacle, the US congress inability to agree on a job stimulus package, then we are talking about another recession. The market now expects something extraordinary to be tabled at the FOMC meeting.

The dollars is lower against the EUR +0.10%, GBP +0.16% and higher against CHF -0.07% and JPY -0.06%. The commodity currencies are weaker this morning, CAD -0.22% and AUD -0.36%.

The loonie started the week under water outright and above parity as risk aversion was aggressively applied on Greek fears of a default. The currency was able to take back some of those losses, however, renewed uncertainty after an Austrian parliamentary committee delayed a vote on an increase in Europe’s bailout fund has the CAD eyeing parity again. There is some genuine interest to own the loonie at these levels by corporate Canada, once this business is concluded the currency is in real danger of weakening much further on the back of broader risk aversion sentiment. Merkel and Sarkozy can only prop up the EUR for so long.

Last week was the second consecutive week for the currency to decline as the BoC kept rates on hold as expected (+1%). Tenuous data south of the border showing the US economy hitting a brick wall does not support the currant loonies’ relevant strength. The US remains Canada’s largest trading partner and an extended slowdown will eventually percolate hard throughout the Canadian economy. Governor Carney has applied the expected ‘dovish’ tone on the Canadian economy, explicitly noting ‘the need to withdraw monetary stimulus has diminished’ which is an ‘expected about-face from the July statement. The Governor will be turning towards becoming more concerned about global growth.

Analysts are beginning to downgrade Canadian growth this year and next, largely based on a downgrade to the external environment in which the Canadian economy is operating. There are better buyers of dollars on dips (0.9924).

Governor Bollard at the RBNZ left interest rates unchanged O/N (2.50%), and signaled no urgency to raise them until the global recovery strengthens, weakening the Kiwi and dragging down the neighborly Aussie in the process. The pricing for RBNZ rate hikes over the next 12 months fell-4bp on the back of the announcement.

The AUD had tumbled earlier this week to a new one month low outright and versus the JPY on fears that Greece may default and on a weak business outlook. The NAB business confidence index earlier this week fell to-8 last month, the lowest level in two-years. Manufacturing, retail, wholesale and construction conditions all remained very weak, while mining and the service industries generally remained strong. Now that the domestic data is coming out a bit negative, there will be some questions ahead on what will happen to the Aussie economy. If anything, the RBA is likely to be on hold for an extended time, allowing investors to sell higher yielding assets.

Australia released a new methodology for calculating seasonally adjusted inflation that indicated the RBA’s core measures may have been lower last quarter. Under the new settings, CPI rose an estimated +0.7% in the second quarter and the weighted mean advanced +0.5%. There’s still strong interest to sell the Aussie on rallies and buy the dollar as it becomes tougher for the AUD to outperform while all eyes are on European issues (1.0247).

Crude is lower in the O/N session ($88.35 down-0.56c). Oil declined yesterday after the weekly EIA data reported that fuel inventories climbed, demand dropped and retail sales hit a brick wall in the US.

Last week’s EIA inventory report revealed that crude stockpiles decreased by -6.7m barrels to +346.4m, above the upper limit of the average range for this time of year. On the flip side, gas inventories moved up by+1.9m barrels (the biggest gain in three months), after increasing +200k barrels in the prior week, and are above the upper limit of the average range. The market had been expecting gas stocks to ease by-500k barrels. Fuel use fell -3.8% to +18.7m barrels a day. Refineries operated at +87% of capacity, down -2.3% points from the prior week.

The big crude drawdown was discounted because of tropical storms which reduced production. With the ongoing weakness of gas consumption crude remains better offered on rallies.

Despite gold finding a temporary base just ahead of $1,800 earlier in the week, bullion was able to erase some of the bounce gains yesterday on the back of the Chinese White Knight potential. US equities rallied for a third day, and the dollar rose against a basket of major currencies, reduced the appeal of gold as an alternative investment. Year-to-date, the commodity has rallied +44% and it is in its eleventh bull year.

Technical analysts believe that commodity prices have recently undergone a strong correction, followed by a decent consolidation and particularly as European sovereign concerns remain. Investors are guessing that the Fed will be required to ease monetary policy in answer to stimulate their economy. The Fed’s efforts to drive interest rates lower to support lending should curtail the dollar’s appeal and by default, support commodities eventually ($1,818-$8.20c).

The Nikkei closed at 8,668 up+150. The DAX index in Europe was at 5,443 up+103; the FTSE (UK) currently is 5,309 up+83. The early call for the open of key US indices is higher. The US 10-year backed up +8bp yesterday (2.02%) and is little changed in the o/n session.

Treasuries yields rallied for a third consecutive day on “eased” concern that the Euro-zone’s debt crisis may cripple the region’s banks and on pressure from this week’s supply. This is a temporary fixed income excuse as dealers begin to position themselves for the FOMC meeting next week.

Yesterday was the last of this week’s three auctions. The $13b-long bond issue was well received as everyone expects the Fed to take action by purchasing assets out the curve, which is driving buying in the long end (Operation Twist).

The 30-year bond drew a yield of +3.31%, below the previous record of +3.54% at the February 2009 offering. Indirect bidders took down +39.4%, compared with +12.2% at the August auction, the lowest level since February 2008. Direct bidders bought +17.3% of the notes at the sale, compared with an average of +11.6% for the past 10 auctions. Some dealers now see a +50% chance of a cut in interest on excess reserves at next week’s Fed meeting.

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