The FED Is As Confused As We Are!

China comes back from the brink, ‘fighting’ the bear market stigma as the Shanghai composite index advanced +5.57% in the O/N session. Is it sustainable? Trichet will be interesting to listen too after the ECB keeps rates on hold once again this morning. The FOMC minutes yesterday provided some excitement, not sure what, but it seems that policy makers are as confused as are any ‘lay’ investors. Interesting experience we are seeing, and it does not add up. Gold is trading above $984 (last seen 3-months ago). Now take a look at the short end of the US yield curve, where 2-year treasuries are yielding a mere +0.90%! Technically, we are trading both inflation (via gold) and deflation (lower yields)! My head hurts………

The US$ is weaker in the O/N trading session. Currently it is lower against 11 of the 16 most actively traded currencies in a ‘whippy’ trading range.

What can we say, yesterday’s ADP was mildly disappointing (-298k vs. -250k expected), however the trend towards improving labor markets remain intact. A side note, despite the weaker headline, it was the smallest pace of job losses in exactly 1-year, and we know what happened after that! The labor market remains suspect. Analysts are waiting for the next wave of wage dis-inflation on excess workers to appear. US productivity growth data was impressive yesterday (+6.6%), combined with a decline of -5.9% in unit labor costs is a winning combination to promote growth. If one superimposed the ADP print on Friday’s NFP headline, the danger lies towards further downside risks (consensus -240k). However it’s worth remembering that over the past 3-months, ADP payrolls have over-estimated the decline in BLS job losses by an average of +87k. Digging deeper, job losses were split between the goods-producing and service-providing sectors at -152k and -146k respectively. Manufacturing experienced its smallest decline 14-months, maybe because of the auto-sector and the cash for clunkers program. Interestingly though, the construction sub- sector recorded another consecutive drop in employment despite the upbeat housing data. Finally, the revisions showed a slight improvement, July’s -371k was revised to a decline of -360k.

US factory orders were disappointing (+1.3% vs. +2.2 expected). If we excluded autos and air, the factory sector remains weak and inventories remain bloated which cannot bode well for the 3rd Q. US companies have made a conscious effort to slash inventories, but the pace of slashing is slow. The ratio of inventories to shipments remains disappointing, July was 1.40 vs. June’s 1.41, and the peak was obviously March’s 1.46. In reality, the auto sector may be lean after production shut-downs, but else where in the US factory sector it remains a concern. Analysts believe that the $159b inventory unwind that occurred in real-terms in 2nd Q may have been the worst pace, but, do not expect the 3rd Q to be much better. If that’s the reality, there will be no surprises for growth in the Q as the current pace of monthly inventory reductions is insufficient to do a u-turn! Digging deeper, July’s +1.3% gain was all due to durable goods orders, as non-durable goods registered the 1st decline in 2-months and the largest drop in 10-months. Ex-transportation fell -0.7% m/m, which suggests ongoing weakness in the core-orders. Amongst the durable goods details, non-defense capital goods, ex-aircrafts (proxy for business investment) remained at -0.3%, m/m, while consumer goods and machinery fell by -1.9%, m/m and -6.3%, respectively. With non-durable goods, weakness was seen in virtually all categories.

The FOMC minutes did not surprise, and their release nowadays is as nervously anticipated just like NFP data! The market should interpret the Fed to keep rates ‘on hold’ longer than what the consensus is. They said rates are to remain ‘exceptionally low for an extended period’. One get’s the feeling that policy makers are as uncertain over the outlook and issues concerning unconventional monetary policy as we are ourselves. Regarding asset purchases, the Fed decided ‘it was not necessary to make decisions at the meeting about any potential modifications to those programs’. The internal inflation debate remains dovish. The members expect ‘….subdued and potentially declining wage and price inflation over the next few years; a few saw a risk of substantial disinflation’. Finally, they remain cautious regarding the sustainability of the growth outlook into 2010 after a recovery phase in the second half of this year. Conclusion, unless we see a strong recovery they will not begin hiking anywhere close to when analysts and dealers have been expecting!

The USD$ currently is lower against the EUR +0.15%, GBP +0.21%, CHF +0.03% and higher against JPY-0.30%. The commodity currencies are stronger this morning, CAD +0.27% and AUD +0.42%. Agh, the loonie does it to us again! When you think you are on to a winner, it takes off in the wrong direction. Yesterday the CAD reversed earlier gains and traded close to its 2-week lows on the back of further declines in stocks and commodities as investors sought shelter in safer waters. Even on good news, Sept. is a tough month to witness sustainable equity rallies. Already this week Canadian GDP disappointed (+0.1% vs. +0.2%, m/m). It’s probably a good bet that the BOC will keep lending rates low a lot longer than what the market has already priced in, similar to what Gross at PIMCO said yesterday (see below). Perhaps Governor Carney is breathing a sigh of relief. Already the BOC has said that a strong CAD is not conducive for strong growth. We can only take our cue from risk aversion attitudes, equities and commodity prices and not from any Canadian fundamentals!

The AUD gained as Asian equities erased losses, boosting speculation that investors will buy the higher-yielding assets. Despite traders previously paring interest rate hike bets after Governor Stevens’s comments earlier in the week, market psychology did a complete u-turn in the O/N session. This week we have witnessed some Australia’s data showing economic growth unexpectedly accelerated in the 2nd Q (+0.6% vs. +0.4%), which has aided the currency on expectations that the RBA will raise borrowing costs from its 50-year low. A healthy rise in commodity prices is also helping the currency cause (0.8386).

Crude is higher in the O/N session ($68.95 up +22c). Crude prices did not stray far from the proverbial home yesterday despite a bullish for prices weekly inventory report. If anything, crude prices remain under pressure following the weaker than expected US fundamental data yesterday (ADP and US Factory Orders), it managed to print a 2-week low, on concerns that the US economy is struggling to recover. The EIA inventory report fell -400k barrels compared with analysts’ projections of a decline of -600k. However, the real eye-catcher of the report was that gas stocks were off -3m barrels, way ahead of analysts’ expectations of a -900k barrel draw down (the bullish element). Distillate stocks rose +1.2m barrels, double the expectation build. Total product demand rose +0.1% over the past month compared with year-ago levels as gas demand increased +0.5% over the same period. Refinery utilization was up +3.1% points to +87.2%.Investors are keeping a close eye on Chinese equities, which technically, entered a ‘bear’ market earlier this week and is managing to pressurize global bourses and heightening investor concerns that a slowdown in lending would impede an economic recovery in their country. China has been the go-to region that the rest of the world has been relying on to drag us out of the worst recession in 50-years. Basically demand destruction remains healthy! It’s expected at the OPEC meeting next week that Algeria will demand that other members comply more strictly with production quotas as global stockpiles climb. Fundamentally, inventories are above the normal level of 61 days’ worth of demand. There is little chance that OPEC will revise quotas is the short term.

Who is buying all that Gold? Conspiracy theorists are beginning to wag their tongues and speculate that someone ‘big’ is in trouble. This always encourages a violent switch to a commodity of surety! The easiest answer would be to say that global bourses are under pressure, by default this increases demand for the ‘yellow metal’ as an alternative investment ($984).

The Nikkei closed at 10,214 down -65. The DAX index in Europe was at 5,323 up +4; the FTSE (UK) currently is 4,816 down -1. The early call for the open of key US indices is higher. The 10-year bonds eased 4bp yesterday (3.34%) and are little changed in the O/N session. Bonds’ prices achieved what we anticipated yesterday and made a break to the top-side and all this despite reasonably positive US data. Treasuries managed to reverse early morning losses as equities fell on concerns that the recent rally is outpacing the outlook for earnings. Gross from Pimco said that the US housing will be incapable of leading the US out of recession and he expects O/N lending rates are expected to stay low for a considerable length of time. Besides he also likes long bonds! With equities finding it difficult to decide on a direction there is no urgency to drive yields higher, as the Fed is expected to keep rates lower for a considerable period of time.

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