19‏/01‏/2009

Risk aversion returns, but it may vanish just as quickly
Markets remain caught between despair and the hope that things can't get much worse. This past week saw waves in both directions, with risk aversion rearing its head early in the week on renewed banking sector losses and overall gloomy outlooks. By the end of the week, however, a number of the key issues were being addressed (among others, additional US government bank guarantees for a major US bank; UK government considering similar bank mortgage guarantees; second half of TARP made available; US House passed $825 bio fiscal stimulus package; and US officials are now considering a so-called 'bad bank' aggregator to absorb toxic debts from banks to repair balance sheets and restore lending), raising the prospect that risk aversion may dissipate as quickly as it re-surfaced. Then there is the unpredictable sentiment shift that may occur with the inauguration of President-elect Obama and the departure of Bush 43.

The backdrop of eroding global growth remains, however, and it will be with us for many months to come. In this light, the US still looks better positioned to emerge before other major economies and this keeps the USD generally better supported. But a significant source of USD support comes from heightened risk aversion, with stock market declines the best barometer of the level of fear, and sentiment swings seem likely to remain frequent and fierce. The USD was showing signs of potentially breaking higher across the board earlier this past week, but the indications are decidedly more mixed as the week closes and the risk is now that the USD relapses and risky trades (long JPY-crosses like EUR/JPY, GBP/JPY and AUD/JPY) recover further. Still another alternative is that key markets continue to bounce around in a relatively volatile range and no clear direction emerges.

Important price levels to watch
In this highly uncertain environment, I'll be watching the following price levels as key indications of likely market direction:

Stocks: The S&P500 index is currently trading below its Ichimoku cloud, keeping the overall bias lower. I would also note that the S&P banking index has led the way lower and has made new lows for the current downturn. A daily close above 858 next week will see back into the cloud and potentially signal strength and improving risk appetites.

EUR/USD: A trend line off the Dec. 29 and Jan. 8 highs is the key to keeping EUR/USD biased lower. That trend line is at 1.3380 to start next week and later moves as low as 1.3150 by the end of next week. The key here is that EUR/USD has been making successively lower highs, potentially setting up an accelerating, parabolic decline. That trend line should not come into play if such a pattern is to unfold. Daily close weakness below 1.2950/1.3000 will open up the downside and likely see declines to the 1.23/25 lows seen last year.

GBP/USD: Currently trading below its Ichimoku cloud (bearish), Sterling was sharply rejected from the base of the cloud at 1.4986 on Friday. The base of the cloud rises to 1.5050 to start the week and ends the week at roughly 1.5150. The outlook for Sterling remains negative while below the cloud and a daily close below 1.4450/4500 may see declines to 1.4200/50 initially.

USD/CAD: Closed the week above its cloud, suggesting a new phase of strength may just be starting. USD/CAD needs to maintain daily closes above 1.2450 during next week to stay above the cloud and potentially test recent highs at 1.3000. CAD's fate will be closely tied to oil and the Bank of Canada rate decision (see below).

USD/JPY: Trading below its cloud, USD/JPY has key resistance at 90.88/91.00. The base of the cloud falls from 92.61 at the start of the week to 91.36 by the end of the week and a daily close above suggests further gains are likely. Weakness below 88.50 is needed to suggest fresh downside potential.

WTI oil: Oil remains well below its cloud and the bias remains clearly lower. However, oil may have made a potential double bottom at $32/33/bbl and this may be a catalyst to a rebound. A daily close above $41.50/80 will be the first signal that such a recovery may be unfolding.
Bank of Canada poised to cut rates next week
The Bank of Canada will meet on Tuesday and is expected to announce its rate decision at 9:00am ET. The market consensus is that the bank will reduce the key interest rate by -50 basis points to 1.0%. With the decline in economic activity and commensurate slowing in inflation, the bank will doubtless take rates lower. From the most current data we have in hand, it is clear that the Canadian economy continues to downshift.

The Ivey purchasing managers survey, which measures activity across public and private industries, sank to a record low 39.1 in December after a 40.2 read in November and 52.2 in October. Meanwhile, the employment picture continued to get grimmer. Unemployment rose to 6.6% from 6.3% in December and the uptick was actually limited by a +36.2K increase in part-time employment - the more important full-time employment measure plunged a massive -70.7K on the month.

With the fundamental picture deteriorating and oil prices revisiting 2008 lows, the bank will be hard-pressed not to cut by a sizeable amount. While the cut itself will likely get little reaction - barring a much more aggressive -75 or -100 bps decision - the accompanying press statement should elicit some CAD weakness. The expected somber assessment has the potential to see USD/CAD towards the 1.2670/80 highs of this past week.
Potential credit rating downgrade in Spain a catalyst for lower EUR
With the downgrade to Greece's sovereign credit by Standard & Poor's to A- from A this week, speculation is widespread that one of the other countries currently on "watch" will be next. The most noteworthy of the bunch looks to be Spain. While Greece and the other countries mentioned by S&P are relatively small, Spain accounts for roughly 12% of EZ GDP and is the fourth largest EUR economy. Given the timing from the point Greece was announced to be on "watch" to when S&P actually cut their rating (about six days), we think the probability that we get an announcement regarding Spain next week is significant.

One of the big reasons Spain's credit rating is in trouble is the consumer borrowing binge the country has been on over the last decade, compared to more prudent borrowing in Germany for example. From 2000-2007 Spain averaged a staggering 19% annual growth in consumer debt while Germany was barely keeping up with inflation at a 2% run-rate. That this credit expansion was unsustainable is an understatement.

To add fuel to the fire, this week we had Spain's Finance Minister Solbes downgrading the economic outlook and suggesting the country will face the sharpest contraction in the last 50 years. Unemployment is expected to surge to near 16% in 2009 with the economy forecast to contract at a -1.9% annual rate. The estimated budget deficit increase - to 5.8% of GDP in 2009 from 3.4% last year - in the face of a contracting economy makes it a prime candidate for a credit rating downgrade as well as EU sanctions for violating maximum Maastricht deficit/GDP ratios.

The implications for EUR on this as we muddle through 2009 are ominous. While many believe that the massive amount of debt the US is taking on will eventually hurt the USD, I think the risk that this global recession hurts the EUR makes more sense. When thinking about debt, we need to consider the ability to finance that debt instead of the "nominal" amount of debt actually outstanding. If recent credit watch/downgrades in the EZ tell us anything it is that the confidence in the ability of some of these countries to finance long-term debt has deteriorated. Witness 10-year bond spreads between Germany and Spain for example, at 115 bps and the highest since 1997.

The risk is that as the global economy slows further, these rating downgrades in the EZ become more pronounced and prevalent. The US meanwhile is still one of the most productive countries on the globe, which acts as a buttress to confidence in the ability to pay creditors. Not sure one can say the same about many of the European counterparts. Bottom line is that continued credit rating downgrades in the face of a significant global slowdown are a recipe for EUR disaster.
Key data and events to watch next week
The US economic calendar is ultra light next week as the Martin Luther King, Jr. Day holiday and the US Presidential Inauguration slow the action in financial markets down a notch. Wednesday kicks it off in terms of pertinent data with the NAHB homebuilder confidence survey. Thursday is the busiest day and rounds out the week with housing starts/permits, initial jobless claims and weekly crude oil inventory data.

It is a bit busier in the Eurozone and the week starts with EZ construction output and the European Commission economic forecasts on Monday. The EZ and German ZEW surveys of economic sentiment are on deck Tuesday. Wednesday sees German producer prices while Thursday has French consumer spending and EZ industrial new orders. Friday closes things out with French business confidence and PMI manufacturing reports.

The UK has a modestly busy schedule, starting with Rightmove home prices on Monday. Tuesday has consumer prices lined up while Wednesday brings the BOE minutes and December employment. The CBI Quarterly Industrial Trend report highlights Thursday while GDP and retail sales finish off the week on Friday.

Japan is uncharacteristically busy and this could see a pickup in JPY price action in the Asia session. Monday has industrial production, nationwide department store sales and the key tertiary industry index. Tuesday sees consumer confidence and machine tool orders. On Wednesday the leading economic index is due while Thursday has the BOJ rate decision (which is likely to be a non-event).

Canada has a plethora of economic events lined up as well. Monday kicks it off with international capital flows. On Tuesday we see manufacturing shipments and the key Bank of Canada rate decision (more on this above). Leading indicators and retail sales are up on Thursday while consumer prices are on deck Friday.

The agenda down under looks just modestly busy. Monday kicks it off with Australian preliminary trade data and New Zealand consumer prices. Tuesday has NZ retail sales and AU consumer confidence on tap. Wednesday sees NZ credit card spending and business PMI while Thursday ends the week with AU consumer inflation expectations.

19‏/01‏/2009

Week of January 18, 2009

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